revisiting (again) value investing

As regular readers will know, I’m a growth stock investor.  That’s even though I spent my first six years as an analyst/portfolio manager using value techniques almost exclusively–and then worked side by side with a motley crew of value investors for a ten-year period after that.

One way of describing the difference between growth and value is that:

–growth investors know when potentially price-moving news will happen (that is, when quarterly earnings are announced) but are less sure what that news will be

–value investors know what the news will be (if they’ve done their job right, they’re holding stocks where the market has already priced in every possible thing that could go wrong.  All they need is one thing to go right).  However, they may have little idea when good news will occur.

 

Each style has an inherent problem:

–for growth, it’s hard to find rising earnings during an economic downturn

–for value, it’s possible that a long time (say, two years) may pass before any of a portfolio’s diamonds in the rough are discovered by the market.  In that case, the manager will likely be fired before the portfolio pays off.  His/her successor will either reap the rewards of the predecessor or will dismantle the portfolio before any good stuff can occur.

 

At times, I do buy what I conceive of a value stocks.  Intel when it was $19, trading at 8x – 9x earnings and yielding almost 4% (I’ve since sold most of what I own) is an example.  But deep value investors would scoff at the notion that this is truly value.

 

For some time, I’ve been maintaining that value investing has lost its appeal in the 21th century.  Two reasons:

–the stronger one is that the shelf life of physical plant, traditional distribution networks and brand names is no longer “forever” in a globalized, Internet-driven world.  So buying companies that are rich in such assets but not making money is much, much riskier today than it used to be.  Such assets can erode in the twinkling of an eye.

–a weaker claim would be that while there are still value names, it’s hard/impossible to fill out a portfolio of, say, 100 of them, which is the traditional value portfolio structure, in today’s world.

 

I’m rehashing the growth/value debate here because I’m thinking the stronger position isn’t as unassailable as I’ve believed.

More tomorrow.

 

is 4% real GDP growth possible in the US?

the 3% – 4% growth promise

One of Donald Trump’s campaign promises is to create 3% – 4% GDP growth in the US.  Is this possible?

The first thing to note is that this is real GDP growth, meaning after inflation has been subtracted out.  I’m not sure Mr. Trump has ever clarified this–or that he wouldn’t be nonplussed by the question–but his appointees to head the Treasury and Commerce departments have said real is what they mean.  Also, 4% nominal (that is, including inflation) growth is about what the US has been churning out in recent years.  So promising 4% nominal growth would be like P T Barnum putting up his “This way to the egress” sign.

where does growth come from?

Simple models are usually the best (as in this case, feeling embarrassed when calling them “models” is a good indicator of simplicity).  Growth can come either by having more people working or by having workers be more productive, meaning churning out more output per hour.

more workers

Having more people working is a function of demographics.

Each year, the population of the US rises by about 0.8%.  Half of that comes from children being born to people already residing in the US; half comes from immigration.  If we take increases in the population as a proxy for increases in the workforce, then demographics can generate a bit less than 1% trend growth in GDP.

This also means that if Mr. Trump carries through on his threat to deport 3% of the workforce and restrict entry of immigrants, not only will the social consequences be shameful, he will make it that much harder to achieve his GDP objective.

productivity

Given that demographics will likely either not change, or will change in a negative way, getting to the low end of the 3% – 4% range will only be possible if worker productivity rises.   Let’s make the optimistic assumptions that the Republicans’ white supremacy rhetoric doesn’t discourage any potential immigrants and that there’s no increase in deportations.  If so, productivity gains would have to be at least +2.2% per year to achieve the low end of the GDP growth goal.

If +4% growth isn’t simply “marketing” in the worst sense of that word, the Trump camp must believe that productivity can be boosted to +3.2% per year.

An aside:  My first stock market boss was a vintage 19th-century capitalist.  He believed that increasing worker productivity meant boosting the workload–and making employees work longer hours for the same pay.  (No, there was no company store where we were forced to buy meals; yes, we had to basically provide our own office supplies.)

That’s not correct, though.  Productivity improvement comes through better employee education/training and by employers investing in labor-enhancing machines (back then, it would have been computer workstations, or in my firm’s case, pencils).

productivity today

Productivity today has been stuck at around +1% per year growth for about a decade.  During the housing bubble, when the US was furiously churning out many more new dwellings than the country could afford and banks were making crazy no-documentation mortgage loans (websites were also sprouting up to show low-income renters how to buy a house and scam the system for a year of “free rent” before foreclosure), we got to maybe +2.8% for a number of years.  But the last time the US rose above 3% was in the 1950s, when industry in Europe and Japan had been destroyed by war.

my take

I hope Wilbur Ross can do what he says.

I think +4% growth is simply hype–and that Mr. Ross, if not Mr. Trump, knows the situation.

The trend in manufacturing is to replace humans with robots. That’s the most straightforward way to achieve productivity gains. Output climbs steadily; output per worker goes up faster.  However, the number of employees shrinks drastically.   For many displaced workers supporting Mr. Trump, this may be a case of being careful about what you wish for.

 

 

 

 

 

value investing and mergers/acquisitions

buy vs. build

When any company is figuring out how it should grow its existing businesses and potentially expand into other areas, it faces the classic “buy or build” problem.  That is to say, it has to decide whether it’s more profitable to use its money to create the new enterprise from the ground up, or whether it’s better to acquire a complementary firm that already has the intellectual property and market presence that our company covets.

There are pluses and minuses to either approach. Build-your-own takes more time.  The  buy-it route is faster, but invariably involves purchasing a firm that’s only available because it has been consigned to the stock market bargain basement because of perceived operational flaws.  Sometimes, acquirers learn to their sorrow that the target they have just bought is like a movie set, something that looks ok from the outside but is only a veneer.

when the urge is greatest

Companies feel the buy/build expansion urge the most keenly at times like today, when they are flush with cash after years of rising profits.

so why isn’t value doing better?

Many economists are explaining the apparent current lack of capital spending by companies by arguing that firms are opting in very large numbers to buy rather than to build.

The beneficiaries of such a universal impulse should be value investors, who specialize in holding slightly broken companies that are trading at large discounts to (what value investors hope is) their intrinsic value.  Growth investors, on the other hand, typically hold the strong-growing companies with high PE stocks who do the acquiring.

On the announcement of a bid, the target company typically goes up.  The bidder’s stock, on the other hand, usually goes down.  That’s partly because the bid is a surprise, partly because the target is perceived to be priced too high, partly simply because of arbitrage activity.

All this leads up to my point.

Over the past couple of years, growth investing has done very well.  Value has lagged badly.  How can this be if merger/acquisition activity continues to be large enough that it is making a significant dent in global capital spending?

 

 

the traditional growth stock model…

…meaning for the past thirty years or so that I’ve been in the business.

 

What makes a growth stock is faster than expected expansion of earnings per share, that carries on for longer than expected.

Let’s say a stock is now trading for $20 a share.  It earned $.90 a share last year; the consensus of Wall Street analysts is that eps will grow by 11% to $1.00 this year.  Under these assumptions, the stock appears overvalued–one would be paying 20x expected earnings for 11% growth.

Assume, however, that our careful securities analysis, based, say, on the introduction of a badly understood but potentially transformational new product, reveals that eps will grow by 35% (and maybe more) this year–and beyond.  If we’re right, the stock is trading at 15x expected earnings for 35% growth.  It’s  a steal.

Stage 1.  eps acceleration.

a.  The company reports 20% year on year eps growth in 1Q16, vs. expectations of 10%.  The stock goes up, for two reasons:

–stock rises by, say, 20% because beliefs about the level of current earning power are revised up, and

–the stock’s PE ratio expands, meaning the stock rises by another, say, 5% – 10%, on the idea that a permanent upward change in the firm’s earning power may be under way.

b.  The process repeats itself in following quarters as long as expectations lag company performance.

Stage 2.  plateauing

In my experience, plateauing almost always results from a negative change in the qualitative story that’s driving the stock.  Earnings per share still look fine.  But there are indications that the force propelling them is looking long in the tooth.  Let’s say a retailer’s results have been going up for several years, both because of increasing same store sales growth and geographical expansion into new markets.  But now sales in the oldest stores are starting to flatten out, maybe even beginning to decline–and the firm has just entered the last 10% of its potential expansion program.

Typically, this is also the time when the stock’s PE ratio has expanded to crazy-high levels.  So, too, consensus expectations for earnings growth.

 

This is also usually the time when the first portfolio investors in are beginning to make their way to the exit.

Time can be another indicator.  Stages 1 and 2 together tend to play themselves out over five years or so.

Stage 3.  weakening comparisons

a.  The company reports earnings that no longer surprise on the upside.  They may be perfectly fine and in line with company guidance, but they’re less than investors expect.  The realization begins to dawn on holders that the peak of profit growth may have passed.

Now, the stock goes down for two reasons:

–current earnings growth expectations are revised down, and

–beliefs about long-term earnings power come down as well, meaning the PE contracts.

b.  This process continues.

Notes:

–The best growth companies are able to reinvent themselves, sometimes more than once, thereby prolonging their five-year growth cycle.

Microsoft, Cisco, Amazon, Apple are all instances.  In Apple’s case, the company was first the plucky PC company come back from near death.  Then it was the iPod company.  Then it became the iPhone maker.  Each reinvention triggered another growth cycle.

–The fall from grace in Stage 3 is often quite ugly and can last for a long time.  The potential buyers of a fallen angel are predominantly value investors, who are typically only avid purchasers at a discount to some notion of intrinsic value.

More tomorrow.

 

 

 

 

variations on growth investing

While I’m on the topic of investment styles, I figure I should say something about growth investing.

I started out as a value investor, concentrating on US companies.  After a few years as a securities analyst, I began assisting a superb value investor who was running a short portfolio, again all US.  A couple of years later, I changed jobs and started working as a portfolio manager in smaller Pacific Basin markets.  There, I was immediately attracted to smaller cap stocks, which at that time had the unusual combination of the best business models, the fastest growth and the lowest PEs in their markets.  What they didn’t have was a lot of market visibility, partly because they were so small and partly because the markets I was working in, like Australia and Hong Kong, were not very highly developed.

Yes, I continued to find stodgy old conglomerates where enormous value could be created by breaking them up and selling the pieces one by one, and others where an infusion of competent management could dramatically reverse declining fortunes. But I became more and more impressed by the raw earnings power of dynamic young firms.  It was only when I was describing my investment process in an interview for another job that I realized I was no longer a value investor.  I had become a growth investor instead!

 

My experience is that there’s a lot of confusion about what growth investing is.  In a sense, this confusion is aided and abetted by us growth investors ourselves, since no one wants to give away professional secrets, especially while he’s still working.

For example, the media talk about momentum investing, meaning buying stocks based solely on the fact that they’re currently outperforming the market.  This is an old offshoot of technical analysis, however, and has nothing to do with growth investing.

Then there’s “pure” growth investing, as practiced by the ill-fated Janus group in the 1990s.  Here the investor (that’s probably not the right descriptive) buys stocks based on accelerating sales and earnings, but without regard to price.  But doing so completely disregards a growth investor’s greatest challenge–knowing when to sell.  To my mind, this is pure speculation, not growth investing.

Growth At a Reasonable Price (GARP) is a genuine, if to my mind odd, growth variation.  Typically, a GARP investor sets a maximum PE ratio, say 25x the earnings likely over the next 12 months, as a maximum price he will pay for any stock, no matter how good the growth prospects.  I’ve sometimes been described as a GARP investor, rather than a “pure” growth disciple.  I find GARP too rigid, however.  For instance, holding firm to 25x would have ruled out Apple for much of its growth period, even though the footnotes to the financials made it clear that the company was using extremely conservative accounting (since changed) to record the profits from its iPhone business.

 

I think genuine growth investing has four facets to it:

–the growth investor buys the stocks of companies he believes will grow earnings faster than the market expects and/or for a longer period than the market anticipates (hopefully, both)

–decisions must be based on meticulous analysis and projections of the financials of the company, done by the investor himself, at least in large part

–judging when to sell is the key to success

–the PE paid should never be higher than the growth rate.

comparing growth and value styles

 

Growth                                                        Value

stock volatility high                                   low

character aggressive                                   defensive

upside high                                                    limited

downside can be high                                 low

firms have very bright future                  cheap assets

outperforms bull market                         bear market

benefit from market greed                      market fear

(sell high)                                                       (buy low)

uncertainty extent of rise                        timing of rise

portfolio size 50 issues                            100

 

All this is leading up to talking about why buying is the crucial step for value investors, selling the most important for their growth counterparts.

growth vs. value test: my answers

The growth stock investor’s answer:  Joe’s, of course.  Why?  I pay $18 for the stock now.  At the end of five years, earnings per share will likely be $2.70.  Assuming the stock keeps the same p/e multiple, its price will be $48 and I will have almost tripled my money.

Look at Bill’s in contrast.  I pay $10 for the stock.  At the end of five years, eps will be up 61% and I will have collected $2.50 in dividends (which I may have to pay tax on, but let’s not count that here).  Assuming the stock keeps the same multiple, it will be trading at $16.10.  Add in the dividends and the total is $18.60.  That’s a return of 86%, or about half what I would get from holding Joe’s.

One more thing.  Maybe in five years, people will start to worry about whether Joe’s can continue to expand at its current rate.  As a result, the p/e multiple could begin to contract.  Maybe that will happen, maybe not.  But even if it does, the multiple will have to drop from 18 to 12! before I would be better off with Bill’s.

The value stock investor’s answer:  It’s obviously Bill’s.  Joe’s has a much more aggressive  growth strategy.  Maybe it will work, maybe not.  I don’t see why I have to decide.  A lot of the potential reward for success is already built into Joe’s current stock price.  And if Joe’s strategy is unsuccessful, the stock has a very long way to fall.

If Joe’s strategy doesn’t work, then I’m much better off with Bill’s.  On the other hand, suppose it really is the way to go.  In that case, either Bill’s management will see the light and adopt a more aggressive stance itself, or the board or activist shareholders or a potential predator (Joe’s?) will force a change.  And the stock will skyrocket.  While it may take a little more time, I’ll enjoy all the rewards of backing the winning strategy without taking on the higher risk of holding Joe’s.

It’s a question of temperament.  A conversation between the growth and value sides could have several more rounds before it degenerated into name-calling, but you have the basic idea already.

Maybe the most salient points to be made about each answer are:

–not that many companies grow so rapidly as Joe’s without any hiccups;

–wresting control from an entrenched management is not that easy (look at the sorry history of  Western-style value investing in Japan–or most places in Continental Europe, for that matter–for confirmation).  It may not be possible, and could be a long and arduous process in any event.