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.
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.
Yes, I was supposed to be writing about trading. But I figured it might be useful for readers to figure out whether they tend to like growth stocks or value ones before going further. Here’s a test I heard about while I was at a value-oriented shop in the early 1990s (it’s a rerun of a one of the first posts I wrote in 2009. Try not to look back to see the answers, which will appear again tomorrow.):
The Rules
I’ll describe two companies. Both are retailers, operating in the US and selling identical merchandise. They are located far enough away from one another that there is no chance of them competing in the same markets for at least ten years.
Both have first year sales of $1,000,000.
Both have an EBIT (earnings before interest and tax) margin of 15% and pay tax at a 33.3% rate.
Therefore, both have first-year earnings of $100,000.
Each firm is publicly traded and has 100,000 shares outstanding. Earnings in year 1 are $1/share for both companies.
Money reinvested in the business is currently generating $2 in sales for every $1 invested. There’s no lag between the decision to invest and the generation of new sales.
Both can borrow up to 20% of earnings from a bank at a variable rate that is now 7%.
Earnings and cash flow are the same (just to keep it simple).
Company 1: Bill’s Stuff
Bill’s management wants to take a conservative approach to a new business. It decides that it will:
reinvest half of its cash flow back into the business,
pay a dividend of $.50 a share ($50,000/year),
keep any remaining cash in reserve in a money market fund.
So, in year 2 Bill’s generates $1,100,000 in sales, earns $165,000 in ebit and $110,000 ($1.10/share) in net income. It reinvests $55,000 in the business, pays out $50,000 in dividends and keeps $5,000 in reserve.
Let’s assume the company can continue to operate in this manner for as far as we can see. Then, the company’s investment characteristics are:
10% earnings growth rate
$.50 dividend payment
no debt; small but growing amount of cash on the balance sheet
Let’s assume Wall Street is now willing to pay 10x current earnings for the company’s stock.
Company 2: Joe’s Things
Joe’s management believes that expansion opportunities are extraordinarily good right now. It decides that it will:
reinvest all the company’s cash flow back into the business,
borrow the full 20% of earnings that the banks will provide and reinvest that in the business as well.
In year 2 Joe’s generates sales of $1,240,000 and ebit of $185,000. After interest expense of $1,400 and tax, net income is $122,400 ($1.22/share)..
For year 3, Joe’s can borrow another $4,500 and does so. Therefore, it reinvests $126,900 in the business. It generates about $1,500,000 in sales and ebit of $225,000. After interest and tax, net income is about $149,000 ($1.49/share).
Assuming that Joe’s can continue to expand in this manner indefinitely, the company’s investment characteristics are:
22% earnings growth rate,
modest and slowly-rising bank debt,
no current dividend.
Let’s assume Wall Street is willing to pay 18x current earnings for the stock
The question: Which one would you buy, Bill’s or Joe’s?
Answer tomorrow.
Yesterday I skimmed the short but valuable book The Investment Answer, by Goldie and Murray. The late Mr. Murray was an institutional salesman for a number of brokerage firms; Mr. Goldie is a fee-only investment adviser.
The book, which I think is well worth reading, contains lots of financial planning basics, laid out in clear, simple language. The first chapter, which deals with the traditional registered representative, is particularly good.
The only real quarrel I have with The Investment Answer is the chart it contains which asserts that value investing generates higher returns than growth investing. This is a common belief, reinforced by numerous academic studies which claim to “prove” this.
I think this claim is just wrong.
But I had a long, and relatively successful career as a growth stock investor, so of course I’m going to think this.
Worse than that, however, I suspect that demographic and technological change are undermining the fundamental pillars of the traditional value investing style.
About those studies–
–the typical procedure is for an academic to take a universe of stocks, say the S&P 500, and divide it into two parts. The “value” part will consist of stocks with the lowest price-earnings ratios, lowest price-to-cash-flow ratios and lowest price-to-book-value ratios, all based either on historical data or on consensus Wall Street estimates (in the case future-oriented information is also used). Put another way, these are the cheapest stocks, based on consensus beliefs. The “growth” part will be everything else, meaning all the expensive stocks.
The studies then show that the cheap stocks perform better than the expensive ones. What a surprise!?!
What’s wrong here? It’s the definition of value vs. growth. The studies assume the difference is between two mutually exclusive groups separated from one another using a single set of rules.
The reality is that growth and value are not mutually exclusive. They’re two different ways of looking at the investment world.
The growth investor looks for stocks where he believes the consensus view is mistaken, either by underestimating how fast earnings will grow and/or how long this superior earnings performance will last. A growth investor may hold many stocks that the academic classifies as “value” (think: the AAPL of a few years ago); there are many that the academic classifies as “growth” that no self-respecting growth investor would touch with a ten-foot pole.
Why don’t growth investors kick up a fuss about this academic nonsense? It’s not in their best interest. Why show your trade secrets for everyone to see? That would just make your job harder.
More tomorrow.