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.

testing for style–growth investing vs. value investing

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.

growth investing and “The Investment Answer”

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.





measuring equity performance using style indices: growth vs. value

value vs. growth

It’s been my strong impression that in the US market growth stocks have outperformed value stocks this year.  I get that impression, among other things, from looking at my own portfolio (remember, I’m a growth investor).  This wouldn’t be surprising, since in a typical business cycle recovery value stocks outperform strongly in the first year.  But as pent-up demand is gradually satisfied and the economy slows a bit, growth stocks typically take over market leadership.


But I know I look mostly at growth stocks.  So I thought I’d check the IWD and IWF ETFs.  These are securities that track the Russell large-cap value and growth stock indices, respectively.  They show a neck-and-neck battle until the past couple of months, when the growth index pulls out in front.

Indices like these are the best we have.  And from a practical money management perspective, if a client were to hire me as a money manager and specify the Russell 1000 Growth Index as my benchmark, it would be simple enough to construct a portfolio whose under- and overweights would be geared to that index.

how good are style indices?

But are such indices really good representations of the relative performance of growth and value stocks?   Not so much.  The reason has to do with the academic tilt to their construction.  To be honest, I don’t have a better solution.  And as you’ll see in a moment, the way the growth index is composed may give a manager benchmarked against that index a slight performance advantage.  So I’m sure these style indices are here to stay.  You just have to remember that the growth index in particular has some drawbacks.

Here’s what I mean.

The idea of style indices has its genesis in the reasonable question, posed by academics, as to whether either a value discipline or a growth investing discipline has an inherent advantage over the other.  Their method was to divide a stock index with broad market coverage, like the S&P 500 or the Russell 1000 into value and growth components and then study the relative performance of the two.

constructing a style index

They proceeded as follows:

1.  They defined value stocks, reasonably, as those with some combination of low price to book (or net asset value), low price to cash flow, and low price to earnings.

2.  Using various weightings of these three factors, or other similar ones, they constructed a ranking of index constituents that ordered them from being the most value-like (scoring the best on the value stock variables) to the least.

3.  Using this list, they (usually) took the half exhibiting the best value characteristics and called it the Value sub-index.  They called the other half of the list the Growth sub-index.

4.  They compared the performance of the two sub-indices.

Looking at the relative performance of the sub-indices over time is itself interesting:  until the Nineties, relative outperformance of either style is short-lived.  Starting in the recovery of 1992, however, Growth and Value each have multi-year periods of significant outperformance.

The overall academic conclusion, supported by the sub-indices, is that Value trumps Growth over long periods of time.

the error in logic

The academics make two assumptions that have no factual, or logical for that matter, support.

–They assume that every stock can be characterized either as growth or value.  This allows them to define growth as being what’s left over when value stocks are separated out.  hey don’t consider that there may be a set of “clunkers,” or stocks no one in his right mind would touch (even though there’s research showing that bad-performing stocks persist in underperformance far longer than good stocks in their outperformance).  They all get tossed into the growth pile.

–They assume that the growth stock universe and the value stock universe are mutually exclusive–that growth investors somehow refuse to buy fast-growing companies unless their price-earnings multiples were already high.  That would be crazy.  At the beginning of this year, for example, AAPL–a classic growth stock–was trading at 10x earnings, with no debt and cash making up a quarter of its market value.  Has AAPL been a growth stock for the past five years?  Yes.  Has it been a value stock, too?  Yes, again.  But which sub-index is it in?  Depending on how a particular style index is constructed, it could be either.

Of these two errors, I think the first is the more serious.  My suspicion is that the supposed underperformance of a Growth sub-index is because of the presence of clunkers.

Why don’t growth investors make more of a fuss over their investing style being maligned?  I think it’s the same reason why professional investors don’t make a fuss about many of the other crazy, erroneous things taught about investing in business schools.  Why invite more competition?