Value vs. Growth Investing

Warren Buffet is all the proof I need that Value > Growth. Value tends to be based in actual fundamental valuation while Growth is far too speculative for my taste.

I find that these terms are misleading. I for one do not make bets solely on what I think the market is pricing too cheaply nor do I focus solely on a company's growth prospects. In reality you should use a combination of the two. They are not mutually exclusive IMO

I don't think the two are mutually exclusive...

I think this is probably controversial statement, but I believe that value vs. growth is a false dichotomy created by mutual fund ratings agencies.

If we grant that valuation is an imprecise art (and by God it is), then we need to think about the constituent parts of what makes goes into a valuation.

So what goes into a valuation?
- Assets less liabilities. - Near term profits ("certain" profits) - Future profits ("uncertain" profits)

If any one of those things is improperly valued by the market, then there is an opportunity to invest in something that is undervalued. Value investors often focus on the first two, growth investors on the last. However, there are periods of time where one or more of those factors will be systematically undervalued and will allow the perceptive investor beat Mr. Market time and again.

Here's an interesting mental experiment.

Say you are considering an investment in an asset-less, liability-less firm that is currently losing $1M a year. However, you know with perfect certainty that it will earn $1M in profits next year, 50% certainty that it will earn $2M the year after that (50% certainty it earns $1M), and 50% certainty that it will double profits each year for the next five years (50% certainty it will remain flat).

If the market P/E is 10x on trailing earnings and corporate profits are flat growth (so an implied 10x forward earnings too), what is the firm worth?

The answer certainly isn't zero. If something is going to be profitable next year, there's a concrete value you can assign to it.

Is it worth 10M (10x forward earnings)? Some investors would say yes because future profit streams are significant less certain. There is the possibility that your profits will stay flat.

Is it worth MORE than 10M? This is where I would place my bet. Here's the reason. There is uncertainty about what profits will be but the expected value of those future profits is actually pretty high. If the stock's selling for a 10M market cap, I'm happy to invest in this company because the expected value of future profits are significantly undervalued. I don't need precise knowledge of future profits to know that this is a deal.

My argument, while coached in value terms, describes how a growth stock can be undervalued because of its growth potential.

A company that is growing profits at 15% a year, selling for 15x current net income can be deeply undervalued. A stock that expects to liquidate its business in the next five years, selling at 10x current net income is often not.

Growth tends to have a higher risk tolerance and a strategy that lends itself towards momentum trading. You have to be willing to overpay for a stock today, looking for it to grow into a higher and higher valuation in the future. Normally they are also growing faster than other companies around them which tends to lend to thinking they are worth more than a comparable, slower growing company. Thus, they trade at rich valuations where all it takes is one slight misstep to send the stock reeling. Take a look at Netflix whenever people worry about subscriber growth or linked-in when worries about competition arise. Normally they get flattened. Growth, to me, represents opportunity or at least the prospect of opportunity. Anyone can grow absurdly fast utilizing a scheme like Pandora or Grupon. The trick is to grow quickly and profitably, a la Apple. That is something I'm willing to pay up for, the other two not so much.

Value has much longer time horizon and really encapsulates what finance is all about. Understanding and valuing a company from the ground up, understanding why it's valuation is lower than it should be and then reckoning whether that company is going to do better than expected over the long run. The problem with value can arise with companies like RIMM which is bandied about as being 'undervalued.' In all likelihood they are a dying company that simply got out innovated in an industry that relies on dynamic change and growth. You simply can't survive when you make awful products. Is it technically undervalued via metics? Probably. Don't, however, confuse cheap with value.

Why choose when you can have both in the same security? The best stocks are value stocks that become growth stocks.

Interesting discussion, I appreciate the responses thus far. I have always been more comfortable with the value investing approach myself. Ravenous, what are some examples you have in mind either today or from past results?

My favorite of all time is Davita (DVA) circa early 2000. I was not in the industry at that time but know someone who bought a fair amount (like half a million or a million worth) at

Interesting discussion thus far. I'd like to try and take it away from equities for a second.

I think that, as a framework, value is much more flexible in some sense (if we define value as buying things the market has undervalued). A margin of safety could, in principal, exist due to attractive valuation in any asset class or product area. You can see this flexibility in some of the the really big value investor's portfolios (ex. Buffet).

The growth investor mindset doesn't really translate as well as far as I can tell, I'd say the closest equivalent is to classical macro investing where you are trying to spot a trend early on.

Growth investing on its own is pretty hard to do successfully without incurring a lot of risk. For one, there are very few true growth companies. To be a consistent grower, you usually need to be involved in some kind of new product or service, and there aren't too many things that haven't been thought of already. Anything new and amazing tends to attract a lot of new entrants that compete away excess returns. Anything that has a barrier to entry and which grows very well is priced very high, disallowing margin of safety in the event that their new product or service doesn't ramp as expected (which is common since a lot of management teams lie). I'd rather be long something at a low multiple with a consistent business that is doing something that will allow them to grow such as a sensible acquisition strategy, cross selling opportunity, bolt on product, etc. I can't get really excited about tech stocks and other high flyers, unless I'm betting against them.

For value investing, what is a good margin for undervalued stocks to be considered a good investment?

Wrong thread.

Wrong thread.

Interesting points from all of you.

I started in value, and I've had trouble adjusting to growth. The most common and toughest growth calls I see aren't simple tech stocks that haven't taken off yet (those are almost always poor picks), but a company in the process of a turnaround-usually when they are losing some portion of their business, but switching the mix for a more profitable customer base. This also coincides quite often with a recent acquisition that is about to be rolled out (a new product). So on one hand you value the old business (from a value perspective trend can be poor, even though bottom line may improve in future due to better mix), while on the other you value the second business (acquisition) and see if the depressed price lets you pick up this portion for a bargain.

Anyone else have a similar experience? For me this has been the toughest transition, and I'm constantly seeing moderate value plays but good growth plays, and unable to know way to approach the company.

I wish more threads on WSO had the combination of both good commentary and vitriol

Who bumps a year old thread just to say that. Impeccable response though. Made my day.

Value investors would like to achieve a total return through a combination of earnings yield and growth, growth investors are content with little earnings yield and obtaining their total return through growth

I wanted to write more about why I don't like pure growth investing but have been busy until now. I define "pure growth investing" as buying high multiple stocks based on expectations for explosive P&L growth, usually revenue growth, but also in some cases EPS growth (revenue growth is more likely because many "growth" companies are subscale and not profitable yet).

This response is not to justify my original comments to the hater, but because I think some people might benefit, and because I have been thinking about this topic a lot since the market is now way up and so called "growth" stocks are ripping.

It's worth pointing out that growth is a component of value, something that definitely enhances returns all else equal, and particularly if you are paying a value multiple and then receiving growth (these are the best investments IMO, no real secret there since you have margin of safety in the value price with the upside kicker of unexpected growth). So when I say growth, I'm referring to high multiple stocks, like >3x EV/Sales and P/E >25, etc. where they are clearly priced for high expectations. I don't hate growth, I am just skeptical of paying aggressively for it.

A full discussion of these types of stocks would be time prohibitive but here are a few off the cuff generalizations:

The US is largely a mature economy and most industries are fairly maturish or are consolidating. Tech and healthcare are notable exceptions. With the S&P 500, you are primarily looking at the winners from our economy, mainly in companies that have developed over a long time period (usually decades), at one point revolutionizing or consolidating the industries they serve. Most of the "growth" these companies experience is from pricing power, increased international exposure, population growth domestically and abroad, and from being on the right side of creative destructionism. From a public company perspective, these stocks represent a large portion of the market by cap, and for most funds, effectively represent a huge piece (or the entirety) of their investing universe. There aren't a lot of "growth stocks" in this pile -- they all were growth stocks at one time, but it's impossible for any company to maintain high rates of growth forever.

Which brings us to the mid-cap and smaller segments of the market. I primarily focus on stocks Onward when they changed the business model (I never owned this unfortunately). AEPI is another good growth stock I used to own, it was nearly a 4 bagger. They make plastic films and it's run by a stodgy old mgmt team, very boring.

I stand by my prior statement that there are very few true "growth companies" in the way that most people define them, though I will say there are lots of good companies that haven't grown in a while but have the opportunity to accelerate and I think these often make excellent investments.

I'm sure someone's touched on this already but value and growth aren't opposites the way that most people think of them as being opposites. For example I'd be best described as a GARP guy. The opposite of value should probably be something more like momentum.

From Cupps Capital, which is a growth-style investment shop (Do a 13-f search on them and you'll see they're not afraid to pay up). Their performance is off the charts recently.

"We believe the more normalized economic and market environment is causing the pendulum to swing toward growth-style stocks for the first time in about 13 years. Growth stocks are solution stocks. These companies solve problems big and small. Some of the solutions are trivial, perhaps improving fashion offerings or providing a better neighborhood restaurant selection, some are solutions life-changing, such as improving education or curing illnesses. Importantly, growth companies grow by providing “better mousetraps,” to earn a reallocation of the dollars already in their customer’s budget, not by being reliant on an improvement in general business conditions and GDP."

Here's some fun math. We have a company that earns $10 of unlevered free cash flow. It has a 12% cost of capital.

If it's growing 0% perpetually, then it's worth: $10/(12%-0%) = $83 If it's growing 3% perpetually, then it's worth: $10/(12%-3%) = $111 If it's growing 6% perpetually, then it's worth: $10/(12%-6%) = $167

Thus, if a company is growing at 6%, and you invest at $150 (6.7% unlevered free cash flow yield -- not generally a value metric), you are in fact getting a good value, whilst paying for growth.

People have cut and paste the Buffet quotes, but his full discussion of this topic is in the 1992 annual letter. I'll cut and paste a few paragraphs that I feel are most pertinent.

http://www.berkshirehathaway.com/letters/1992.html

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

 Though the mathematical calculations required to evaluate 

equities are not difficult, an analyst - even one who is experienced and intelligent - can easily go wrong in estimating future "coupons." At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes.

 Second, and equally important, we insist on a <span class='keyword_link'><a href="/resources/skills/finance/margin-of-safety-formula">margin of safety</a></span> 

in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.

Pure gold- NUGT to be exact