Value vs growth investing: a vague debate

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The rise of smart beta ETFs, also known as factor investing, has popularized some concepts such as value and growth leading to generalized misinterpretations that extend to the whole industry. The misunderstanding arises when the concept “value” is not defined properly – or when it is mentioned on purpose to mislead.

There are two possible interpretations of “value”: firstly, it can relate to companies that trade at low nominal multiples, typically low P/E and P/B ratios. Secondly, it can be associated with companies that trade under their intrinsic value.

The first concept of “value” is kind of vague, as multiples do not have any sense other than the comparative interpretation. Is a 10x P/E ratio “low” for a cyclical company in a competitive and mature sector? It could be accepted the concept “value” as a synonym of “low-multiple”, but it is misleading and happens to confuse investors. Yet, when “value” is used as such, it is fair to admit that a “value stock” is the opposite of a “growth stock”.

But, where does the confusion come from? Associating “value” to low multiples has its origin in one of Ben Graham’s cleverest axiom: buying a company with low multiples is much better than buying the same company with high multiples, which, with the underlying concept of margin of safety, is the cornerstone of value investing. Therefore, based on this weak relationship between low multiples and value investing some people wrongly associate both ideas, assuming that a value investor cannot invest in the so-called “growth stocks”, associated with those with high growth rates in revenues and profits.

As an example, Merril Edge, a brokerage firm owned by Bank of America says:

“Growth and value are two fundamental approaches, or styles, in stock and stock mutual fund investing. Growth investors seek companies that offer strong earnings growth while value investors seek stocks that appear to be undervalued by the marketplace.”

Fidelity, similarly, explains value investing as opposed to growth investment, although it recognizes that there is a “blended” approach called GARP (growth at reasonable prices). Even Wikipedia shows this antagonism between growth and value investing: “In typical usage, the term “growth investing” contrasts with the strategy known as value investing.”

However, there is no conceptual reason to differentiate between “both” investment styles. It is not pioneering to say that value and growth are not two sides of the same coin. In fact, it was Buffett who said, in 1992, the following:

“Most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual crossdressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” Buffet, Letter to Berkshire Hathaway Shareholders, 1992.

Therefore, it is important to understand the difference between the strategy of investing in low-multiple stocks and value investing. Additionally, it is worth digging into the fact that being a value investor is not opposed to investing in high-growth companies. Nevertheless, it is important to summarise what I understand by value investing.

As I wrote once in my tentative to understand value investing, “value investing is a stock picking investment strategy in which each investment is analysed individually with a fundamental approach in a bottom-up process. Behind each investment decision, there is a high margin of safety, and, therefore, high return expectations.” Hence, the nominal multiple paid for a stock is not relevant as long as the company is trading below its intrinsic value.

But, is not a company that is trading at a low multiple cheaper than a company that is trading at a high one? Well, not necessarily. Let´s see an example. Imagine we have two companies A and B with similar risk profiles. Company A is trading at a P/E ratio of 25 (Year 0) whilst Company B is trading at 5 times net income. In ten years, we expect both companies to trade at a P/E of 15x (i.e. Company A is going to have a contraction in its multiple, whereas Company B is going to expand its multiple three times). However, Company A has an expected growth rate of 20% annualised while Company B has an expected growth of 0%.

P/E Year 0

P/E Year 10

Annualised EPS Growth rate

Company A

25

15

20%

Company B

5

15

0%

Some would argue that a real value investor should invest in Company B as it is trading at a really low multiple and that Company A is not suitable for him, as the P/E ratio is extremely high. However, based on the above definition of value investing, a value investor would invest in Company A. Why? Let’s see the numbers.

Company A

Company B

EPS

Price EPS

Price

Year 0

1.00

25.00 1.00

5.00

Year 1

1.20

1.00
Year 2

1.44

1.00
Year 3

1.73

1.00
Year 4

2.07

1.00
Year 5

2.49

1.00
Year 6

2.99

1.00
Year 7

3.58

1.00
Year 8

4.30

1.00
Year 9

5.16

1.00
Year 10

6.19

92.88 1.00

15.00

10-year return 272%

200%

The expected return of Company A is 272% (14% annualised) while the return on Company B would be 200% (11.6%). Therefore, from an investment perspective, Company A will always be better than Company B for a stock picker with a long-term horizon, provided the risk is similar.

A 25x P/E company could be better than a 5x one, as long as the growth in EPS is not offset by the “normalisation” of the multiple. Therefore, an intelligent value investor should be willing to pay high multiples on certain occasions and should be sceptical of low multiples as they can lead to value traps.

Value investing does not require buying companies with low multiples, although, ceteris paribus, the lower the multiple, the higher the expected return. In fact, a high-growth company can be a wonderful investment idea for a value investor despite trading at a high multiple. Therefore, the dichotomy between value and growth investing is an artificial construction that does not have any theoretical support.

 

Appendix: “Growth stocks” held by genuine Value investors

Some of the best value investors in Europe hold companies that could be considered “growth stocks”. However, although these companies trade at optically high multiples, these investors estimate a fair value that is higher than the current price, implicitly assuming that the fair multiple should be even higher. With data from Morningstar and Bloomberg as of 21/09/2018, the following stocks (and its P/E multiple) are included in their top 5 holdings by investors such as Terry Smith, Michael Lindsell and Nick Train, Emérito Quintana, Alejandro Estebaranz and José Luis Benito or Luis de Blas and Jesús Domínguez:

  • Amadeus (32.47x)
  • Pay Pal (43.5x)
  • Microsoft (32.17x)
  • Idexx (63.55x)
  • Unilever (27.87x)
  • World Wrestling Entertainment (102.59x)
  • Nintendo (33.65x)
  • JD.com (513.53x)
  • Naspers (54.57x)
  • MTY Group (25.41x)
  • Judges Scientific (29.17x)
  • Global Dominion (29.82x)
  • Facebook (22.81x)
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