The fight between the two corners has been going on forever and in recent years ‘growth investing’ might have had the upper hand, but I believe discussions mostly miss the point! I believe it is time to classify the two from the view of a value investor in a broader sense. I hope I can provide some clarity on the matter …
I wanted to write this post for a long time now. Prof. Damodaran wrote a three-part series on value investing on Friday, Oct 23rd and I was reminded that it is time to finish the article. I believe, it is of utmost importance to define some terms first.
What is value investing? That’s the question I’d like to address first to define, what value investing is and what it is not (for me). In the broadest sense, you could define value investing as buying things for less than they are worth. Further, I believe it has to be based on an educated informed guess on true or intrinsic value derived on the basis of conservative and realistic assumptions. Ideally, there is a strong level of downside protection which brings me to the purest and probably most traditional form of value investing. Decades ago, Graham used to buy net nets or businesses trading for much less than what you could expect to make when liquidating them quickly. This approach clearly works best, when you have the resources to buy whole companies and thus, being able to define its future (i.e. liquidation). Mostly this situations showed low price earnings or P/E ratios and low price book or P/B ratios.
Value factor: These low ratios are broadly used nowadays to define value investing in the academia world and comparing value vs growth investing styles, introducing many problems. Factor ETFs and Bloomberg articles reference to these factors as well, inspireing historical performace comparisons and ‘value vs growth investing’ discussions on a superficial level.
In his part 1 (or this video) Damodaran discusses several classifications for value investing and growth investing that make a lot of sense.
Investing on low valuation metrics may have worked spectacularly well in former times, because information was much less accessible and financial markets were most certainly far from being efficient (whatever that may exactly be). Additionally, capital was scarce. I know, it’s hard to believe nowadays with money flooding the markets and being perceived (or used) as the panacea for ailing economies. So in former times, capital in the form of property and machinery actually gave you some competitive advantage, you may call it moat (about moats). I believe it is likely that this regime change rendered the B/P ratio obsolete or at least much less important. At the same time, intangibles are much more important nowadays.
Anyway, investing on the basis of some superficial low valuation metrics like low P/E and P/B or high dividend yield is not how I understand value investing. Here it becomes clear, that almost all of the discussions about value investing make use of a problematic definition based on quantitative factors (P/B, P/E). And how could it be any different? Academic studies and factor ETFs need a clear definition to implement it in codes. As I wrote in my book review, such
[conventional valuation yardsticks] … must be used with caution and should only be part of a more comprehensive analysis of underlying value.Book Review: Margin of Safety (Part 2)
Sadly, discussions are also framed on these quantitative factors. Since many investors call their investment strategies value investing, looking at their real life performance might also be problematic, since any investor can call himself a ‘value investor’. Still, Prof Damodaran admits the following:
the ultimate test of a philosophy is not in whether its strategies work on paper, but in whether the investors who use those strategies make money on actual portfolios.Damodaran (Tough times for Value Investing)
My value investing philosophy is strongly based on performing absolute valuations. Most of the time I use DCF valuation or SOTP valuation approaches. A discounted cash flow valuation ultimately incorporates earnings or more precisely cashflows, growth and risk in the form of applied discount factors. In my opinion, to call your investment approach value investing, it is necessary to value a business and only to invest below your fair value estimate. Such a valuation will always be imprecise and it is better to be aware of that fact.
- The value of a company ultimately rests on cashflows but there might be (prolonged) periods where ‘the market’ values them on other metrics
- like sales (when earnigns are missing)
- or eyeballs (when sales are missing)
- sales can eventually translate into earnings, but one should have a clear and realistic view on that
- see internet hype (2000).
- like sales (when earnigns are missing)
No investment strategy will produce excess returns consistently on an annual basis (and it does not need to). Otherwise, everybody would pursue it and returns would deminish. What is important for me and many other value investing believers is our notion that value investing will produce reliably high absolute returns in the (very) long term. Short term results are not that important.
- In fact, longer periods of underperformance might be the reason why value investing works in the long term.
Growth investing can be understood quite differently. In my view, nowadays many ‘retail investors’ understand it in the following way. They buy popular companies with very high growth rates (referring to total sales) neither caring for earnings or cashflows (now or in the future) or price. They happily make use of a shortcut, that very high sales growth should eventually turn into high profits (scaling) and ultimately justify todays prices. In many instances, such behavior looks more like ‘momentum investing’. And in fact, such a strategy performed very well over the last years proving these retail investors right (for the moment). Buying bigger and populara technology names has performed very well recently.
- Lower (discount) rates make profits far in the future much more valuable today.
But what will they do when Tesla* falls to $ 100 tomorrow from 420 today? Did they have performed a valuation that resulted in a reliable fair value estimate? Would they happily buy more (undervalued) shares or would they look at the stock chart and draw their conclusions?
*) I just chose Tesla as an example here! I believe it is a good one, since opinions on it and its valuation seem to be at two extremes (and I have no educated opinion on it). If you are interested: Vitaliy Katsenelson just published a book with his Tesla research for free.
Growth investing as a value investing category might be a viable strategy in my opinion. As written above, growth is one dimension affecting value. From this (value) point of view, growth investing is a value investing strategy subset. Such growth investors are looking for companies that rely on higher growth rates. Howard Marks writes the following (you can also watch Marks on value vs growth investing):
In a nutshell, value investors aim to come up with a security’s current intrinsic value and buy when the price is lower, and growth investors try to find securities whose value will increase rapidly in the future. … the choice isn’t really between value and growth, but between value today and value tomorrow. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current worth. … … it can fairly be said that growth investing is about the future, whereas value investing emphasizes current-day considerations but can’t escape dealing with the future.Howard Marks, The most important Thing
Within the value investing spectrum growth investing might be at the opposite of traditional value investing. Buying whole companies and realizing value quickly (net net approach) might be the most conservative approach within the value investing spectrum since uncertainty about future developments (range of outcomes) plays a very small role. Grwoth investing, on the other side includes high uncertainty with future developments giving rise to a potentially very wide range of outcomes (and results).
As an investor, I analyzed some companies using SOTP valuation approaches and bought some shares as a result (examples can be found here). Since I sadly still lack the resources to buy whole companies, these investments include much more uncertainty then the very conservative net net approach, but there are some parallels.
Most of my investment rely on growth. Most of my investment analysis and actual investments rely on a DCF valuation (examples can be found here) and thus depend very much on growth and on the future. Thus the ‘value vs. growth’ framing of discussions is very much misleading in my view! My invesmtents are positioned somewhere within the value investment spectrum and most of the time also rely on growth.
Since starting my blog, no invesmtents come to my mind, where I bought shares simply on the basis of a low P/E or P/B ratio (see my portfolio). Some of my analysis may primarily make use of simplified ratios instead of applying a full DCF or SOTP valuation. But even in such cases, my analysis does not stop there (low P/E or P/B) but includes further analysis of the business to evaluate the investment opportunity.
I believe value investing is the right approach for me and that it is not dead. I am quite confident that I will be satisfied with the returns (adjusted for risk which is not easily measurable). And my value investing philosophy will help me during market crashes to behave more rational.
I hope you enjoyed the article. What is your take on value investing and ‘value vs growth’ investing?
Damodaran with his three posts, released Oct 23rd: Value Investing I (The Back Story), Value Investing II (Tough times for Value Investing – Passing Phase or a Changed World?) and Value Investing III (Requiem, Rebirth or Reinvention?).
AQR performed rigorous research on the value factor and tested many of the popular explanations for its demise. It empirically disproves many of these explanations like ‘winner-takes-all markets’. Cliff Asness from AQR writes the following
We think the medium-term odds are now, rather dramatically, on the side of valueCliff Asness, Is (Systematic) Value Investing Dead?
- What is Value Investing? An exposition of the definition of value investing (Aaron)
- Value, Growth & Intrinsic Investing (ensemble capital / intrinsicinvesting)
- Value investing has and always will consist of two basic ideas … (Bruce Greenwald)
- Value & Growth Demagogues by Vitaliy Katsenelson
In addition to general equity risk, the risks faced by Value investors are different than those faced by Growth investors. A Growth investor risks overpaying for future growth that fails to meet lofty expectations. This can be especially true when growth is a scarce commodity or when specific industries become the subject of extreme hype. Value investors, on the other hand, risk buying those stocks that are cheap for a reason: they are value traps facing secular headwinds whose fundamentals deteriorate and never experience the multiple expansion that is an important driver of returns for Value investors. (GMO)