Columbia University
Graduate School of Business
B9301-74
Advanced Seminar in Investing
Value versus Growth Investing
Standard Definitions
Value Investing is thought to be the purchase of "cheap stocks." The idea, of course, is to purchase stocks below their "intrinsic value" and wait for that value to be recognized by other investors. The only problem with this definition is that it may be impossible to define true intrinsic value, therefore the entire argument may be fallacious.
Growth Investing is thought to be the purchase of fast and/or consistently growing companies. The idea is to buy a growing company and then let the company’s value (stock price) increase as the company grows. The only problem is that this investment technique assumes that the stock price and company growth are directly linked, which is true only under specific circumstances and not in all cases.
Warren Buffett was quoted in the 1992 Berkshire Hathaway Annual Report on the subject as follows:
In answering this question, 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 cross-dressing. We view this 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. In addition, we think that the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid?
Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investment. Correspondingly, opposite characteristics -- a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield -- are in no way inconsistent with a "value" purchase. Similarly, business growth, per se, tells us little about value. It’s true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing -- in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts investors.
John Burr Williams set forth in his seminal work, The Theory of Investment Value, published in 1938, the following equation for value:
The value of any stock, bond or business today is determined by the cash inflows and outflows -- discounted at an appropriate interest rate -- that can be expected to occur during the remaining life of the asset.
As Mr. Williams comments, "growth" is merely a component of the value equation, while "value" is not a determinant of value.
Despite the brilliance of these two seminal thinkers on investing, we answer the value versus growth question as follows:
Value investors tend to buy stocks with low expectations with the belief that these expectations are "too low" and temporary in nature. Value investors believe these expectations will increase in due time because the current, but temporary, "conditions" will pass. Low expectations tend to correlate with stocks with "value" indicators such as low price to book ratios, low price-earnings ratios and high dividend yields. These are merely coincidental indicators, however; the key to the investment is the low expectations.
Growth investors tend to buy stocks with high expectations, but with the bet that the expectations are also "too low" and they will increase in due time. Growth investors believe these expectations will increase, although they may be already high, as the company continues to produce financial results better than expected. High expectations tend to correlate with high price to book ratios, high price-earnings ratios and low dividend yields. Once again these are merely coincidental indicators and not a measure of investment fitness.
Therefore, in both cases the investor is betting that expectations are "too low" and will increase in "due time." Investing in either high expectations or low expectations stocks is essentially the same bet. As such, we conclude that "value investing" and "growth investing" are exactly the same exercise, just bets on different sets of expectations.
One further thought:
"Value" stocks tend to have expectations of short CAPs or depressed cashflows; the investment payoff comes from the acceleration in cashflows (versus expectations) and/or a lengthening of CAP. Value oriented stocks may also suffer from neglect (a potentially good thing) which may lead to an inefficiently priced security. Interestingly, neglect may be a consequence as well as a cause of low expectations. Value investors claim to focus on asset value with the implied hope/belief that some catalyst will come along and allow the "market" to realize this hidden value. As such, value investors do not want to forecast future earnings/cashflow growth. More importantly, they NEVER want to have to rely on these growth forecasts when making investment decisions. Value investing usually requires two investment decisions: when to buy and when to sell; selling comes once the stock reflects "realistic expectations." This sometimes is referred to as the last drag on a cigar butt!
"Growth" stocks tend to have expectations of long CAPs and fast growing cashflows, and most times are value-creating companies. Growth investors want a high unit growth rate to drive these cashflows -- a natural growth in unit demand. These high valuations imply a very large growth opportunity, sometimes referred to as a high PVGO (present value of growth opportunity). In turn, this implies high future EVAs, or "very large investment opportunities." This can be characterized as large IC * (ROIC - WACC) -- (invested capital times the spread between return on capital and the cost of capital). As a consequence, it is clear that ROIC is critical component of growth (and value); without a high ROIC, at least on incremental investments, the company cannot finance its growth. Another view is to realize that growth investors are betting that the company will create more value in the future than is implied by market expectations. The investment payoff comes from static to lengthening CAPs and higher than expected cashflow growth or returns on investments (again versus expectations). Growth oriented stocks may suffer from group-think or mania (a potentially bad thing) which may lead to a security being over-priced. One of the key paradoxes of growth investing is that investor expectations should adjust to upside surprises. Therefore, for a growth stock to continue to outperform, the underlying fundamentals must constantly, and continuously, exceed expectations. This is not a trivial accomplishment to maintain.