“I often wonder why the whole world is so prone to generalise. Generalisations are seldom if ever true and are usually utterly inaccurate.”Agatha Christie, Murder at the Vicarage
Generalisations are a dangerous game and in this type of environment can cost investors money. Over the last few months publications on the topic of value vs growth have increased exponentially. While both sides of the argument tend to declare absolute victory, there are nuances that investors need to consider.
Value investing, a term pioneered by Benjamin Graham, has come to mean buying stocks with low valuation multiples and selling those with high multiples. Much of the rewarded premium is exploiting human behavioural biases, however, more importantly it is predicated on the assumption that valuations mean revert over time.
There are a couple of issues with this approach to value investing. While adherence to a simple valuation multiple approach will produce a portfolio of businesses whose current share price appears attractive relative to cashflows, earnings or book value, there is no guarantee that this represents value. For example, who is to say, that in some circumstances a company does not deserve a low valuation; especially if its operating in a structural declining industry or has lost its competitive advantage?
At the end of 2014, IBM was cheap on almost all traditional measures of valuation. However, over the next 5 years, it underperformed the S&P 500 by 11% pa. Traditional methods of value investing tend to systematically ignore the power, source and reliability of cashflow growth in determining the intrinsic value of the business.
As well as undervaluing growth, protagonists of value investing have also tended to place a higher value on tangible assets, such as machinery, relative to intangible assets, such as brands or intellectual property. Should investors ignore the fact that media companies such as Facebook and Twitter have enormous platforms and established communities when considering their potential to generate advertising revenue? Such network effects would be almost entirely absent from traditional accounting metrics such as book value. These are important considerations when evaluating charts similar to Figure 1, as understanding what is driving the dispersion may lead to different conclusions on the optimal strategy to navigate through the current market cycle.
On the other hand, the power of technological innovation and the importance of intangible assets do not give growth managers the free pass to completely ignore price as a measure of value.
Microsoft, a constituent of the FAAMG acronym, has had a remarkable prolonged period of extraordinary successes. The company has incredibly managed to grow its earnings at 20% per cent compound growth rate over 30 years. This would have translated to approximately 24% annualised return for the same period. Proponents of growth investing would often use Microsoft as an example to illustrate that valuations and mean reversion is a phantom of imagination; instead what matters the most is recognising these characteristics that sustainably add value over the long term.
It is indeed hard to argue against the case of Microsoft when it comes to the quality of the business and their underlying competitive advantages; however, this has not necessary translated to uniform returns over the period and the price you paid for Microsoft was equally crucial in terms of the future expected returns investors would have earned.
As shown in Figure 2 below, if investors had held – or even worst bought for the first time- the stock at the peak of the Tech Bubble then they would have experienced a 62% drawdown over the next 12 months and would have taken on average 16 years for the price to recover. This is an opportunity cost that any fundamental investor would struggle to accept. Earnings growth is a powerful source of returns, however this is not always sufficient to offset a large valuation headwind.
So where does this leave investors today in terms of navigating their equity strategy through the current market cycle?
The first step is recognising the facts; and in this case no matter how you slice or dice the data the dispersion between traditionally-defined value and growth stocks is higher than at any point in recent market history. While making definitive judgements on future performance is a fool’s errand, the investment pendulum is at an extreme and the probability that the average growth stock outperforms the average value stock has greatly diminished. From this perspective, the latter offers a more fertile ground for the fundamental investor to generate excess returns.
This is not to say that investors should generalise and assume that all growth stocks or all value stocks are equal. Instead all investors should ensure that the current price for any security held is justified for the future potential of the business in terms of cashflows, growth, and risk; this is what fundamental investing is all about and this is the strategy that can sustainably add value to clients portfolios over the long term.
As Charlie Munger, long standing partner to Warren Buffett at Berkshire Hathaway, has said: “All intelligent investing is value investing.” Generalising and attributing stocks and manager styles into abstract labels is ignoring the fundamental principles of long-term investing.