Wednesday, March 9, 2011

Value vs. Growth

For the average person a bull market is a fantastic thing. Those with jobs outside the financial sector aren't following the markets daily and have portfolios filled mostly with mutual funds, etfs, and maybe a few bonds. For the average investor, bull markets are strange. Obviously when the index is skyrocketing there is a greater chance that any individual stock will rise, but it also makes it much harder to outperform - the goal of all fund managers.

The value investing method, historically, provides the greatest rate of return. This is not arguable, it is fact. When in a bull market, however, investors are often tempted to seek growth instead of value. This is perhaps the single greatest mistake an investor can make, and I'd like to show why.

Book Value + Future Retained Earnings + Dividends = Stock Price

This is the bare bones way to value a business. Ben Graham's defensive investor focuses on the net book value and dividends portion of the equation, while the majority of investors today are consumed with forecasting earnings growth. The logic here is wrong.

When looking at a company's balance sheet, it is very easy to decipher what the assets are worth. Without oversimplifying it, generally the more liquid an asset is, the more favourable it is. Cash can be used to buy new businesses, buy equipment and land, and can also be returned to investors as dividends and stock buybacks. This is why I prefer to spend my time focusing on the assets of a company. If a company sits on a mountain of cash: that is a huge check mark. It also means that companies with massive inventories and slow turnover are a big red flag. The other side of the equation is the liabilities section. Even if a company reports low total liabilities (giving a higher book value), we can still look to see what proportion is short-term versus long-term debt. If a retailer has a higher proportion of long-term debt at a high interest rate, then the business may need to re-finance to stay competitive. If all of a company's debt is short-term and you know the company's earnings are questionable, this would be a potentially deadly situation as well.

Doing this analysis is easy, not time-consuming, and with some common sense can provide insightful investment opportunities. Here the hope is that the market realizes that the assets are undervalued or the liabilities are not an issue, and raises the stock price as a result (often called mean-reversion).

The problem with focusing only on forecasting future earnings is that it is extremely hard to do. Here is just a short list of some of the problems:

  1. For companies with diverse operations, it is often difficult to make predictions on multiple business divisions (for conglomerates, it may be impossible)
  2. For global companies impacted by various economies it is almost impossible to predict how currencies/population trends/product trends will go when the company operates in several countries
  3. Although it may be easy to say a product or service will increase in demand, the effects on the bottom line are very hard to tell and in some cases revenue really does go through a corporate 'blackbox' before it ends up being reported as earnings per share
  4. Even if the company has a stated plan to grow earnings, there is always the possibility that a failure to execute means earnings those are not realized
These problems increase with the size and complexity of the company. For example, it would be much harder for me to predict EPS for General Electric (GE) than for Avalon Rare Metals (AVL), a Canadian small cap with a few mines.

The problems associated with value investing are not nearly as bad as with growth investing. It is my belief that the value method provides a more accurate appraisal the of a company's worth, and involves less assumptions and consequently less risk.


























The chart above shows what a dollar invested in 1927 would be worth in 2006. For picking value stocks it identifies low p/e, low p/fcf, low p/b, low p/s, and high dividend yields. For growth it uses high p/e, high profit margin, high roe, and high sales growth.

There is a reason you never hear Warren Buffet or Ben Graham talk about growth: they don't believe in it. The logic is all there, and I hope you'll see it to.

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