The picture of value investors roaming the streets for cigar butts is an old and out dated analogy.
Big Cigar Butts Do Exist Though
Value investing just means getting a deal on your investment.
Getting a deal doesn’t mean getting it cheap based on today’s metrics. The deal has to include the future growth potential of the company.
The problem with typical value investing thinking is that “growth” companies trade at high multiples of current earnings since it has to accommodate the growth factor.
I have a problem with this.
If I pay the seller of the stock for that future growth, how do I profit from that growth?
Well now, I own the risk of that company.
The seller captures the potential growth with a higher price and unloaded the risk. If I’m the one now taking the risk, I need to get rewarded somehow.
Value Investors love growth. Just not willing to pay in advance for it.
Here’s the difference between a value investor and growth investor. Let me know if you have a different definition.
- Value Investor: too cheap to pay for future growth.
- Growth Investor: will gladly pay above current fundamentals and hope that the growth out paces the price.
When you pay a high multiple for a company, you pay the current shareholder a large chunk, if not all, of future growth up front.
The person on the other side of the trade is reaping the benefits of growth that is not 100% certain. If you’re the buyer, how sure are you that the company will match your growth assumptions to come out even?
With growth companies, the future is always uncertain, there’s too much excitement. It’s a large assumption to take on.
Microsoft the Wall Street Darling Growth Stock from the Past
For the last 10 years, Microsoft Corporation (NASDAQ:MSFT) was the Wall Street punching bag.
The stock did absolutely nothing since the dot-com crash. If you look at the logarithmic chart of MSFT, it’s amazing to see it do… nothing.
Where did all the growth go with MSFT?
The growth in the company and stock price was huge. But why the flat line? Did the company just stay stagnant year after year?
It’s not like Microsoft stopped growing. If you look at revenue alone, sales for 2004 was $36.8b compared to $83.4b in the trailing twelve months. That’s still good for a compounded annual growth of 8.5%.
Here’s some more info I pulled from the OSV Stock Analyzer. These figures are for the last 10 years.
Microsoft Cash Flow and Effectiveness
Microsoft didn’t stay at a standstill. It’s been growing, the last 5 years of data show that it’s been performing better than it has over the past 10 years. This shows that things have picked up and the business has grown.
CROIC is a term used to judge how effective management has been with invested capital. Stands for Cash Return on Invested Capital and a value of 93% means that for every $1 of invested capital, Microsoft has been able to extract 93c in cash. Microsoft is a cash machine.
FCF/S shows what percentage of sales is transformed into FCF. At 35%, for every $1 in sales, 35c becomes FCF.
Over the last 10 years, Microsoft has grown FCF by 9% and their effectiveness has been remarkable. Check out these other earnings metrics.
Microsoft FCF Earnings Tell the Story | Click to Enlarge
EPS, Owner’s Earnings and FCF are all trending in a nice steady growth pattern. If the market was truly efficient, Microsoft’s stock price should be steadily increasing year after year.
So what’s the issue?
The problem isn’t the performance of the company. The problem is that when you prepay too much for growth, you won’t reap the benefits of growth. The guy who sold you the shares does.
Ever heard of the greater fool theory?
A theory that states it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price. – Investopedia
When Microsoft was trading for $50 (adjusted for splits) back in 2000, there was no way it was trading for similar metrics. It’s hard to imagine Microsoft having Amazon or Tesla like metrics back in the day, but it did.
Looking at some valuation ratios you can see what’s going on.
MSFT Valuation Ratios | Click to Enlarge
A Successful Investment is Where the Stock Prices Grows into the Company
This is a case where Microsoft is clearly growing into the stock price.
This is the opposite of what you want to happen. You want the stock price to grow into the company. The multiples for each earnings metric show big shrinkage over the years. If you rewind back 15 or 20 years, the reduction is even more severe.
Sad to say, but the growth assumptions are no longer there. Microsoft grew into one of the largest companies in the world and even that isn’t enough to produce higher returns.
Microsoft gets bashed for the stock not performing.
If you bought the stock in the 2000 to 2003 era, why did you give all of your investment’s growth to somebody else?
One Foot Hurdles
I’m a fan of the one foot hurdle analogy.
When you buy something at a high multiple, you add feet to your investment’s hurdle. It now has to jump over your growth assumptions to be successful.
So keep this in mind when you think about value investing versus growth investing. The reason value investors don’t find themselves in stocks with a lot of growth potential is because the price is too high.
Warren Buffett said it best.
Price is what you pay, value is what you get. – Warren Buffett
Prices are flying high in many stocks today thanks to people prepaying for growth.
However, when the market declines, I’m there with open arms.
Growth is great, but if I’m going to buy, I want the growth to go to me and not someone else.
Now, here’s what I’d like to know, how much are you willing to pay for growth?
This post was first published at old school value.
You can read the original blog post here An Important Lesson Microsoft Can Teach You About Growth.