Imagine this scene:
A boxer sits in one corner of the ring, his shoulders hunched as his trainer pours water on his head, matting his greying hair across his forehead. He sits steady and still as his hands are wrapped and then taped into his gloves, as they’d been nearly a hundred times before. He might be a veteran with experience, sure, but he’s old, and well past his prime and into the stage of his life when all of his peers have retired, most ages ago. Some would say he’s washed up, but this fighter knows he still has some strength left in him. The crowd hisses and boos as the announcer booms his name over the PA system. He’s the underdog in this fight and is clearly unloved by the audience. Everyone’s betting against him. He doesn’t care.
In April, Li Lu and Bruce Greenwald took part in a discussion at the 13th Annual Columbia China Business Conference. The value investor and professor discussed multiple topics, including the value investing philosophy and the qualities Li looks for when evaluating potential investments. Q3 2021 hedge fund letters, conferences and more How Value Investing Has Read More
His opponent stands in the corner opposite him, bouncing energetically on his toes. The young buck. The up-and-comer. The challenger to the throne. The young man’s muscles ripple as he punches his gloves together in front of him, ready for battle. He looks strong and powerful. He turns toward the crowd and lifts his arms above his head, raising their cheers for him ever louder. They love him. They’re certain he’ll win by knock-out… the only question is in which round. They overlook the fact that he’s never been in a fight before. The boy’s a sure winner.
The fight described above is the same one that plays out every day on Wall Street, where “value investing” (the veteran boxer) is pitted against “growth investing” (the young gun) in the battle for superior returns. It would seem that if you own a brokerage account, then you must sit squarely in one or the other camp. Indeed, the investment “style box” is ubiquitous in investment literature and stocks and portfolio managers alike are constantly pigeonholed into corners of that box. You’re either one or the other – a “growth” investor or a “value” investor.
The classical definition of “value investing” is the strategy of selecting stocks that trade for less than their fundamental – or intrinsic – value. Value investors believe that the true worth of a stock and the price that is reflected everyday by the stock market, are not always the same and often can differ dramatically. Value investors proverbially “pay 50 cents to buy $1.” They find the diamonds in the rough. Generally they “focus on companies with lower-than-average sales and earnings growth rates” and stocks “with lower price-to-earnings and price-to-book ratios.” Value investorsseek safety in exchange for lower returns. The prototypical “value” company operates in a mature industry. Value investors would pick the old-timer over the fresh-faced boxer.
The classical definition of “growth investing” on the other hand is the strategy of picking stocks of companies that are expected to experience faster than average growth as measured by revenues, earnings, or cash flow. Growth investors are looking for the next “homerun stock” or the next “ten-bagger.” Growth investors tolerate more risk but are compensated with the potential for higher returns. Shares of most high-tech companies are considered “growth” stocks. Growth investors would choose the kid over the veteran.
However, at the end of the day this battle royale between “value” and “growth” investing doesn’t have a clear-cut winner. In fact, there is no winner at all, because there is no fight at all. See, the question to “Which is better, value or growth investing?” doesn’t have an answer because the question is fundamentally flawed.
Let me explain.
Value and growth investing are not enemies. They should not be thought of as contrasting strategies, on either end of some imaginary style spectrum.
Take this passage from Warren Buffett’s 1992 Berkshire Hathaway Shareholder Letter:
But how, you will ask, does one decide what’s “attractive”? 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 that 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 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? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).
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 value, 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 investments. 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. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
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 the investor.
So what’s Warren saying?
For one, the classical definitions of value investing and growth investing as I described above don’t make any sense. To understand why, let’s first define each style by what it is not. If value investing is purchasing assets for less than their true value, then what is “growth investing”? It is the opposite, or purchasing assets at a price greater than their true value. But paying more for a stock than it’s worth “in the hope that it can soon be sold for a still-higher price” is not investing at all – it’s speculation.
Even if a “growth investor” were to buy a “growth stock” that was supposed to grow earnings at an above-average rate, he or she would correspondingly have to pay a higher multiple for those earnings in the first place. In other words, the growth rate of those earnings has already been baked into the purchase price (picture what happens if you increase the growth rate in a simple DCF analysis – present value increases). If that wasn’t the case, the stock would be worth more than the purchase price, which is the definition of value investing. Consequently, growth investing cannot exist: you’re either value investing or you’re speculating.
But now let’s look at “value investing” as defined earlier. If growth investing is purchasing shares of companies whose revenues or earnings are predicted to grow at an above average rate, then value investing is purchasing shares of companies whose revenues or earnings are predicted to remain flat or decline. Now, this is not technically wrong. Value investors can certainly invest in companies whose earnings are flat or are declining. But it is merely a subset of all the strategies available to value investors.
Take a look at “the father of value investing” Benjamin Graham’s investment in The Government Employee Insurance Company (better known as GEICO). GEICO was founded in 1936. By 1940 the Company booked its first underwriting profit of $5,000. Graham started investing in the Company in 1948 and by the next year the Company’s profits exceeded $1 million. That’s an annual growth rate of over 90%. Ben Graham invented value investing, but GEICO looks like a “growth” investment to me.
Now let’s look at Graham’s greatest student, Warren Buffet, and his investment in GEICO. GEICO’s earnings eventually peaked in 1972, followed by 10 years of decline. The Company’s stock had hit a high of $61 per share in 1972 – a few years later it was trading at just above $2 per share. GEICO began reporting huge losses in 1975 and was on the brink of bankruptcy. Buffett, who had first purchased stock in the Company back in 1951, started snapping up more shares and by 1980 had invested $45 million in GEICO. Okay, typical “value” investment. But today, GEICO now records profits of over $1 billion a year! Again, there’s no way that isn’t above average growth!
As Warren said in his 1992 Shareholder Letter, growth is merely a component in the calculation of the value of a stock, and it can be present or absent, and a positive or negative influence. So the common definition of “value investing” is already wrong, because value can also incorporate growth.
Secondly, the term “value investing” itself is redundant. “What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?” Remember, “price is what you pay, value is what you get.” The only way to make an above average return in any transaction is by giving up less than the value you are receiving. This is pure common sense. There is no way that I would trade you three nickels for a dime – I’d trade you one nickel for a dime or at the very least a nickel and four pennies. That is investing; all else is speculation.
Despite the confusion caused by the media and finance professionals, who toss the term around without knowledge of its true meaning, the core tenets of value investing can be accurately summarized as follows:
1. PRICE IS WHAT YOU PAY, VALUE IS WHAT YOU GET
It’s all in the name. Above all else, value investors focus on the price they pay and its relationship to the value they are receiving in return. Many people forget that a stock is an actual partial ownership in a business and not just a paper certificate. As such, a stock’s true worth lies in the cash and economic value that the business is able to generate over time and not in the market’s quoted price.
In The Intelligent Investor, Benjamin Graham introduced a metaphor for this principle: Mr. Market. Mr. Market is a kind neighbor who stops by your house every day, offering to buy shares from you. Sometimes Mr. Market is in a wonderful mood and makes a generous offer. Other times Mr. Market is cranky and offers you a ridiculously low price. Mr. Market also offers to sell shares of businesses to you, and always at a price that is dependent on his mood that day. You are always free to accept or decline his offer, for he will be back again the next morning.
Value investors do not pay much attention to the short-term fluctuations of the market, knowing that the true worth of a stock lies with the company itself, and not in a stockbroker’s hands.
Warren Buffett also has given sage advice on this matter: “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”
Value investors, above all else – and at their very primal core, know the price of everything, and the value of everything, and they only buy when the price is right.
2. VALUE INVESTORS ARE INTELLIGENT INVESTORS
Don’t worry, this has nothing to do with SAT scores. As Warren Buffet has said, if you’ve got an IQ of 160, you’re better off selling 30 points to someone else because you won’t need them. This concept, introduced in Ben Graham’s The Intelligent Investor, is more about managing yourself than it is about managing your portfolio.
The key characteristics of intelligent investing are: a focus on price, as already mentioned; a detachment of your own emotions from the vicissitudes of the market; a reliance on hard facts and realizable historical performance, rather than hopeful projections and guesswork; and the concept of “margin of safety,” which is the difference between a stock’s intrinsic value and its market price.
Value investors seek out large margins of safety when investing.
“You don’t drive a truck that weighs 9,900 pounds across a bridge that says ‘Limit 10,000 pounds’ because you can’t be that sure. If you see something like that, go a little further down the road and find one that says, ‘Limit 20,000 pounds.’ That’s one you drive across.”
Ben Graham had a saying that I always liked: “You don’t need to know a man’s weight to tell him he’s fat.” In other words, the biggest margin of safety you can have when analyzing a stock is when you don’t even have to do any calculations to know it’s a good investment.
3. CHOOSE YOUR WEAPON
The traditional and common idea of “value investing” (as we discussed earlier) is the strategy of selecting stocks with low P/E or low P/B ratios. But there are many other strategies available to value investors, such as the following:
- Net-nets: Finding stocks that are trading for less than their “net net working capital,” or for less than their current assets less total liabilities.
- Deep value: Finding stocks with very large margins of safety.
- Distressed: Investing in stocks or bonds of companies that are distressed or in the midst of bankruptcy.
- Turnaround: Purchasing a control position in a company to effect operational changes or efficiencies, a strategy of some private equity shops.
- Activist: Investors like Carl Icahn who acquire large stakes in companies and then lobby for changes in the Board of Directors, increased dividend payments, and/or share repurchases in an effort to release untapped value.
- The Buffett Disciples: Buying amazing companies at good prices.
- “Growth at a reasonable price”: Peter Lynch’s strategy of buying high growth companies at an appropriate price.
- Pawn Stars: Value investing can also be found outside of the financial world, such as in thisHistory Channel TV show where a Las Vegas pawn shop tries to find, haggle for, and ultimately buy items for less than their true value.
- Moneyball: Value investing has even found its way into sports. Billy Beane’s strategy of using certain statistics such as on-base percentage and slugging percentage to find baseball players that were “undervalued” by other teams (rather than the more popular and headline-grabbing stats like number of home runs and stolen bases) allowed the Oakland Athletics to become one of the best teams in baseball on a payroll that was only a third the size of many other teams’.
4. IT’S NOT A STRATEGY, IT’S A LIFESTYLE
Value investing is not a strategy, as the common definition would have you believe. It’s a philosophy. It’s a lifestyle. Value investors believe in the price-to-value relationship and the importance of having a margin of safety down to the very marrow of their bones, and this belief is evident in all aspects of their lives.
Warren Buffett still lives in the same house he bought in 1958 for $31,500 and has worked in the same modest office building for over 50 years. Earlier in his career when he had business to do in New York City, he would stay with friends, sometimes for several weeks at a time, to avoid paying for a hotel room – despite the fact that he was a multimillionaire at this point.
The famous value investor Leon Cooperman drives his own car (as does Warren), buys his own newspaper every morning, and stays at a friend’s house instead of getting a hotel when he visits the Hamptons. Many value investors set up their investment shops as lean machines with few employees and little overhead – all in an effort to avoid wasting money.
It’s hard to say for certain if individuals are driven to value investing because of their personalities or if they develop their personalities because of value investing – but I tend to believe in the former. If it’s already part of your personality – if it’s in your DNA – then the concept of value investing should just “click.” Value investors are able to tune out the market noise and keep their wits about them while everyone else succumbs to fear and greed because it’s a part of who they are.
Let’s return to the boxing ring, where the veteran and the rookie are about to face off. With all that you now know about value investing, it doesn’t matter who wins the fight. The only thing that’s important is that you’re in the ring when the bell sounds.