Decoding Value vs Growth Investing

Discussion of the conventional notions of value and growth investing strategies (or styles) and how true value investing is growth investing.

Understanding Value Investing

While this subject has gotten a lot of explanation from Mr. Buffett and friends, value investing is still misunderstood.  I get questions all the time asking me about the value style box and the distinction between value and growth investing strategies.  Also, I hear a lot about value investing "having a hard time" or being out-of-favor or even dead.  Value investing does not fit in an equity style box despite Morningstar's desires.  As Mr. Buffett and the late Mr. Munger pointed out, value is a function of growth.  Value and growth are two sides of the same coin.  

Conventional Wisdom: Value vs Growth

Conventional wisdom of a value investor is an investor who typically looks for stocks that have a low price-to-earnings (P/E) ratio, low price-to-book (P/B) ratio, or other indicators of undervaluation.  This is not value investing.  I agree with Mr. Munger on this one - using a point in time multiple to determine undervaluation is a "know nothing" way to approach valuation. 

Conventional wisdom of a growth investor, on the other hand, is an investor who typically focuses on stocks that have the potential for high earnings growth.  Investors who follow this approach are willing to pay a premium for stocks that they believe will experience significant growth in the future.  Growth investors typically look for companies that are in growing industries or have innovative products and services.  They believe that these companies will be able to sustain their growth and generate strong returns for shareholders.  True value investing loves growth - a growing pie provides an ever increasing slice to its owner.

Unconventional Wisdom: Value Investing

Value investing is a strategy that involves buying stocks that are considered undervalued.  Investors who follow this approach believe that the market sometimes undervalues certain stocks - business value disconnects from market price - leading to opportunities for long-term gains.  This strategy is based on the belief that the market will eventually recognize the true business or intrinsic value of these stocks, leading to price appreciation.  Intrinsic value represents the amount of cash  (a/k/a free cash flow) the owner can take out of the business during its remaining life.  This is value investing, the determination of intrinsic value.  In order to figure out how much cash can be taken out of a business, an investor would consider whether the stream of cash produced by the business was declining, flat, growing or some combination thereof.  The trajectory of the cash flow stream would affect the present value of those cash flows and therefore business value.  A growing stream of cash flows would be worth more and its intrinsic value would be higher.  All value investing is growth investing.

The Value Equation

The Value Equation blog was born out of the questions I get almost daily from investors, speculators, friends, family and strangers.  As I sought to simplify my explanation of value investing, I reduced it to a formula (which may be a gross over simplification but makes sense to me): 

VALUE = GROWTH + QUALITY + STEWARD + ECONOMICS + TIME

further 

OPPORTUNITY = (VALUE + VOLATILITY) - PRICE

VALUE

Growth is the concept that a growing pie provides an ever increasing slice to its owner.  Quality has to do with the durability of the cash flows the business produces (notice this screens out businesses that do not produce free cash flow).  A steward is the desired manager to run the business - business operated by a manager that acts like an owner if they are not an owner.  Economics points to high returns on tangible assets and reinvestment opportunities at those high returns.  Time is the friend of a good business and the necessary ingredient for compounding.

OPPORTUNITY

Value is noted above.  Volatility is the factor rooted in open outcry, auction driven markets as participants show up each day playing different games and generate "activity" (i.e. technical, speculator, investor, timing, familiarity, etc.).  Price is the market price of the business and not always a reliable indicator of the underlying business value, especially in the short run.  My mantra is volatility creates opportunity for the discerning investor that shows up to the market each day only transacting on the basis of intrinsic value and seeking to compound over a longer-term horizon.  Price is what you pay, value is what you get.