The stock markets currently offer us very few opportunities to go bargain hunting. It isn’t easy to find companies that meet our simple but quite strict requirements. While we know that we cannot time the market, we also don’t want to blindly follow the herd and throw our money into the current hype stocks. We look for value in return for our investments. I used to make the mistake of thinking of value and growth as alternatives. Today, however, I know that there is no value without growth investing.
Value and growth investing
Before I share some of my own experiences, let’s take a quick look at the terminology. As always, the Internet is full of in-depth explanations. I’ll only summarize them to have a basis for my thoughts.
Value investing
Value investors try to use fundamental data to assess the intrinsic value of a company. In doing so, they primarily look for unpopular companies, which have a hard time, or generally have not yet been “discovered” by the market. The great role models of value investors are Warren Buffett and Benjamin Graham. Other examples are Charlie Munger, Bill Ackman, Li Lu, or Davin Einhorn.
Among value investors, the difference between the company’s intrinsic value and its share price is decisive for an investment. In a nutshell: If the price of a share is below the intrinsic value, then the share is undervalued and considered a good buy.
Investors often refer to traditional dividend payers as value companies. These are primarily mature companies with a strong position in consolidated markets. Growth tends to be low and usually in the single-digit percentage range. To compensate for the somewhat meager growth, these companies often generate stable profits and high cash flows, which allows them to buy back shares or pay dividends to shareholders. The investment risk is thus a bit lower, but so is the upside potential.
Growth investing
When investors say they pursue growth investing, they are looking at companies with a high growth rate. These are mostly younger companies, acting as pioneers that shape and drive new markets. The FAANG companies are perfect examples for those companies.
Often these companies are not yet profitable or put a lot of money into further growth. Perhaps, they still need to scale their business to become profitable. In the absence of profitability, investors then look at variables such as price/sales ratio. An investment in unprofitable growth companies therefore always has a speculative element. Since the company is not yet profitable, investors are speculating that it will cross this threshold in the near future.
Investors often hope that growth investing will allow them to accumulate capital quickly. But we know already that with the prospect of more return comes more risk. Thus, there is, of course, no guarantee of excess return. No method allows you to accumulate capital quickly and then invest it in so-called value companies. From my point of view, this is, for example, the big argument against the idea of swing trading.
What is superior (in theory)?
According to this classification, we can also halfway evaluate the performance of both strategies. In the long term, we see that the value investing strategy outperforms growth investing. Since 1928, value investing has outperformed a strategy based on growth investing by more than 4.5 percent on average.
As we can see above, one of the biggest outperformers for growth stocks was during the dot.com bubble. But the last few years have also been cumulatively good years for growth investing strategies. So we see that just because something has outperformed in the past doesn’t necessarily mean it will also in the future.
We cannot simply extrapolate past time series. We otherwise start to see patterns and correlations where none exist. Why should the performance of value stocks in the next few years be based on how they have performed over the last 50 years? Why shouldn’t they underperform in the next 50 years? Then the statistics would change. Would we then only use the growth strategy?
My readers know that I am pursuing a radical Socratic “I know that I know nothing” approach here. That’s why I don’t rely on backward-looking statistics when making forward-looking investment decisions. Instead, I try to ignore those statistics (mostly) right from the beginning.
Some additional thoughts
I also believe that, as a result, there is no value without growth. At least not according to my investment approach. Growth can be worthless without the right ingredients. Likewise, value does not necessarily lead to growth.
No value without growth
One thought is that value does not exist without growth. Let’s dive a bit into this.
The very idea of investing is to take a stake in a company. It is an exchange – a do ut des. I give (money), and you give (ownership) in return. I want to become an owner so that I can profit from the success of profitable companies. By taking these profits, I steal a chunk of substance from the company. The company is like a tree in a field. And now and then, I grab a few juicy apples from it. That is the essence of my approach. I want my investments to put food on the table for my family and me.
My readers and I don’t have just one apple tree. Our approach is to own a whole farm. But what is valid on a small scale is also true on a large one. We can’t live off our companies’ substance. Otherwise, we would end up consuming our investment. If we want to own a farm, we should think like a farmer or entrepreneur.
Instead of consuming the value-bearing assets, a farmer has to make sure that the plants grow and that the animals are doing well. That’s the only way the farmer can profit from the farm and the work he is putting into it. Standstill and deterioration are destructive. So without continued growth, our farmer would be in real trouble.
Growth does not necessarily lead to value
Therefore, value without growth is not possible. But be careful. The opposite is not automatically true. Growth is very much possible without value. We often see companies growing and getting bigger and bigger without creating more value for us as owners. The decisive criteria here are cash flow and profits.
I invest mainly in companies that generate at least a positive cash flow. That is a sign of a healthy business model. Otherwise, anyone can make money with debt. I, too, can generate more revenue by taking on more debt. That’s not hard at all. But it’s not what I want.
Mistakes I made in the past
In the past, I have also made some mistakes on this front. Often I paid too little attention to the growth criterion. Instead, I have mainly focused only on the value criterion. Especially with some traditional and noble dividend companies like Royal Dutch Shell, Altria, IBM, or AT&T, this can have negative impacts on the overall performance. There, I have ignored the competitive environment in which the companies operate somewhat.
Yes, payout ratios, favorable valuations, all that was (mostly) great, but in the long term, companies must also be able to compete in the market for the reasons mentioned above. And here is the problem. It is challenging for companies to grow when they operate in markets that do not make it easy. The tobacco and the oil sector have a hard time. IBM has missed out on the cloud business.
That doesn’t necessarily make the investments in the companies bad decisions or mistakes. Nevertheless, my mistake was that I paid too little attention to the growth criterion. Business growth is just as significant as the aspects we investors usually associate with value. So my mistake was not being aware of my actions’ consequences. If I live at the expense of my companies, I automatically steal their substance. In the long term, I will hurt myself as the owner of these companies.
My growth and value investing strategy
I have realized that there can be no value investing without adding elements of growth investing. That’s why I look at the growth prospects of companies very carefully now. If future growth is uncertain, I give the company a wide berth. Maybe I’ll miss one or two turnaround stories, but that’s the way it is then.
Of course, this approach limits the selection of possible investments. I mean, at the end of the day, I am looking for a highly profitable, fast-growing dividend payer with a dividend yield of over 2 to 3 percent. Of course, finding such a company is impossible. Accordingly, we have to adjust and find compromises. There is no such thing as the perfect investment at the time we invest in it. But that’s what makes it so exciting. The search for the great company that will put food on our table for decades.
All the best,
TEV
