"Value" and "Growth" Stocks

Much has been said recently about the performance of big tech stocks, and rightfully so. A few of them are growing rapidly, including due to heavy investments into artificial intelligence—think Nvidia or Microsoft, for example. The conversation often turns to the dichotomy between so-called “growth” and “value” styles of investing. As the industry convention goes, growth stocks are the ones growing rapidly, whereas value stocks are the ones that trade at low price-to-earnings, price-to-book, or price-to-cash flow multiples—an industry quick hand for valuing businesses. Investing in low-multiple stocks is then taken further to mean “value investing”. Here’s Warren Buffett’s quick take on the issue:

“Growth is part of the value equation, so there is no such thing as growth stocks or value stocks the way Wall Street portrays them as being contrasting asset classes.”

Our followers know that we are investors in individual companies and, similarly to Buffett, do not subscribe to Wall Street’s definitions of “growth” and “value”. Instead, we work to understand the intrinsic value of a given business, which may or may not incorporate growth in some real element of the business like the number of customers, product shipments, insurance policies, or stores. Take your local dry-cleaning business, for example. The price that a private buyer would pay for that business would surely be based on the cash flows it generates and its prospects, including growth in customer traffic, the quality of cleaning, and the impact of buying a new, more efficient piece of equipment. A dry-cleaning business with better prospects would presumably sell at a higher price and a higher price-to-cash flow multiple than the one with more modest attributes such as a low-growth location or stiff competition. Does that mean that a low-price multiple business with modest prospects (i.e. the “cheap” one) is a better investment than the higher-price multiple one with a high-growth potential?

To answer this question, it might be worth revisiting the way we value businesses. The first and arguably the surest component of value is the price a business would get if it sold all its assets (think property, equipment, or inventory), net of obligations, to reasonable buyers. The second level of value—call it the earning power value—is based on current, normalized cash flows the business is generating. The price multiple would then vary based on the certainty around those cash flows and the length of time during which the business can sustain them. Companies are often priced at cheap price multiples for good reasons, i.e. their cash flows may be declining or even stopping sometime in the future because of an insurmountable competitive threat or too much debt.

The third level of value is the least certain but potentially most consequential. It is based on growth of future cash flows with or without reinvesting profits back into the business. A business can satisfy growing customer demand using existing capacity or reinvest profits into additional talent, equipment, or acquisitions at some rate of return. Attractive reinvestment rates can expand business value for years and years into the future whereas poor ones can destroy it. Buffett describes the merits of reinvesting into growth as follows:

“Growth is usually positive for value but only when it means that by adding capital now you add more cash later on at a rate that is considerably higher than the current rate of interest… At Flight Safety, we are going to buy $200 million worth of simulators this year. Our depreciation will run at $70 million this year. So, we are putting $130mln above depreciation into that business. That can be good or bad. It’s growth, there is no question about it, because we will have more simulators at the end of the year, but if it’s good or bad depends on what we earn on that incremental $130 million. So, if you tell me that, if you own a business that’s going to grow to the sky, and isn’t it wonderful, I don’t know if it’s wonderful or not until I know what the economics are of that growth…“

In addition to the math behind business value, investor behavior often gets in the way and creates significant mismatches between intrinsic business value and the market price. Companies with attractive growth opportunities get bid up unreasonably high in times of exuberance or punished in times of stress. Likewise, companies with low or no growth prospects sometimes get sold or bid up to unreasonable levels. All of this is to say that there is considerably more to value investing than buying stocks at cheap price multiples. Our job then is to find businesses with attractive and sustainable reinvestments opportunities, invest in them at good market prices, and take advantage of those reinvestments for years into the future.