Value vs Growth? How About Both!

Humans love to use labels. From low carb to bridezilla, labels are used in almost every walk of life.  It comes out of a need to identify and place something within a group. I myself have fallen victim to this very affliction, I purposefully called myself the GARP investor. Investors don’t stray from this norm, in fact they typically embrace it. Investors generally fall into one of two overarching categories: value or growth. Of course there are hundreds of subcategories ranging from deep value to angel investing but ultimately these are just derivatives of the main two categories with a slight spin. These two frequently find themselves at odds with one another. Members of one group can never seem to grasp the thinking of their counterparts. I personally find these arguments to be all for naught. In my opinion growth is just a factor used in determining a company’s value. They are two sides of the same coin and inextricably linked

Let’s examine what Warren Buffett had to say on the matter. In his 1992 letter to his shareholders(which you should all go ahead and read in its entirety), he tackled this very issue.

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?

I don’t understand why an investor can’t be both a growth and a value investor, or rather just a regular plain vanilla investor. When making an investment, the goal should always be to find value. Growth is merely a factor in determining whether there is value in the investment or not. In fact, there can be investments of incredible value with no growth and even no value with incredible growth. This is why the price paid is so important. Let’s look at some examples to demonstrate:

Value With No Growth

Imagine a company that earns 1 million dollars a year in profit manufacturing toasters, whose fixed assets equal all of their liabilities. This company then needs to spend 1 million on capital expenditures in order to fix their machinery to sell the exact same amount of toasters. In year 2 they will make that same 1 million and spend that 1 million on fixing their machinery. There is never any cash leftover in the business. In years prior however, they were more profitable and were able to save up 5 million in the bank. Because they are unable to grow their earnings the P/E ratio has fallen to a pittance of 3. This means the whole business is only selling for 3 million. A classic value investor would buy what Buffett would call a “cigar butt” for 3 million. He would close the business, sell off the fixed assets to pay off the liabilities and walk away with the 5 million in cash. He bought it for 3, walked away with 5 and made a quick 2 million dollars, a 66% return. Unfortunately, the market is more efficient these days and such easy money is no longer there for the taking. Had you paid above 5 million for the same business, it wouldn’t be nearly as enticing. Price paid is what ultimately determines the success of an investment, even if there is no growth in the business.

Growth With No Value

First let’s look at another Buffett quote from the same letter.

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.

Let’s now imagine a successful company with a decision on their hands. This company has no debt, earns 200 million dollars in profit and has a billion dollars of equity. They therefore have a Return on Equity(ROE) of 20% and have a market cap of 2 billion(a 10 P/E). The company generates lots of free cash with no maintenance CapEx and doesn’t know how to spend it. They can either pay out this money for a 10% dividend, buy back 1/10 of the shares outstanding for a 10% return(buying shares back at a 10 P/E) or invest internally to try and grow the business. If we ignore the effect of taxes, paying out a dividend and buying back stock should have the same result. The question is what kind of return can the company generate by growing internally. Should the company invest that 200 million back into the business but grow earnings by any less than 20 million, it will generate less than a 10% return. Even if sales and earnings grow, this would be a poor allocation decision. While ROE is currently high at 20%, each dollar reinvested will have a Return on Incremental Capital far lower. Why dilute a great business by investing in low returns?

In this example, growing the business could actually hurt the investor. While they could  maintain the status quo as a high ROE business paying a generous dividend or buying back stock, plowing money back into the business at lackluster rates of return actually loses value for an investor. Unless you can invest each dollar back into the business at high rates of return, it is best for a company to look elsewhere for allocation decisions. Just because a business is growing, doesn’t mean it is the best way to provide value to its shareholders.

In conclusion, the difference between value and growth is really just semantics. As investors we are all looking for the same thing, finding value and making a good return on our investments. There are any number of ways to do so, but ultimately it all comes down to the price paid being less than intrinsic value.

As always thanks for reading! Please subscribe on the side and you can find me on Instagram and Twitter @thegarpinvestor

 

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Building a Watch List

Before you can buy a stock, creating a watch list is vitally important. A proper watch list focuses your attention and lets you weed through most of the junk. I am attempting to put together a list of companies that could be interesting should they hit a reasonable price. That’s not to say you should automatically buy them, but they deserve a closer look. For that matter, they may already be at a perfectly reasonable price, but there is no rush to buy in. I am looking to buy stocks for the long run. If you intend to hold a stock for 10+ years, waiting weeks or even months before you pull the trigger isn’t all that important. It is far more important to make sure you pick the right companies rather than picking the right price.

5 Stocks to Look at:

Here are 5 stocks I’m currently looking at. Each of these companies displays classic GARP tendencies. They grow revenue and earnings each and every year, employ limited amounts of debt and can be found at reasonable P/E ratios. My own personal list is over 40 companies long, but I don’t have the time for a write up on each of them.

ODFL

Old Dominion Freight Line is a less than truckload freight company. An essential part of the economy, trucks are always in need. While rail is still the cheapest way to ship coast to coast, you need a way of getting items to and from the warehouse. ODFL is best in class for smaller orders, where a full truckload isn’t quite necessary. A classic capital compounder. Since they went public in 1991, this stock has gone up over 70x. Last quarter YoY revenue growth of 23% and EPS YoY growth of  65.8%. Can’t ask for much more than that.

LEA

Lear Corp. manufactures a product you all have probably sat on and never even thought about. They are a vertically integrated world leader in automated seats for automobiles. They really only do one thing, but they do it incredibly well. They generate a tremendous amount of free cash flow, which enables them to buy back shares of the company in droves. At the start of 2014 they had 81 million shares outstanding. That number now stands at 66 million. Every shareholder should be happy to now own significantly more of the company.

IPGP

The leader in laser technology, IPG Photonics creates laser powered technology that is sold to manufacturers around the globe. These lasers enable manufacturers to produce items at a lower cost, which encourages more spending on CapEx. These lasers are used in all kinds of fields ranging from car manufacturing all the way to medical devices. The total addressable market is massive. They have hit a bit of a hiccup lately due to the Trump administration trade war, given that their main customers are foreign manufacturers. For that reason I think it is best to wait and see how this trade war plays out.

APH

Amphenol develops small components and connectors used in complex electronic machinery. They are a company no one would ever think of, but sells more every single year. They sell to virtually every industry imaginable. Like others on this list, they generate ample free cash flow. They use this free cash every year to make acquisitions, buy back stock and pay a growing dividend. A classic compounder, since going public in 1992 they have been a 200 bagger.

FB

Given that we’ve gone over a bunch of really well known names, let’s look at one nobody has heard of. Just kidding of course. Facebook is one of the biggest, strongest companies on earth. They have fallen a bit lately due to fears of slowing growth rates and falling margins. I feel these fears are short sighted. Looking years into the future, we simply don’t know how strong a network Facebook could be. They already have daily average users of nearly 1.5 billion, a number that is still growing rapidly. Given how many people are on the platform, monetization is only just beginning. They make their money primarily through advertising, but could start making money through any number of different avenues. How about the fact that they also own Instagram? 10-20 years from now I think we could legitimately be looking at Facebook as a multi trillion dollar company.

Thanks for reading. Comment any companies you have on your own watch list. As always follow along and subscribe!