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

 

I Got a Dollar

This morning I bought 7 shares of Dollar General stock for $110.57 a piece or 773.99 total. I am left with $5,949 to work with. I have invested just over 40% of my original 10K into 5 different companies. I hope to diversify a little more, making smaller positions going forward. I intend to buy somewhere between 12 and 15 companies total.

Why DG

As a dollar store, Dollar General sells cheap items providing great value to their customers. How can you make money selling things for a dollar? Well as it turns out DG is able to make a whole lot of money selling at discount prices. This past quarter they sold almost 6.5 billion dollars worth of goods and earned 407 million on those sales. By selling only a limited number of SKU’s and ordering in huge quantities the company can source products at bare bone prices. When they buy from a supplier, they are making an order for a company with over 14,000 stores. This leads to great economies of scale. Additionally, they only target small inexpensive items. Don’t expect to find a new car in a dollar general.

What separates Dollar General from their competition is their focus on location and on the customer experience. Instead of targeting large cities, they focus on small towns. Think of how Sam Walton built Wal Mart and his focus on rural america but at a micro level. These small towns aren’t large enough to support a Wal Mart or a Target and they are difficult to reach for Amazon. For Dollar General however they are moneymakers. DG builds out small stores, under 10,000 square feet and stocks them with brands consumers want. They also take great care in design. Every store is bright and welcoming, encouraging shoppers to come more often and spend more.

Financially, the company has performed superbly. While not the fastest grower, they have increased both sales and net income every year since going public in 2010. I particularly like the way Dollar General has been able to plow down their share count. At the start of 2014, DG had over 317 million shares outstanding. That number now stands at 266 million, a 16% reduction. This cutback is substantial. Each share now owns considerably more of the company, therefore a larger share of a growing stream of income.

The company is also becoming a free cash flow machine. This past year their cash flow from operations equaled 1.8 billion and had 640 million in capital expenditures, leaving them with almost 1.2 billion in free cash. They were able to use this free cash to pay a reasonable dividend, buyback a meaningful amount of shares and pay off a fair amount of debt. This free cash number should grow meaningfully over the years.

DG is now trading right around a 20 P/E. While not incredibly low, it is a fair price to pay for a strong and growing company. Remember as a GARP investor, I’m not looking for the cheapest possible company. I’m looking for a great company to hold for years into the future and if I can find such a company, I’m willing to pay a reasonable price. Dollar General has ticked my boxes and therefore I’ve decided to become an owner.

As always thanks for reading and subscribe on the side! Follow me on Twitter and Instagram @thegarpivnestor

 

Stock #2 (HII)

I logged on this morning and bought my second stock for the portfolio. Huntington Ingalls Industries (HII) is a military shipbuilder and the leading supplier of the United States military. I got in today at $249.00 and purchased 3 shares for a total of $747.00. I still have $8,579.88 of cash left in my 10K Portfolio.

Why HII?

From a broad perspective, I often like to have an impetus behind an investment. You need to be able to tell a story and then focus in on the minutia. Looking at the Trump administration, I don’t think it is a stretch to say he favors a growing military budget. This set me on a quest to look at all the public military contractors. One thing I noticed is that they are almost all great companies. It is no wonder the US military spending is so large and growing. From there I determined HII was my favorite and have been following it ever since.

Huntigton Ingalls is a classic high moat company. They are the leading supplier of the US Navy, supplying over 70% of all ships. They are the only company capable of building and refueling nuclear-powered aircraft carriers and one of only two that can build a nuclear powered submarine. They were spun off from Northrop Grumman in 2011. Spin offs are often a good candidate for research, as they are not always properly valued. Seven years later, HII continues to gain market share and grow their earnings.

HII generates ample free cash flow each and every year. You might start to sense a theme, I prefer companies with lots of leftover cash ever year. This gives a company flexibility, they aren’t constrained to any one strategy. Should they see a good acquisition opportunity then great, otherwise they can pay out dividends or buy back shares of the company. The board recently increased the buyback allowance from 1.2 billion to 2.2 billion. If my math suits me correctly 2.2 billion is just over 20% of the entire company. They won’t buy it all back overnight, but the share count should fall dramatically over time.

While 2017 wasn’t quite a banner year, they more than made up for it in the first half of 2018. Due to lower taxes, a reduced share count and higher sales and margins earnings increased YoY from 3.21 to 5.40. That’s an increase of 68% in a single calendar year. While we can’t expect such growth going forward, that would be impossible. The company will continue to perform with precision.

Conclusion

Huntington Ingalls is a simple but extremely well run company. They will never be the fastest growing company, but they are almost guaranteed to grow at a decent clip over time. They have a growing backlog that will keep them busy for years to come. As of the end of 2017 their backlog stood at $21.4 billion. The company will continue to buy back shares and grow their earnings. They are trading at a reasonable multiple and over the course of 5-10 years the company will be considerably larger.

My First Purchase

Guess what? I bought my first stock this week for my 10K Portfolio! I am now the proud owner of 4 shares of the Lear corporation(LEA). I purchased 4 shares for 168.28 a piece for a grand total of $673.12. This still leaves me with a cash position of $9,326.88. Of course as soon as I bought it, the stock continued to fall. O well. If an immediate fall in price causes you trauma, I fear investing in stocks just might not be for you. Keeping an even temperament is probably even more important than a high IQ.

Why Today?

When I logged on to Robin Hood on Wednesday, I checked my watch list and saw that Lear was down almost 3.5%. Seeing that a stock I follow is down, I made a quick google check to see if there was any news. Turns out that there is increased worry about trade within the auto sector in NAFTA. The trade war is real and it may materially impact the earning power of the business. That being said, I think the company exhibits a strong moat and this is just providing an opportunity to buy a stock on the cheap. Would I have rather made my initial position even lower? Of course, but you never know when you will find the bottom. Buy in and if it falls lower, buy more.

Digging Deeper

Lear now sits at a P/E of 9.06. According to the Wall Street Journal, the S&P 500 average P/E is 23.79. This means that on just a P/E basis, Lear is almost 1/3 the price of the S&P 500. Looked at another way, Lear’s earnings could be cut in half and their P/E ratio would still be noticeably cheaper than the S&P 500.

As mentioned in my Watch List post, Lear is a vertically integrated manufacturer of automated seats for automobiles. It is simply the best in the business, displaying a wide moat. In the last 5 years it has increased sales from 16.2 billion in 2013 to 20.5 billion in 2017. EPS grew even faster going from 5.61 to 17.66 in the same time period. In 2017, Lear generated just under 1.2 billion dollars in free cash flow. Based on the current market cap of 10.9 billion, it has a free cash flow yield of 10.9%.

I also like what management had to say in their most recent annual report.

We also have an outstanding record of returning cash to our shareholders. Since we initiated dividend and share repurchase programs in 2011, we have returned more than $4 billion to our shareholders, which includes buying back 42% of  our shares outstanding and steadily increasing our quarterly cash dividend.

I believe that this is a great time to invest in Lear. We have the strongest team in the industry, a focused strategy that is delivering superior results, a growing market share in both business segments, a footprint that is second to none, a well-established and growing position in china and a record three-year sales backlog of $3.2 billion.

Conclusion 

Lear is a classic GARP stock, growing at a fast rate and selling for a bargain price. Even if it is impacted by this trade war, they have the financial strength to withstand a couple of tough years. 5-10 years from now they will be a significantly bigger business which earns appreciably more free cash. The company should actually be rooting for the stock price to fall. Given that they spend so much on share buybacks, Lear could buy back considerably more shares should the stock fall or remain flat.

 

 

Welcome!

Hey there and welcome to my new blog! As some of you might know, I used to run a blog called Tuckerinvesting.com. You can still find the site, I pay a menial fee to keep it up and running. I ran the blog for about a year, but ultimately gave it up when I failed to attract a meaningful following. I figured it simply wasn’t worth taking the time to write up a post if nobody was going to read it. Well, hell with it! After a long hiatus, this blog boy (shout out Kevin Durant) is finally back in action and better than ever.

Every now and then I like to reminisce and read some of my old writings. Sometimes I was right, sometimes I was wrong, but mostly I think I was young and naive. Naive in my thinking, naive in my belief that you could only invest the same way I do, and moreover naive in how easy I thought it would be to attract readers without doing any real marketing.

Why The GARP Investor?

Part of my problem was that I failed to identify my niche and therefore failed to find the right readers.  In order to be successful, every investor has to identify the style that fits their personality. There are all kinds of ways to be successful in investing. Some people focus on commodities, shifting in and out when they find price discrepancies. Others like to short companies, capitalizing on failing businesses. Some can even find success investing in cryptocurrencies(though you won’t find me barking up that tree.) None of these are necessarily wrong, they just don’t work for me personally.

After doing some soul searching, I finally arrived at my own style. It is commonly referred to as GARP investing or growth at a reasonable price. I’ll leave it up to Warren Buffett to explain it in his words found in the Berkshire Hathaway 1996 annual report:

 

To invest successfully, you need not understand beta, efficient 
markets, modern portfolio theory, option pricing or emerging markets.  
You may, in fact, be better off knowing nothing of these.  That, of 
course, is not the prevailing view at most business schools, whose 
finance curriculum tends to be dominated by such subjects.  In our view, 
though, investment students need only two well-taught courses - How to 
Value a Business, and How to Think About Market Prices.

Your goal as an investor should simply be to purchase, at a rational 
price, a part interest in an easily-understandable business whose 
earnings are virtually certain to be materially higher five, ten and 
twenty years from now.  Over time, you will find only a few companies 
that meet these standards - so when you see one that qualifies, you 
should buy a meaningful amount of stock.  You must also resist the 
temptation to stray from your guidelines:  If you aren't willing to own a 
stock for ten years, don't even think about owning it for ten minutes.  
Put together a portfolio of companies whose aggregate earnings march 
upward over the years, and so also will the portfolio's market value.

Astute investors will obviously notice why I have named this blog The GARP Investor. I am indeed paying homage to the grandfather of value investing, Benjamin Graham, who famously wrote The Intelligent Investor

With that, I encourage you all to follow along and subscribe.

Thanks for reading!