“A challenge only becomes an obstacle when you bow to it.”
― Ray Davis (Famous General in the Marines)
In the investing world, one major challenge is defining the differences between “growth” vs. “value.” Warren Buffett said it best when he described growth and value as two separate sides of the same coin. In general, low or declining growth will be valued less than a comparable company with faster growth.
Often, most companies go through a life cycle just like a human would (see Equity Life Cycle). In other words, companies frequently start small, grow larger, mature, and then die. Of course, some companies never grow, or because of lack of funding or outsized losses, end up suffering an early death. It’s tough to generalize with companies, because some businesses are more cat-like than human.
For example, Apple (NASDAQ:AAPL) may not have had nine lives, but the stock has been left for dead several times during its lifespan, before managing to resurrect itself from value status to growth darling (with a little assistance from Steve Jobs). Whether Tim Cook can lead Apple back to the Promised Land of growth remains to be seen, but many investors still see value.
Fluctuating price and earnings trends over a company’s life cycle frequently create confusion surrounding the proper categorization of a stock as growth or value. The other frustrating aspect to this debate is the absence of a universally accepted definition of growth and value. A few specialty companies have chosen to address this challenge. Russell Investments in Seattle, Washington is a leader in the benchmark/index creation field. Russell tackles the definitional issue by creating quantitatively based definitions, tediously explained in a thrilling 44-page paper titled, “Construction and Methodology.” Here is an exhilarating excerpt:
“Russell Investments uses a ‘non-linear probability’ method to assign stocks to the growth and value style valuation indexes. Russell uses three variables in the determination of growth and value. On the value side, book-to-price is used, while on the growth side, the I/B/E/S long-term growth variable was replaced by two variables- I/B/E/S forecast medium-term growth (2 yr) and sales per share historical growth (5 yr).”
As I bite my tongue in sarcasm, I like to point out that these methodologies constantly change — Russell most recently changed their methodology in 2011. What’s more, there are numerous other indexing companies that define growth and value quite differently (e.g., Standard & Poor’s, Lipper, MSCI, etc.).
Like religious beliefs that are viewed quite differently and are prone to passionate arguments, so too can be the debates over growth vs. value categorization. I’ve been brainwashed by numerous great investors (see Investor Hall Fame), and underpinning my philosophy is the belief that price follows earnings (see It’s the Earnings Stupid).
As a result, I am constantly on the lookout for attractively priced stocks that have strong growth prospects. If Russell or S&P looked under the hood of my client portfolios, I’m certain they would find a healthy mix of growth and value stocks, as they define it. If they looked in Warren Buffett’s portfolio, arguably similar conclusions could be made. Most observers call Buffett a value investor, but over Buffett’s career, he has owned some of the greatest growth stocks of all-time [e.g., Coca Cola (NYSE:KO), American Express (NYSE:AXP), and Procter & Gamble (NYSE:PG)].
At the end of the day, expectations embedded in the value of share prices determine future appreciation or depreciation, depending on how actual results register relative to those expectations. If stock prices are too high (as measured by the P/E, Price/Free-Cash-Flow, or other valuation metrics), slowing growth can lead to sharp and painful price declines. On the flip side, cheap or reasonably priced stocks can experience significant price appreciation if earnings and cash flows sustainably improve or accelerate.
In my view, the greatest stock pickers think about investing like sports handicapping (see What Happens in Vegas, Stays in Las Vegas). The key isn’t buying fast growth (high P/E) or slow growth (low P/E) companies, but rather discovering which stocks are mispriced. Finding heavily shorted stocks that are poised for growth, or discovering unloved stocks with underappreciated potential are both ways to make money.
While defining growth vs. value is certainly difficult, the more important challenge is calibrating a company’s future growth expectations and determining the fair price to pay for a stock based on those prospects. Investing entails many difficulties, but categorizing investors or stocks as growth or value is a less important challenge than honing forecasting and valuation skills. Investing is challenging enough without worrying about superfluous growth vs. value definitions.
Wade Slome, CFA CFP is President and Founder of Sidoxia Capital Management and shares his investing insights at Investing Caffeine.
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