Let's start the December edition with a little quiz. Take a look at the two companies below and pick which one will be better off…
Company A
The company will be profitable for the next 15 years. Its sales will grow by 40% annually and will pay a dividend in the 3rd year.
Company B
The company has some debt and will grow for the next 15 years. The firm’s liquidity will remain low and will never increase. However, its stock price is selling at a discount relative to its profits.
Did you choose one? You will probably be surprised to learn that we are describing the same company! Curious to know which one it is? Be patient, the answer will be at the end of the text.
If you chose Company A, you are probably a growth-style investor. You prefer companies that increase their sales quickly. If you chose Company B, you are most likely a value-style investor, someone who is primarily looking for securities on the stock exchange that are trading at a discount. Now, the question is, which management style is preferable?
When analyzing the data during the last two decades, growth-oriented stocks have outperformed value-oriented stocks. Below there is a chart portraying the difference between the S&P Growth Index and the S&P Value Index (The chart is indeed good, there are only 6 months out of 30 years where the value-style had the advantage)
Historically, this has not always been the case. There has been a time where value stocks beat growth stocks. However, investor preference has changed. The last time growth stocks were ahead was from 1926 to 1941[2].
In the world of portfolio management, style is often the basis of a manager's investment philosophy and I believe this decision can be costly in the long run.
When analyzing an investment, such as farmland or the road tolls system, you would never tell yourself "I would like to see the income decrease year after year ...”. In fact, you hope that sales increase significantly! Growth is therefore a crucial part of the equation. On the other hand, if I offer to sell you an income property at 90 times its annual profit, you're going to tell me that I’m crazy and you would be right! As I have written in the past, every company has a maximum price.
Aesop, the Greek writer who lived in 600 A.C gave us the following maxim: "A bird in the hand is worth two in the bush". Without realizing it, Aesop practically defined modern finance. A business is simply worth the value of its net income, between now and the time it ceases to operate. So the question is, how many birds are in the bush and how healthy is the bush?
Some considerations are important to note. Let's go back to the example of our income property. If we increased the rents, it will now be twice as profitable! Obviously, this increases our rate of return and the attractiveness of the investment. If, however, we were to pay 10 times as much for the building, due to the rent increases, this would be a bad trade.
Anthony and I keep the Aesop expression in mind when we face the issue of growth vs value. Our approach is simple. We try to find the value of a business including its potential growth and once this is determined, we seek to buy it at a fair price, just like the company we described at the beginning of the article. The suspense having lasted long enough, I can now reveal that the company we were referring to is Walmart (1972-1986). History shows us that buying good companies for less than what they are worth has never been a bad investment strategy.