Value
Expectations
submits:
There once was a time when the "learned" believed the sun
revolved around the earth, the world was flat, and government
spending led to sustainable economic growth. This week's
Investment Advisor Ideas
focuses on another such misconceived idea, classifying stocks with
growth and value designations. While the investment consultant
community has firmly adopted the growth vs. value concept, at some
point, hopefully in the near future, this classification will go
the way of the buggy whip, leaching, and the above silly
misconceptions. After all, the classification tends to imply a
choice between owning a stock that can grow but doesn't offer much
value, versus one that offers a compelling value but doesn't offer
much growth. Such a choice is silly - every stock valuation implies
a future stream of cash flows to justify its price. If today's
price implies a smaller cash stream than a company is capable of
generating, it is a value stock. If a stock's price implies greater
cash stream than a company is capable of generating, it is a value
trap, regardless of how sexy its products are or how strong its
future revenue growth appears. It does not get much simpler than
that.
Years ago, in 2005, I traded emails with a popular financial
writer that had just criticized AutoZone (
AZO
) for failing to deliver sufficient comparable store sales growth,
though the company continued on its stated path of improving
margins. He appeared smart as AutoZone shares were underperforming,
and carried on with his typical snarky tone in his email. I more or
less let him know he was clueless and silly for not understanding
wealth creation and how that translates to intrinsic value.
Needless to say, he did not reference my analysis in his later
article on the company and AFG failed to obtain a PR win. Our
analysis was vindicated, however, as over the past 5 years AZO has
moved from approximately $80 at the time to $250 today, while the
S&P 500 remained flat. Worth noting, for most of the years,
AutoZone's comparable store sales growth was still negative to
mediocre. His (and other investors) obsession on "growth" versus
"value", rather than understanding that AZO was taking the right
steps to create shareholder value and the cash flow expectations
embedded in its price were very reasonable caused him to miss a
great trade of our day. He was fixated on AZO as a growth stock
that failed to deliver "growth", rather than understanding AZO's
valuation. It is often said that history repeats itself, and
today's lesson may apply to many technology giants. For example,
[[CSCO]] was recently crushed on weak growth numbers, but
justifying its stock price requires virtually no
top line growth if
it can maintain its existing margin levels. As today's kiddie set
often whines - Just saying....
Much like Beta as a risk proxy survived long after its "use by"
date, due to its simplicity so I suspect has been and is the case
for the growth vs. value classification. Instead, we would like to
see stocks classified in duration terms, as companies will pursue
different strategies which lead to different cash flow durations.
This provides a much better framework to structure a portfolio for
different phases of the economic cycle. Further, it better allows
analysts to discuss stocks in terms of the operational expectations
(sales growth, margins, and turns), and how they translate into
future cash flows to evaluate how attractive a stock looks as an
investment. At the same time, we are also mindful of reality - some
investors still want traditionally defined growth and value stocks.
Like golfers with stubborn hitches in our swing, we understand the
need to "play through our slice" and thus prepared this list to
help identify attractive "growth" and "value" stocks.
Growth vs. Value - The New Buggy Whip
Traditionally, most investors tend to identify themselves as
either growth or value oriented when they approach constructing
their portfolios. There are many varying approaches of how to
classify stocks in either category, but growth investors typically
focus on earnings and sales growth regardless of the company's
ability to add value to its shareholders, whereas value investors
search for stocks trading at relatively low price multiples. We
believe that both approaches for picking stocks have their pitfalls
if the investor fails to understand the cash flows that are driving
the company's value and how they relate to its stock price. If a
growth company is capable of generating larger cash stream than is
implied by its current stock price, we consider it attractive.
Likewise, if a low P/E company's stock price implies greater cash
stream than a company is capable of generating, it is a value trap.
Below we have provided a list of stocks which we consider
attractive right now in both the "value" and "growth" universes, to
help investors from both groups identify investment
opportunities.
But first let's examine the past performance of growth vs. value
stocks. We looked at many past studies comparing the performance of
the two groups and although the approaches to differentiate one
from the other may vary, most studies tend to show that value
stocks have outperformed their growth brethren over the long haul,
even when taking into account the high growth technology led stock
markets of the 1990's, just prior to the tech bubble. The chart
below is a study by Fama & French (via thedividendguyblog.com),
comparing the value of a one-dollar investment back in 1927, based
on size and growth/value characteristics. This study confirms that
value stocks did earn far greater returns than the growth stocks
regardless of the size classification.
As mentioned before, there are many different methods investors
use to separate growth and value universes - here are some of the
most common characteristics for the two groups:
Growth companies tend to have...
- High earnings growth rate
- High sales growth rate
- High R.O.E
- High profit margin
- No or low dividend yield
Value Companies tend to have...
- Low P/E ratio
- Low price/sales ratio
- Low price/cash flow
- Low price/book ratio
- High dividend yield
At AFG we have developed our own methodology of classifying the
companies within a certain universe as value and growth - we use
their relative Market Value/Net Invested Capital ratio. Companies
with MV/IC greater than the median for the group are considered
"growth", and those lower than the median are considered "value"
stocks. The following chart provides some insight into how growth
has fared relative to value stocks in the past based on AFG's
classification. As you can see, in line with what we have already
found out, AFG defined value stocks have outpaced growth stocks
over the past 12 years.
click to enlarge
In addition, we wanted to shine some light on how our buy and
sell recommendations have done within each group. The chart below
demonstrates that there is a significant positive spread between
the returns of the companies we find attractive and those we
recommend to stay away from in each style category.
Now that we have viewed the past performance, let's look at our
outlook of the attractiveness of each investment style going
forward using our EM framework and valuation metrics. Based on
current valuation attractiveness within our default valuation
model, value looks more attractive as an investment opportunity
than growth in any size category (small, mid, large), with the
large cap value bucket looking the most attractive of the
bunch.
In an ideal world, our portfolios would be filled with stocks
with booming earnings growth and discounted price tags, however in
reality any solid growth stories will attract investors, which
inflate the price. We recommend not to automatically ignore
companies based on style as there are plenty of attractive
opportunities in both the growth and value universes, especially
when utilizing AFG's research and valuation techniques to identify
attractive long and short prospects. By not overlooking companies
based on style you will increase the size of your fishing pond and
your portfolio will benefit from the diversification.
In the table below, you will find a list of companies in both
styles (based on MV/IC) that look attractive going forward. When
creating our list of Attractive Growth/Value stocks we looked for
companies that fit the following criteria:
- Attractive valuations
- Profitable from an economic standpoint
- Expected to improve economic profitability
- Poised to outperform
Disclosure
: None
See also
Do Patents Hold Promise for OPTi's Future?
on seekingalpha.com