04 Jul 2018
A favourite pastime of many market commentators and advisors is to classify different equity funds and their managers according to their “investment style” and in particular as either “growth” or “value” investors. At a basic level, value stocks are considered to trade on “low” valuation ratios, such as price-to-earnings and price-to-book, and growth stocks trade on relatively higher ratios due to their greater growth prospects.
If you’ve ever read a review of a fund by an advisor, it may say something like “This manager favours growth stocks” or “This fund has a bias towards value”. But do these classifications actually tell you anything and what does it mean? Is it sensible for commentators and advisors to refer to such terms?
We believe the use of value and growth is very misleading and misunderstood and should be discontinued in the industry. To explain in more detail we outline three key points below:
1. The definition of value investing
Firstly, consider the definition of value investing and where it came from. According to Wikipedia, “Value investing is an investment paradigm which generally involves buying securities that appear underpriced by some form of fundamental analysis”. Well I’m pretty sure that’s what every investor is doing, regardless of “style”? Anyone who makes any sort of investment would surely use these criteria? Are those who use these terms suggesting that “growth” investors don’t want to buy stocks they consider undervalued? That is ridiculous.
This confusion stems from a misinterpretation of the famous work of Benjamin Graham and David Dodd who suggested that a relatively low valuation ratio “may” suggest a company is trading at less than its intrinsic value. Graham and Dodd never used the phrase “value investing” and simply advocated the concept of intrinsic value vs. market value and the margin of safety. Nonetheless their work was misinterpreted over the years and the phrase “value investing” has been conflated with stocks that trade at low valuation ratios.
So in summary, our first rebuttal to value vs. growth is that the definition of value is deeply misleading.
2. How value stocks are classified
Secondly, consider what stocks are typically classified as“value” and you will see a clear distinction between two different types:
- One type predominantly comes from deeply cyclical sectors such as financials, energy and materials. The low valuation ratios for such stocks typically reflect high leverage ratios and a high cost of capital due to the cyclical uncertainty they face.
- The other type is structurally broken companies who are seeing a decline in returns on capital, squeezed profit margins and declining sales and earnings. In other words, bad companies. Retail stocks in recent years have exemplified such a classification. Valuation ratios based on next year’s earnings look cheap but earnings are going backwards for structural reasons and terminal value is diminishing.
So again, the term “value investing” is very misleading because two distinct sets of stocks, deeply cyclical and structurally broken, get conflated into one style. This surely makes no sense?
3. “Growth” investing is a choice not a style – it simply makes the most sense based on the fundamentals
For our third and final point, we need to reclassify the market into more sensible segments based on the points previously made. We will consider three different types of stocks:
A. Stocks with structural growth prospects (they can grow quicker than the overall economy over the whole cycle), which can maintain or improve profitability
B. Deeply cyclical and typically leveraged stocks
C. Structurally broken stocks with declining sales and earnings and diminishing terminal values
We currently focus our entire portfolio on the first set of stocks, not because that is our style, but because we think that is the most sensible strategy for achieving outperformance. So why do we not bother looking at B & C?
We can quickly eliminate any desire to buy the C set of stocks as buying structurally broken companies never makes any sense to us. Picking up pennies in front of a moving train might work for some aggressive private equity investor but not for fundamental active equity managers.
We can then eliminate the second set because of the current and likely future global economic picture. Firstly we need to consider the drivers behind the golden period of value investing in the 2000s brought about mainly by the Chinese-driven commodity supercycle.
The rapid growth of China throughout the decade drove an unprecedented period of growing demand for commodities and oil.
During these 10 years, copper prices were up nearly 300% and the oil price rose more than 200% resulting in the energy and materials sectors outperforming the MSCI World Index by 176% and 156% respectively between 2000 and 2007.
In addition, light-touch regulation together with high levels of economic growth and easy money drove profits in the financial sector which outperformed by 36% in the same time period.
However, the world has now changed:
So in conclusion on this point, the 2000s was a sensible time to invest in the deeply cyclical stocks due to the structural growth prospects of commodities, oil and financials. Our investment criteria looks for companies that can grow and improve profitability over the medium-term. It is likely that some commodities and energy companies would have met our criteria at the start of the 2000s. The reason we are not invested in such stocks now is that we no longer think such stocks meet our investment criteria due to the reasons previously mentioned. So that poses another question – are we invested in “growth” stocks because that is our style or because we think, based on our understanding of these different subsectors of stocks, that this is the most sensible strategy? We would argue the latter.
We think it is dangerous when the terms “value” and “growth” get banded around. The terms do not stand up to any proper fundamental scrutiny and add no value by themselves. The definition of value investing is deeply misleading, value stocks can actually be split into two distinct sets (deeply cyclical or structurally broken) and we invest in growth stocks because based on our fundamental understanding this is the most sensible thing to do and the only place where we find stocks that meet our investment criteria.