Benjamin Graham, buy and hold, catalyst, growth investing, growth vs. value, investment theme, Joel Greenblatt, multi-bagger, Philip Fisher, reading, survivorship bias, value investing, Warren Buffett
Ah yes, the great investing debate & divide…
At one extreme, we have the wild-eyed growth investor foaming at the mouth over a great story. A silky-tongued CEO’s painted unicorns & castles in the air, and our reckless plunger’s itching to dance the magic rainbow. No price is too high, no management too sleazy, no risk too great, to deter him from the boundless opportunity he now sees stretched out in front of him… His investing idol’s Philip Fisher, of ‘Common Stocks & Uncommon Profits’ – which I had the misfortune of re-reading recently. How this book was ever nominated a bloody investment classic, I don’t know!? OK, let’s grant some credit. Yes, I’m sure Fisher was a gifted investor, but he was also in the right place at the right time – in California, at the dawn of the electronic (& venture capital) ages.
So, who’s ever sat down & really studied his book, and actually figured out how to bloody implement his 15 Points? Who among us has the time, the means, the resources, or the determination to practice 95% of what Fisher preaches? And where in the book is the real secret exposed – the foresight to pick a 100 or even a 1000–bagger? That’s the problem people forget with growth investing – survivorship bias. Consider a buy & hold investor seeding his portfolio with a selection of promising growth stocks – some die off quickly, most turn out so-so, but maybe one (or two) actually grow & grow to dominate his entire portfolio. Of course, the losers are long forgotten, and he’ll nod wisely & tell you he always knew the real winners! Or how about the chancer who bought a single long-shot stock…and ended up making a friggin’ fortune?! Well yes, he’s obviously a media darling now. But where are the stories about his fellow slobs who bet the ranch & lost everything? Well, like I said, the losers are long forgotten…
Not to mention the fact share prices of even the biggest winners usually suffer some pretty sickening plunges along the way. Of course, every growth investor’s confident he won’t be the sucker shaken out of his wonder-stock’s long-term parabolic trajectory by a mere trading blip. Learn from Black Monday ’87, he savvily reminds you – it’s a mere blip on the charts now! Yeah, but the average investor wasn’t calling it a blip then – he was too bloody busy selling…
But c’mon, is the wretch at the other end of the investing spectrum really any better? The hard-core value purist hopelessly drooling over a great price…of some cheap micro-cap which trades by appointment, is at the mercy of its lenders, and is fighting a relentless battle against the decline of its business & industry. The guy who fervently believes everything’s a buy at the right price – even if it’s just a soggy cigar-butt, or a busted whore at five am. He has his investing God too – Benjamin Graham, an exemplar perhaps even more difficult for the average investor to emulate.
I mean, who has the stomach, the sheer bloody mindedness, to buy scads of the neglected, the dying & the near-dead? And then wait years for some sudden & mysterious re-valuation to occur. All the while changing the subject when somebody asks about your dirty little secret of a portfolio. Could you really take the lies & blandishments of so many of these management teams, let alone expect them to actually deliver? I guess you’re supposed to ignore something so qualitative as management…while they do their livin’ best to destroy and/or divert all remaining corporate value. I mean, trained monkeys could do a better job – even incontinent & badly trained monkeys. And consider the very mixed success & investor reaction to Joel Greenblatt’s magic formula experiment (a far more palatable approach than Graham’s). It’s a recent reminder of how difficult purely quantitative analysis & investment can actually prove to be – for investors in the real world.
OK, so maybe Warren Buffett is the answer instead?
Perhaps – but I suspect most investors have never really benefited from their devotion to Buffett. Ugh, sacrilege..!? But really, why should they? Buffett’s indisputably an investment genius – he hoovers up every scrap of information he lays his hands on, and simply waits for that inscrutable brain to spit out all the right answers. Hand each of us some clay, and he’ll create Ming vases, while we potter over misshapen mugs whose handles fall off minutes later. And yet we all seem to think we can emulate him in a few easy steps…
This doesn’t happen with other bloody geniuses. Take Einstein – because of him, how many average Joes are out in their garages right now trying to split the atom, or create a wormhole?! And how many hack writers are publishing articles titled ‘Albert Einstein – Time Travel In 10 Easy Steps’? Exactly… Yes, Buffett may be the perfect embodiment of value & growth, but investors should perhaps accept him for what he really is – an inspiration. We can’t hope to emulate his unique investment process or record, but he can certainly inspire us to find our own path to investing success.
And like him, we should recognize that path’s actually…growth investing.
No, that’s not a typo – I assure you, for the vast majority of investors, growth will inevitable trump value! Buffett figured this out almost half a century ago now, setting aside Ben Graham-type investing as a fond memory. But still the purists cite studies which prove value (particularly Graham-type value) beats growth. But like a growing/alarming percentage of scientific research & experiments, it’s doubtful whether this result could actually be replicated in the real world. Putting aside investor psychology issues, there’s two other big problems to consider:
First, by their very nature/neglect, value stocks are often small/micro-caps – which suffer wide spreads & poor trading volumes. Growth stocks, by definition, are often the opposite. It seems clear most studies under-estimate, or even ignore, this issue – a common academic failing, and one which can be very misleading. Because small/micro-cap spreads can be pretty bloody wide. [I’m currently working on a stock with a 12% spread & I’ve seen much wider!] Investors also face a potentially larger cost – their buying & selling may have far more impact, so they end up being forced into chasing the price. Whether this is real, or not (‘market-makers playing games!’), is frankly irrelevant. And for any kind of decent volume, investors may be forced to work with a full service broker which can also prove expensive. String all these together, and this may significantly handicap real world returns for the cheapest of value stocks. Of course, all this is exacerbated with more frequent trading (and the impact of taxes & stamp duties).
Which highlights the second issue – which tends to go virtually unremarked. Most of the studies incorporate regular ranking & re-balancing. The expected cycle of neglect & then re-valuation for a portfolio of value stocks surely implies a far higher level of turnover than a growth stock portfolio. Unlike other aspects of these studies, this actually reflects real world practice. Most of the time, true value (& event-driven) investors are simply trying to capture a valuation gap – so they’re investing with limited upside potential (albeit, ideally, for a limited time period). Whereas growth investors are investing with potentially unlimited upside potential (well, within reason). Which ultimately means time is the friend of the growth investor & the enemy of the value investor…
Or we can revisit Einstein again – as he put it: ‘Compound interest is the eighth wonder of the world.’
Let’s consider this in practical terms – if a growth investor finds a decent growth opportunity, he may end up enjoying a single wonderful buy & hold stock for the next 10-20 years! But what about our poor value investor – how many stocks does he have to try buy & sell during the same period? Three, four, six, how many..?! Unfortunately, there’s no good answer. Because less stocks probably implies the value-realization process took far longer than expected, so his annual returns probably suck. [Of course, in each instance, a catalyst would ideally accelerate his investment timeline & improve his IRR]. And more stocks may be worse. Think about it – the less time & research an investor’s willing to invest, the more unappetizing a strategy becomes which requires the constant identification, analysis & purchase of fresh stocks. While the more dedicated an investor is, the more he ends up swamped by this endless research, ranking & re-balancing cycle. Who really has the time, energy & resources for that? And one has to wonder anyway what the end-result might be if he re-directed his efforts into identifying some long-term growth opportunities instead..?
I believe the solution’s neatly encapsulated in a favourite phrase of mine when I talk about stocks & investing. Now I look back, I’m astonished to see how absent it’s been from the blog. I guess, in writing, I recoil from something that sounds suspiciously like a talking head sound-bite. But I have to admit, it’s definitely proved to be the most memorable & useful piece of investing wisdom I’ve ever passed on to friends, family & fellow investors. And after hundreds of thousands of words on the blog, it’s also a wonderfully succint summary of my underlying approach to investing. Sorry, I should have got to it sooner… 😉
Great Story, Great Stock, Great Price!
Let’s jump right in & take a closer look at each of these investing attributes, and then consider the potential implications & benefits:
As any coach will tell you, you can buy the best players, but it’s no guarantee of a great team. How they fit together & complement each other is often what really matters. An investment portfolio’s much the same – it’s not supposed to be a hotchpotch of the best picks you just stumbled across along the way. My year-long Portfolio Allocation series (beginning here, ending here) covers this ground in much broader fashion, but here I’ll ask a single key question:
When you’re buying a stock, what’s the investment theme?
It might be the new new thing – social media, cloud computing, fracking, DNA sequencing, whatever. It may be an investment theme that provides above average secular growth – like luxury goods companies (such as Saga Furs) which offer exposure to exploding emerging market wealth, plus growing income inequality in developed markets. Or agri-businesses (like Avangardco & Donegal Investment Group), which benefit from emerging market population growth & the demand for cheap protein/calories. Then there’s German residential property (like KWG Kommunale Wohnen) – a defensive European asset that’s cheap in both absolute & relative terms. Or perhaps Middle Eastern/Islamic (oil) wealth management (via European Islamic Investment Bank).
It might be exposure to a particular country/region that’s reached an inflection point, has attractive fundamentals & growth prospects, and/or has a cheap & neglected market (like Ireland – FBD Holdings, or Vietnam – Vinacapital Vietnam Opportunity Fund). It may simply reflect a desire to add low correlation investments to your portfolio – event-driven, special situation or catalyst stocks (see my series on Catalysts, here & here). Or a stock that’s totally neglected by the market, but won’t stop nagging at you because you see a radically different story unfolding (see The Activist Investor). Maybe you’re just looking for uncorrelated (Alternative Asset Opportunities, plus agri-businesses again) or even potentially inversely-correlated opportunities (Distressed assets & consumers).
It must be remembered, most of the stocks you’ll find are already fairly priced & will only deliver average earnings growth. You’ll also face the head-winds of potential corporate inertia & decline, and also the vagaries of the economic cycle. Instead, you’re ideally looking for lower risk, accelerated growth, and/or immunity from that same economic cycle. Investment themes are the answer – they’re like a good stiff tail-wind for your investment portfolio. And the more original & varied they are, the more diversified & the less correlated your portfolio will become. Aah, but where do you find these investment themes? Well, that’s where my previous advice comes in:
I could just have easily said ‘Great Company’, but great stock flags up some important distinctions. Presuming you identify a pure-play company (and/or its competitors) which exploits a particular investment theme, all too often you’ll discover it’s private – or it’s buried in a larger listed company. [It’s still worth including such companies in your research – it’s amazing the info you’ll find on the internet these days, and I’ve previously highlighted the value of segmental/divisional analysis for comparative purposes. But avoid private companies/funds who actively pitch their ‘unique’ secular investment theme…they’re likely sink-holes]. Obviously, you’ll want to stick with listed stocks, which may unfortunately restrict (& sometimes distort) your available choices. You may also opt for a specific comfort zone – which could mean you prefer to avoid foreign stocks, small/micro-cap stocks, illiquid stocks, etc. [Though it can be rewarding to carefully stretch your investment boundaries].
You’ll want to examine the history of the company. Does it display consistent growth in revenues. What type of business model does it employ, and is this the usual model you see in the sector/industry? Does it earn high, low, or erratic operating margins? Does it enjoy an economic moat, or at least a No. 1 or 2 competitive ranking? Does it require significant fixed asset or working capital investment? What is management’s attitude to leverage, and/or shareholder value? Do they appear to have any idea of intrinsic value, or return on investment? [Far too many companies & management teams seem to think shareholders’ equity is literally found money..!?]
And what about management themselves – do you trust ’em, what does your gut say? Have they lied to you, or (even worse) do they lie to themselves? [Nothing’s more dangerous than a promoter who believes his own shtick – as so many junior resource investors discover, to their cost]. Are they over-paid, or do they own enough shares to (hopefully) ensure they’re aligned with shareholders? How candid are they in annual reports – read at least 5 years worth – do they ever admit to failure, or do they simply move the goalposts each year?
Just remember, a great company & management team doesn’t spend all its time pitching investors a great story. If they do, it’s most likely a bullshit story… Coming straight from promoter(s) who somehow always seem to fail to deliver – often because they’ve nothing to deliver. [US Oil & Gas, and its subsequent collapse, provides a gloriously awful lesson – though likely wasted on muppets who’d even consider such a stock in the first place!]
When it comes to an in-depth valuation, I don’t consider it excessive to review & analyze at least 5 years (& preferably 10 years) of annual reports, accounts AND notes. The higher and more consistent the growth in revenue & earnings (watch out for any disconnect between the two), the higher the multiple you can apply – of course, the more erratic they are, the lower the multiple. Handicap your valuation severely for excessive leverage (and/or pension deficits), and think twice about making such an investment anyway – it’s nigh impossible to predict the winners from the far more frequent losers.
Price/Earnings (P/E) is usually the worst multiple to focus on – it’s an exceedingly narrow lens for any investor to peer through & discern an appropriate valuation. Anyway, net (adjusted) earnings figures are still way too easy for companies to manipulate. Focusing on operating margin, and a corresponding Price/Sales (P/S) multiple, is a far superior approach – revenues rarely tend to be manipulated these days (well, except for Chinese companies!), and margins can usually be cross-checked against cash flow. Admittedly, it’s a more static approach to valuation – it gives far less credit to a company’s growth rate(s) – but personally, I prefer to include this element of conservatism.
Actually, I’m surprised how few investors actually use P/S valuations. Which I consider a little short-sighted, as it’s a far closer approximation of a private equity or corporate acquirer’s perspective (for whom, incidentally, net earnings figures are usually irrelevant). Of course, one may still need to adjust for a company’s financial strength, or (more importantly) its weakness. Arguably, this is better achieved with an EV/EBITDA approach, but I think this simply introduces a new set of problems. Because nearly everything looks cheap on that bloody basis – EBITDA often has little connection to a company’s true cash flow or earnings power. [I’m no fan of DCF either – it may have some qualitative merit, but it’s ridiculously sensitive when it comes to assessing valuations or potential returns]. And I can’t stress enough the importance of analyzing the cash flow statement. Sure, it’s volatile, but over a reasonable time period it should definitely confirm the earnings statement. I generally consider operating cash flow shortfalls to be unacceptable, even with immature companies. And wholesale re-investment of cash flow into capex & acquisitions should obviously be predicated on (readily apparent) high growth/high return opportunities.
Ultimately, your valuation should be firmly grounded in a company’s current & historical figures, with little credit given for glorious estimates of future growth. You should also learn to price companies based on alternative valuation metrics which are appropriate to their specific business model, sector or industry. In fact, it’s often a good idea to employ as many different valuation techniques as possible & average the resulting price targets. [Of course, with this approach, significant valuation discrepancies should be carefully examined – do they spell risk, or opportunity?]
Buy & hold investing seems to have become somewhat maligned these days, but it’s still a highly attractive & rewarding investment strategy – if it’s done right. I believe the above trifecta of investment attributes may offer the best real world solution for investors of all stripes – both value AND growth, and everything else in between. It may not be Buffett exactly, but it’s still a pretty damn good synthesis of growth & value. Hopefully, a great story represents an above average long-term growth opportunity (or a catalyst, and/or a lower risk/uncorrelated investment), a great stock ensures you invest in a company & management team which can actually leverage, exploit & deliver genuine long-term shareholder value from this opportunity, while a great price requires you exercise the patience to buy (& sell) at the right time. This approach is obviously & deliberately biased towards growth, of course. Yes, we still need value as a necessary & unavoidable foundation – but we must learn to love valuing stocks, rather than necessarily loving value stocks themselves…
This trifecta can appeal to both qualitative & quantitative investors alike, and it effectively offers a defensive and offensive investment strategy. Make a poor decision with one investment attribute, and hopefully the others still bail you out…get them all right, and ideally you accelerate & increase your returns accordingly! Perhaps most importantly, it’s flexible. Yes, it may be a demanding analytical framework, but it still offers investors huge scope to adapt & exploit according to their individual biases & perspectives. In my case, I tend to find: i) cheaper and less glamorous picks & shovels plays, which offer equally attractive exposure to compelling long-term investment themes, and/or ii) cheap businesses/assets with a free option attached, which may also offer substantial upside potential. And I tend to find my best ideas as described – that is, I occasionally discover/identify an attractive investment theme, then I search for great companies & management to exploit this theme, and then I’m often forced to simply wait for the right price to come along.
I expect other investors may just as easily come up with a very different set of growth opportunities. And also approach their stock ‘screening’ & selection in a different order – for example, some might still prefer to seek out great prices, then use the other investment attributes to pan for gold amongst the dross. While others might simply focus on great stocks – that is, great companies & management – then ask themselves what kind of growth story/exposure’s on offer, and at what price. In the end, no matter how you choose to execute, if:
– You want to cover all the important analytic bases a good investor should,
– You want to enjoy the best characteristics of growth and value investing,
– And most importantly, you want to save yourself from the worst excesses of your own investing bias(es)…
All you need do is insist upon those three key attributes, before you pull the trigger on each & every investment:
Great Story, Great Stock, Great Price!
Happy hunting, readers…