art vs. science, asset allocation, diversification, Event Driven, GARP investing, growth vs. value, IRR, Margin of Safety, Return on Market Equity, stock picking, stock selection, stock valuation
Continued from here.
Value vs. Growth:
In my last Stock Picking post, I highlighted a common value investor failing – namely, a preference for over-leveraged & illiquid small/micro-cap stocks. All too often, it seems like this kind of preference (& others like it) are simply hard-wired in…maybe you’re born to be a value or growth investor! Now, we could get all touchy-feely here & try to personality-map this out – cautious vs. aggressive, quantitative vs. qualitative, thinker vs. dreamer, and so on – but does it really matter? Far better to recognise & accept what you are – if you haven’t already, just stop reading right now & come out to your wife:
‘Um, darling, it’s time you know…I’m a value investor!’
You may even find out she knew already…
Acceptance is the first & most important step in recognising inherent investing biases, and maybe trying to curb some of the worst excesses of hard-core value investing. [Of course, the same is equally true of growth investing]. This might take years…it definitely took me years! And pride often gets in the way – sometimes it’s nice to feel different, one of a select breed of smart investors who can boast of finding hidden gems in the rubble. But this is just an illusion – true growth investors are equally select. [Yes, most people seem biased towards growth stocks (if they ever mention stocks at all!?) – but in reality, they’re fairly clueless about money & investing. At best, they’re TALT* investors…] For them, genuine growth stocks are equally difficult & just as precious to find. And let’s face it – on average, in the real world, nobody can reliably claim value investing is superior to growth investing, or vice versa.
But accepting your value investing biases, curbing your excesses, and exploiting your natural advantages, is surely the best way to maximise your comfort & your returns as an investor. Except this can ultimately prove a double-edged sword…the world you end up living in may just be a value ghetto. Sure, it may feel large enough, it may even feel comfortable enough, but if that’s as far as your horizons stretch, you’re missing out on a whole other world of opportunity out there. Forget about investment ideology – again, this is about diversification, and it’s about becoming a better investor.
If you choose to ignore growth stocks & investing, you’re voluntarily cutting yourself off from vast swathes of the available investment universe – that’s countless companies, entire sectors, new/disruptive business models & secular trends, even geographies, etc. you’re missing out on, maybe forever…how does that make any sense? And even if you heed everything else I’ve written about diversification, how meaningful will the impact be if your portfolio remains blighted by the absence of growth stocks?
Of course, the classic value objection to growth stocks is that they’re invariably over-valued. But this, my friends, amounts to nothing more than a red herring… A true growth stock always seems to be over-valued, yet its share price can subsequently look astonishingly & ridiculously cheap after the business/stock somehow manages to scale up by hundreds or even thousands of percent. The real complaint here, I suspect, is that growth investing is just too hard!?! And if you’re a value investor, there should be no shame in admitting this – because that’s exactly how it feels: You naturally take a primarily quantitative approach to investing & you always require an adequate margin of safety, but identifying true growth stocks demands a far more qualitative approach & appears to offer little in the way of safety…
Which implies an intense focus on intangibles like management, moats, business models, research & development, disruptive advantage, costs, margins, peer/sector analysis, scuttlebutt, and all manner of other SWOT, scenario & competitive analyses – yes, all the difficult & squishy stuff that never boils down nicely to a cheap price/book ratio. Hey, I’m not saying it’s easy!? I mean, I should bloody know:
Hi, have we met? I’m a recovering value investor. Always will be…
But a share should never be reduced to a mere quantitative juggling of the numbers – it’s always just as much about management, the company, the business model, the industry, the short & long-term risks/opportunities, etc. [This doesn’t mean you ignore price – again, leave that to the idiots who’ll buy any story at any price]. [As for safety…golly, if value investing is so much bloody safer, how come you’ve ended up with so many dogs over the last few years?!] Focusing on these aspects will help you identify true growth stocks/companies & to discern why they’re often not as expensive as they first appear, but it will also make you a better value investor – like it or not, it’s this more qualitative analysis which will also ultimately distinguish & enhance your value stock selection & returns, rather than finding the cheapest price…
[NB: GARP investing might obviously seem like a compelling bridge between value & growth investing. I’d definitely agree, but not if it’s simply used as some kind of excuse/short-cut to reducing growth investing back down into a purely quantitative exercise…which would surely defeat the purpose, and quite often proves the most efficient way to find broken growth stocks & business models.]
Once again, let me make a suggestion – take your current portfolio, and just label each stock as growth or value (an event-driven investment’s simply value with a catalyst). You may end up surprised by the result…an absence of growth stocks is a real problem you may need to urgently address in terms of your portfolio diversification & overall investment approach.
Expected Internal Rate of Return (IRR):
One of the best ways to appreciate growth stocks vs. value stocks is to formally incorporate an expected IRR analysis into your stock selection process. This comes naturally to event-driven investors (who obsess over precisely weighing their expected investment upside vs. their expected investment period), and it’s not at all unusual for growth investors to also focus on the (long-term) compounding potential of their investments (in terms of revenues, earnings & share price). Oddly enough, it’s value investors who often skip this step…maybe because they’re too busy drooling over what they see as a free lunch – i.e. an obvious & substantial share price discount to a stock’s intrinsic value, something you’re far less likely to see up-front with a growth stock.
But there’s usually
good bad reason(s) for such a discount – sometimes, it’s simply down to bad luck – though in the fullness of time, management’s obviously & ultimately responsible. Of course, market sentiment might suddenly improve all by itself, but many value stocks eventually require a specific catalyst to close the value gap – i.e. most value stocks (esp. deep value stocks) are essentially another form of event-driven investing. Trouble is, there’s no telling how long this might actually take – management often proves far more obtuse & lackadaisical than you’d ever imagine…and I’m talking in terms of years, not months! Meanwhile, your margin of safety looks increasingly shaky as a 60 cent dollar relentlessly grinds its way ever lower, to a 40 cent dollar…and/or you realise things have gotten so bad, even a generous takeover premium won’t return you anywhere close to break-even.
Now, let’s picture two stocks:
From your stock valuation process, you know you have a 50 cent dollar stock on your hands vs. what looks like a bona fide growth stock trading on a bare sliver of a discount.
Yes, maybe you suspect the growth stock could be a great long-term winner…but you can already taste the 100% profit that value stock offers, and in half the time! Let’s be realistic though: What you hope to see in 2-3 years may easily take 5 years, and that bargain stock’s fair value may not be appreciating in any kind of meaningful way (remember, it’s probably a value stock for a bad reason). In fact, even with a catalyst, there’s a good chance this stock ends up becoming an 80 cent dollar after 5 years – because it continues to trade at a smaller/semi-permanent discount, or simply because its fair value actually declines – which only offers a 60% cumulative gain, or a 9.9% IRR. Now consider the growth stock: It actually ends up delivering a consistent 15% annual gain in revenue & earnings – based on that performance, your fair value estimate rises accordingly & we can be pretty confident the market’s happy to maintain or increase its valuation multiple. Which means a 15.0%+ IRR, or a 100%+ cumulative gain!
OK, that’s a somewhat idealised example, clearly to make a specific point – but it’s a really good point! A value stock will often present a relatively static value gap to be captured, while a growth stock will hopefully create & compound value – they’re priced accordingly, i.e. growth stocks invariably appear more expensive (or less cheap) up-front. And don’t be fooled, both present risks in terms of safety – it’s just the pain is usually much quicker & more unexpected with a growth stock, vs. the slow & crushing torture you might experience with a value stock gone wrong. True growth stocks tend to compensate for the growth duds anyway…taken to an extreme, for example, venture capitalists often expect the bulk of their gains will be derived from just 20% of their investments.
It’s also a great reminder: Value stocks might seem easier to pick, but there’s a price to pay – success can often force you to sell & head right back to square one (so tell me…what’s your next pick?!), while a successful growth stock might actually prove a rewarding investment for many years to come. The fact is, time’s often the enemy of the value investor & the friend of the growth investor.
Of course, all that matters in the end is your actual IRR…
But you’ll obviously have to estimate those respective IRRs ex-ante – albeit your in-depth analysis of each stock should qualify you to do that. Let’s not fool ourselves here, that’s clearly a far more qualitative (rather than quantitative) exercise. [Esp. when looking back at some of your previous efforts]. And that’s why I think it belongs firmly in the realm of stock selection, rather than stock valuation – but even though you risk getting it wrong, an estimated IRR analysis can & should still be an integral component when narrowing down the potential quality & upside of your final stock selection candidates. [Your level of confidence in each of those respective IRRs is also crucial].
All in all, an excellent filter to help level the playing field in terms of better weighing up growth vs. value stocks for inclusion in your portfolio.
Return on Market Equity (RoME):
Right, lest you think I’ve given up on my roots here – this last filter/analysis works best with value stocks. It’s particularly useful for re-calibrating an investor’s perspective on such stocks (esp. deep value stocks) & helping to choose between final stock selection candidates.
I call it RoME…
There are two sources of return a shareholder can expect to derive from a stock – the company’s return(s) on capital & changes in the company’s valuation multiple. [Dividends are often cited as a source too, but these are invariably funded from return on capital]. Value investors tend to focus far too much attention on this potential change in the valuation multiple, and often ignore what’s otherwise a company that offers a poor return on capital. An excellent bridge between the two is to actually focus on:
Current Underlying/Run-Rate Net Profit / Equity Market Cap = RoME
[NB: You should determine the (underlying) run-rate of the business as accurately/conservatively as possible. Don’t anticipate expected improvements & by all means factor in likely declines/head-winds…it’s probably a good idea to also ignore management assurances & pro-forma figures/projections! And if the current underlying profit run-rate isn’t immediately obvious, I recommend focusing on free cash flow instead.]
This neatly side-steps the issue of fair value altogether, which obviously helps avoid the temptation to exclusively focus on & assume a sudden step-up in a stock’s valuation multiple. It also helps flag what might be a poor return on capital, but compensates if the stock’s priced accordingly. The beauty of the analysis is that it (ideally) presents current/potential holdings in terms of an ongoing rate of return, coupled with what might better be considered a free option predicated on a revaluation ‘event’. In your stock selection process, this will usefully highlight stark differences between possible buys, which may otherwise appear to offer similar upside – a great reminder of the underlying quality & returns potentially on offer. Of course, down the road, when you’re three years into an investment, losing money & no signs of change on the horizon, knowing you’re in a stock which continues to generate a decent underlying return can really save you from losing heart & being swayed by the naysayers…
Of course, this analysis makes mince-meat of companies losing money/burning cash…as it should. Even if you sincerely believe a company isn’t a value-trap, how long will you be comfortable staring a negative RoME in the face, while the shares plumb new depths in terms of price & volatility? And companies which barely break even aren’t much better – as the months & years stretch out, and the share price continues to drift & trail the market, is a zero RoME going to keep bolstering your confidence?! I have to wonder..?
On the other hand, let’s consider a company which produces a meagre but sustainable 3-5% return on equity – the management team’s so-so, but you’re convinced the business is worth far more sold. Fortunately, other investors have given up on it & the market’s now pricing it at 50 cents on the dollar, which isn’t necessarily an unwarranted discount. In fact, it’s probably priced at similar levels to its weaker peers…yet it stands head & shoulders above them, because you’re looking at a stock which manages to generate an average 8% RoME! Not so exciting you may think, but certainly not a bad return in today’s environment – it gives you plenty of support & cushion while waiting for that free option to kick in, and if it doesn’t work out, hopefully it proves to be more of an opportunity loss in the end (rather than an outright loss).
Then there’s the happy extreme – I own, for example, a stock which now offers what I’d considerable a pretty sustainable 22% RoME. [And ex-cash (which doesn’t necessarily imply a revaluation, but would require a catalyst), it actually offers an astounding 40% RoME!?] Every week, I get agitated thinking how ridiculously under-valued it is, but then I take another look at its RoME, and I calm down & rub my hands in glee – I mean, why even bother worrying about its obvious & substantially higher fair value, or about selling/realising value sooner rather than later? Because good things really do happen to good companies…and meanwhile, with that kind of underlying return, ideally I should just concentrate on hoovering up more shares instead (& persuading management to do the same)!
OK, that’s it – time to wrap up (v briefly):
When buying stocks, stock valuation is a paramount hurdle – you should obviously ensure it’s a quantitative process that’s as rigorous & consistent as possible. Stock selection is an equally important but entirely distinct process – obviously, it’s a far more qualitative process. So yes, clearly it’s much more of an art…but your ultimate success as an investor is well-served by grounding it in science as much as possible.
In this series, and my prior series on portfolio allocation, I hope I’ve suggested & shared with you plenty of stock selection techniques (or filters) you can employ. Some focus on your negative investing biases, others promote positive biases, while all are holistically focused on properly weighing up the stocks you own vs. the stocks you buy vs. the stocks you don’t buy – i.e. they’re all focused on achieving true diversification & improved risk/reward in your portfolio.
[*Tips And Lottery Tickets!]
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You lost me. How is your marvellous news measure different from the good-old fashioned earnings yields, or its reciprocal, the PE ration
Well, it isn’t…but it was never really billed as some marvelous new measure. In fact, here’s really nothing new under the sun, when it comes to investing – RoME is just a specific analysis/perspective I find very useful.
Even though a P/E ratio is simply the inverse of the earnings yield, I actually consider it a (far more) dangerous tool to use for investing – particularly if it’s the key/sole metric on which an investor relies. In somewhat similar vein, you can obviously equate earnings yield to RoME, but that would perhaps miss the point – with an analysis, how you get there is often just as important as the end-result… If you re-read that section of my post, the important point is to force myself (or readers) to stop focusing on book value, or intrinsic value, or even the potential upside – and to re-focus more specifically on what kind of return may be on offer, based on the current market cap & ignoring any revaluation potential. So rather than just trot out earnings yield as another tool (for people to gloss over), I’m trying to use/offer up tips & techniques – i.e. specific approach(es) to investing/analysis that help combat my (& hopefully a lot of readers’) negative biases & to promote positive biases instead.
My posts on Fear & Greed have a similar focus – some tips/techniques may seem simple/ineffective, or even silly, but I guarantee they can offer something useful for a lot of people. [And frankly, even simpler stuff works – if you use a checklist, for example (whether it’s medical, or for investing), the mere act of printing it out, forcing yourself to read aloud each step & actually ticking them off, will actually guarantee greater value & compliance!].