According to most advisers and market commentators, fund managers adhere to a simple style – typically classified as either “value” or ”growth”.
At a basic level, value stocks are typically viewed as companies trading on ‘low’ valuation ratios, such as price-to-earnings and price-to-book, and growth stocks trade on relatively higher ratios due to greater growth prospects.
It is not uncommon for an adviser fund report to reference something such as: ‘this manager favours growth stocks’ or ‘this fund has a bias towards value’. However, what do these classifications really mean and are they useful? Is it sensible for commentators and advisers to refer to such terms?
We do not think so and believe the industry’s use of value and growth is misleading and misunderstood. In our view, such terms should be discontinued.
Investors should seek to find companies with long-term growth prospects while avoiding paying over the odds.
Every investor wants to find value
According to Wikipedia, value investing is an investment paradigm which generally involves buying securities that appear “under-priced by some form of fundamental analysis”. However, surely every investor wants to achieve this, regardless of “style”? It is ridiculous to assume growth investors do not want to buy stocks considered undervalued.
This confusion stems from a misinterpretation of Benjamin Graham and David Dodd’s famous work, which argued 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 versus market value, as well as the margin of safety. This work has been misinterpreted over the years, with the phrase value investing now largely associated with stocks trading at low valuation ratios.
We believe the definition of value is deeply misleading and there is a clear distinction between the two types of stocks typically classified as value.
The first group are predominantly housed in deeply-cyclical sectors – such as financials, energy and materials. The low valuation ratios for such stocks typically reflect elevated leverage ratios and a high cost of capital, due to the cyclical uncertainties faced.
The definition of value is deeply misleading
The other group are structurally broken companies seeing a return on capital decline, as well as squeezed profit margins and declining sales and earnings. In other words, poor companies. Retail stocks in recent years have exemplified such a classification. Valuation ratios based on next year’s earnings look cheap, but earnings are structurally heading backwards, and terminal value is diminishing.
Classifying these distinct sets of stock into one group is erroneous.
Investing for growth at reasonable value simply makes sense
To us, growth investing is a choice not a style – it simply makes the most sense based on fundamentals. Our entire portfolio is currently allocated to structural growth prospects – these are companies able to grow quicker than the overall economy over the whole cycle, as well as maintain or improve profitability. This is not a style bias, we believe it is the most sensible strategy for achieving outperformance.
It makes far more sense than buying into structurally broken companies. Picking up pennies in front of a moving train might work for an aggressive private equity investor, but not for fundamental active equity managers.
As for stocks in deeply-cyclical sectors, we are avoiding this area of the market simply because of the current, and likely future, global economic picture. Remember, the golden period of value investing in the 2000s was primarily driven by the China-led commodity supercycle – where we witnessed an unprecedented period of growing demand for commodities and oil. During the decade, copper prices climbed nearly 300 per cent and the oil price rose more than 200 per cent. However, the world has now changed. The commodity supercycle seen in the 2000s is unlikely to reoccur any time soon and post financial crisis, it will be a long time before we see another golden period in banks.
In conclusion, 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. We seek to identify companies that will grow and improve profitability over the medium-term, but we will only buy companies that exhibit intrinsic value to market value. A growth at reasonable price approach makes sense and has the greatest potential to outperform over time.
Stephen Yiu is chief investment officer and fund manager at Blue Whale Capital