RSS feedIn our last post, we discussed the strategy of attempting to piggyback famous investors, particularly famous value investors who participate in shareholder activism. In the post before that, I discussed simple methods of finding value stocks, but I don’t think the real definition of value investing (or at least my interpretation of it) has been discussed here and it’s about time.
In the end, fundamental analysis results in two kinds of investments - value or growth. When I analyze a company using fundamentals, I typically apply a three step process. First, I identify a potential investment candidate either through a screen or from reading an article on the company. Second, I make a quick check of fundamentals to ensure that the company is financially sound. Basically, make sure that the company has at least positive earnings (even better if it has positive free cash flow) and check certain financial ratios. Third, I take a look at valuation multiples (essentially just price ratios)- price to book, price to earnings, price to sales, EV to EBITDA. These valuations can really only lead to two conclusions: the stock is currently trading at a valuation which is too low or a valuation which is either fair or too high. In the first case, it is necessary to go back and determine what a correct valuation is. In the second case, it is necessary to be able to justify the high valuation. The best (and maybe only) justification for a high valuation is that the company in question has a very good chance of being more valuable in the near future meaning its business is growing at a better than normal pace. This is the basic distinction between value and growth.
Are the two approaches to investing mutually exclusive? Not really. Investing in anything is really just a search for value. You’re looking to pay less for a stock than you think it’s worth so that you will be able to sell it for more in the future. (Okay, some people invest for dividends or to gain control of a company, but, in most cases, investors are just looking to flip their stock holdings to someone else willing to pay more.)
Growth investors allow themselves to buy stocks with high valuations because they believe that they can accurately project a company’s growth over future months and years and they believe that this company’s growth will be reflected in the stock price.
Value investing as it is used to describe an investing strategy might better be described as undervalued investing in that the hope is to find stocks which are undervalued, buy them, and wait for the market to properly value them higher. The true value investing strategy is more conservative in that it is not willing to pay for growth. That’s not to say growth isn’t something a value investor would shy away from. Value investors are just more skeptical of projections and instead prefer to analyze a company for what it is currently. After all, it’s easier to do analysis and decide whether or not you’d like to buy a company as it is today as opposed to doing analysis and attempting to decide whether or not you’d like to buy a company as it will be in the future. Changing economic conditions, new competitors and a plethora of variables could throw off projections into the future which could hurt an investment based only on a company’s potential for growth. These same variables, while still bothersome, are less ominous for a value investor who only needs to ascertain whether or not a company’s current business is sustainable in the future.
Where do I stand on the Value-to-Growth investment spectrum? I would say somewhere in between but closer to the value side. Some might describe this mentality as growth at a reasonable price (or GARP) investing. I learned my lesson on full on growth investing with my recent investment in Cosi which was projected to finally become profitable this year as it switched from an operating model to a franchising model. Unfortunately, the transition did not happen as fast as was hoped and changing consumer sentiment kept same store sales from growing as fast as it had projected. The company ended up having to retract its guidance and has yet to post a profitable quarter. These days, I intend only to buy company’s which already have positive earnings as well as strong year over year growth in quarterly earnings.
I’m not a strict value investor in that I am not unwilling to pay for future growth and I am not afraid to invest based on relative value as opposed to a strict analysis of the value of companies I’m interested in. Yes, there’s a little greater downside risk, but a little extra thought can go a long way into guarding against it. A great example of this is J. Crew which has had a string of earnings beats and monster year-over-year earnings growth since it IPO-ed. I first became interested in it during what looked like an intermediate term base which typically represents a period after a run-up where a stock’s price waits for its earnings to catch up. At the time, it was trading in the high 20s for P/E but had a Price-Earnings-to-Growth ratio well within its industry range. No, it was not a strict value play, but the analysis did ensure that the stock’s price had room to appreciate despite moderately high valuation at the time. That is, as long as the company continued to perform. Yes, there are a few more sleepless nights than usual especially before earnings reports and sales numbers because these not only drive the stock’s price but also support it. That being said, the returns have been well worth it especially in a market environment where true value is getting more and more difficult to find.
