General ThoughtsInvestment PhilosophyThink DifferentlyWarren Buffett

Thoughts on Value and Growth

I wrote a few posts on “quality” recently, which has sparked a few emails, comments, and questions on the overall investment philosophy.

I got to thinking about the interplay between quality and valuation, and thought of Buffett’s shareholder letter in the early 1990’s where he said “value and growth are joined at the hip”. Essentially, value is determined by what you return on your initial investment. This is fairly obvious, but I thought I’d point this out… This “investor return” (the total profit we make on our investment) comes from three possible sources (or ideally a combination of the three):

1.  The first source of investor returns come from a higher valuation of assets or earnings. 

For example, the market “assigns” a higher P/B ratio or a higher P/E ratio to the stock. Deep value investors often buy asset based investments at low price to book ratios expecting at some point the market will revalue those assets to a higher level, which is often the case as Ben Graham and Walter Schloss proved over the course of decades.

2.  A second source of possible investor returns come from the internal results of the business itself. 

For example, the market may continually value a business at a P/E of 15, but the business is generating consistently higher earnings per share each year (possibly through either accretive acquisitions or through internal growth). In this case, the stock price increases even with no change in earnings multiples.

3.  The last main source of investor returns comes from capital allocation decisions made by management.

In this case, it’s possible to make a positive return on an investment even with no change in valuation and no improvement in the underlying business performance. This pleasant result comes from management improving shareholder value by either returning cash (paying dividends) or reducing the shares outstanding via buybacks.

In the best investment case, a combination of all three of these factors creates a compounding effect that can create significant shareholder value.

The Classic Davis Double Play

Shelby Davis was a famous insurance investor who took a small grubstake of around $50,000 and turned it into a massive family fortune of close to a billion dollars through investing in primarily insurance stocks. Davis called the combination of the first two factors (earnings and multiple expansion) the “Davis Double Play”.

He liked to use the example of being able to make 4 times his money when he bought a stock at a P/E of 10, and then it doubled its earnings over a period of years and the market revalued the business at a P/E of 20, thus creating a 4x return for Davis as an investor.

Value Investing is Redudant

So it’s a somewhat obvious (but also a sometimes misconstrued) conclusion that Buffett makes when he said in his 1992 Shareholder Letter that value and growth are both inherently a part of determining what a business is worth:

But how, you will ask, does one decide what’s “attractive?” In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

Buffett is simply saying that valuation and growth are two inputs that determine value. Think of it as a “value” equation. Including management, we’d have:

  • Valuation + Growth + Capital Allocation = Value.

This simple equation shows how negative growth (a shrinking business) can destroy value, even if the multiple is quite low—hence the dreaded “value-traps”. It also shows that a “negative number” in capital allocation (i.e. poor management decisions) can also destroy value. And of course, overpaying for any business (i.e. too high a valuation) is never a good thing.

But all of these are crucial components of value that we potentially get from each investment we make.

Buffett went on to say that the term “value investing” is redundant. Everyone is trying to invest in something that is worth more than they are paying…

Greenblatt sums it up best when he says: “Value investing is simply figuring out what something’s worth and paying a lot less for it.”

That’s really all we’re trying to do…

4 thoughts on “Thoughts on Value and Growth

  1. Thanks – it seems the financial punditry views a “value investor” as one who always uses low expectations of growth when valuing a company.

    A good investor will factor in even explosive growth, as long as that growth is well-justified (which it seldom is, and if it is that obvious, that growth is usually well priced into the stock price)

  2. As always, good post. I wanted to share a quick thought, particularly a quote from harry truman that Buffett used in one of his partnership letters.

    He said that it is possible for a good investment that you paid for goes down 20-30% in market value, which (i) makes sense and (ii) should be irrelevant if your analysis is sound. However, people may have emotional or financial distress and are forced sellers. Then he followed with the following quote that stuck to me. I admittedly use it when people ask me, “are you worried about the investment that is down 15%?”:

    “If you can’t stand the heat, stay out of the kitchen, it is preferable, of course, to consider the problem before you enter the kitchen.” – Harry Truman

    Though I follow this “value-oriented strategy,” I think the letter implied that this strategy is not for everybody because they may not be able to handle the fluctuations of market value, though their intrinsic valuation could be sound.

  3. Hey John, thanks for this post. The formula, value = higher valuation+internal results+allocation will be burned in my brain.

    You separate your investments by two factors: quantitatively cheap and compounders. You’ve often mentioned buying banks trading below book that generate earnings.

    Would you buy a business that has a poor return on capital but with an extremely cheap earnings yield? Say there’s no leverage, little to no capex, business risk is off the table. It’s just a poor business but extremely cheap. Would you purchase such a business?

    1. Hi Jake, That’s a good question. It’s hard for me to answer because although I do talk about a few “categories” of investments such as great operating businesses and special situations (cheap assets, spinoffs, etc…), I don’t really think of each investment in these categories at first. In other words, I really just focus on seeking out large gaps between price and value. Sometimes these gaps come from hidden assets, real estate values, significant free cash flow, or sustainably high returns on capital.

      I have a hard time answering your hypothetical question because each investment situation is different. I have some general guidelines and such, but each situation has many different nuances that impact the value. And remember, we’re buying a business, and each business is different. So it’s hard to say “yes, I’d buy such a business” or “no, I wouldn’t buy it”.

      I will say that in general, I don’t like businesses that produce low returns on capital (businesses that have costs of capital greater than their returns on capital will destroy shareholder value over time). But in some cases I have invested in special situations where I felt that–despite poor economics and low returns–the business had assets or some sort of corporate catalyst that would unlock value that significantly exceeded the price. As Buffett warned us with his Berkshire Hathaway investment in the 1960’s, these poor businesses–despite their incredibly cheap price to earnings or assets ratios–can end up destroying value.

      However, I try to look at each situation and my goal is always to invest in situations that I see obvious value. I don’t want to work to hard to see value.

      Hopefully that helps. I guess it’s a really long-winded way to say “it depends”. 🙂

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