Charlie Munger: “All investing is value investing”.
Let’s play a game. As we write this in May 2023, we have recently witnessed an aggressive Fed tightening cycle, inflationary pressures in most global economies, multiple bank failures, war in Europe, the rise of Chinese authoritarianism, all in the shadow of a global pandemic that killed over 6 million people over the last few years. Looming ahead, a potential default of US debt, a widely predicted recession, and a fractious election cycle about to start. So here is the challenge – with a 10 year forward view, would you rather own the stock of a software company like Salesforce.com (CRM) or a public utility whose demand is guaranteed and price is ensured by regulators?
Different investors will answer differently – some will value the predictability of the regulated public utility, its cash generating power, its stellar return dynamics, and its potentially high dividends in a time of currency debasement. Others will be attracted to the open-ended growth opportunities of a software company, with the scale benefits and operating leverage of being cloud-based. Our view is that investors should evaluate both businesses similarly – will future earnings and cash flows increase? What will enable this business to succeed for a long time? How will that translate to attractive profits and returns, and ultimately, how will that translate to a rising stock price?
A sound framework for business evaluation and security selection is far more helpful than mechanically categorizing stocks and investors into “growth” and “value” camps, making bold calls that the market will favor “growth” or “value” or rotate at some point between them, or worse, ignoring large swathes of the market because we bucket ourselves as part of the “growth” or “value” tribes. But a shockingly large number of investors still classify themselves using these terms. So how did we get here?
Birth of a False Dichotomy. Since the 80’s, the tremendous substitution of software we have seen across the entire financial services sector, and the investment industry in particular, has led to what seems to be and never-ending variety of investment products. As software became more powerful, it removed the friction from building new investment products which could now be continuously created, modified, bundled, unbundled, re-labeled. We have seen this most pointedly in recent years with the rise of ETF’s that enable individual investors to buy a wide variety of assets in seemingly endless combinations. Despite the excesses, this degree of increased fungibility and combinatorial variety in the investment industry is decidedly a net positive for both individual and institutional investors.
On the other hand, over the years, some labels and terminology evolved for reasons that were advantageous to some investment industry participants but not necessarily to the industry’s end customers, i.e., investors. That is the nature of evolution in its context. In the context of the economics of the investment industry, investment performance is not the prime determinant of evolutionary fitness and success, though demonstrably poor performers are quickly weeded out and new entrants usually cannot take share without stand-out performance. Like the central role that big colorful tails play in the sexual selection and evolutionary fitness of peacocks, giving the impression of good performance, low risk, or stability… aka evolutionary fitness within the investment industry is actually more important than investment results. Trust counts. Marketing counts. There is nothing wrong with that per se. It’s just an evolving system, it’s not a conspiratorial cabal.
Nevertheless, bad terminology leads to wrong beliefs, biased approaches, and faulty processes – all of which ultimately harm investor returns. And investor returns are exactly what we are focused on. At best, we do not see the growth vs. value framework helping people make better equity investment decisions. But, it’s worse. Thinking in terms of growth vs. value can be perniciously misleading for asset managers, materially sapping performance, in our view. While we still at times use these terms to describe investment strategies, along with everyone else in this industry, we are not fans of doing so. We recognize the faults and limitations of the “growth vs. value” framework, and they are significant.
The main danger in losing oneself in the labels is forgetting the underlying fundamentals of the businesses on which stocks are based. Ideally, we’d like to see this “growth vs. value” lingo fall out of use, but it is so entrenched at both the retail and institutional levels, we are not holding our breath. While we begrudgingly talk in terms of “growth vs. value”, it is a false dichotomy, in our opinion. Further, it is a dichotomy we try to avoid when we discuss stocks internally and make investment decisions.
We have four main problems with the growth vs. value framework.
1. Orthogonality. The attributes “growth” and “value” are talked about as if they lie on the same spectrum, but the terms themselves are orthogonal. They measure different things. The antonym of “growth” is not “value”. The antonym of “growth” is “decline”. Of course, marketing a “SMID-cap Decliners Fund” might be a little tough, as would an “Expensive Large Cap” strategy. We jest, but, right from the get-go, directly from first principles, using the growth vs. value framework to differentiate stocks or to describe an investment strategy was always problematic. It is quite possible to have stocks of companies with above average revenue and EPS growth rates that also present an attractive value relative to what the market is paying today. That’s the whole of the point of equity investing. As investing guru Charlie Munger has said, “All investing is value investing”.
2. No Clear Definitions. There are multiple competing definitions of both “growth” and “value”, for labelling both stocks and the funds following a “growth” or “value” approach. While definitional differences are not by themselves problematic, they can be when they are being applied in a coarse-grained manner to divide the universe of equities into two things with a supposedly meaningful difference. Further, these definitional differences make it difficult to make apples-to-apples comparisons among stock or among funds, which is sometimes the point of these definitions.
However, these differences can also sap the substance from conversations about the underlying variables, like growth rates and valuation multiples. Further, the definitions themselves change in order to be more or less inclusive. That’s to keep the ratio of growth stocks to value stocks at about 50-50, which helps in packaging and marketing mutual funds to maximize overall sales. However, the ongoing active maintenance of this 50-50 balance between growth and value stocks is a tell-tale sign that these designations are relative and light on intrinsic meaning.
3. Lagging Indicators. In most definitions, growth and value designations are based on lagging indicators. Of course, lagging indicators play a key role in evaluating a company and analyzing its stock. It is just that the variables that determine “growth”, such as historical revenue and EPS growth rates of various durations, and those that determine “value”, multiples on earnings, revenue, book value, free cash flow, etc. shift around enough from year to year that value stocks become growth stocks and vise-versa at a frequency high enough to sap the descriptive and predictive value from the label.
In doing so, investors who define themselves as followers of a growth or value investment philosophy will miss opportunities because they are looking in the wrong bucket, and because of this self-imposed adherence, are actively biased against looking for future value among “growth stocks” or looking for future growth among “value stocks”. In other words, it places a lot of emphasis on a variable with limited predictive value. It is why many growth investors were late to the Microsoft (MSFT) growth acceleration in the late 2010’s, simply because MSFT was not considered a “growth stock”. We saw the exact same story play out with Adobe (ADBE), a little before MSFT, and Autodesk (ADSK), a little after.
4. Mixed Purposes. The Growth vs. Value framework tries to describe two very different things at the same time: equities and investment styles. They can overlap from time to time, but they are different things, which leads to problems involving this dual purpose that does not serve either especially well.
This is another aspect that makes meaningful conversations and consistent viewpoints within this growth vs. value framework difficult. In my career, I have seen many growth vs. value debates created out of thin air just because that’s the way we’ve always talked about stocks, portfolios, investment strategies. There is an argument that “growth vs. value” characterizations may have flaws but are better than nothing. We disagree. If you divide the world of equities into growth and value before you look at anything else, you will miss opportunities and that’s worse than nothing.
We Are Not the Only Ones. Others are questioning the relevance of the growth vs. value framework: Randall Dishmon, (Senior Portfolio Manager at Invesco)1, Derek Bergen, (Partner and Portfolio Manager at Applied Finance Capital Management)2, and Tom Ricketts (Founder and CIO of Evolutionary Tree Capital Management and a former colleague whose opinions we hold in high regard)3. But Saira Malik, Chief Investment Officer for Global Equities at Nuveen, an asset manager with over $1 trillion in assets under management (AUM), may have put it best in a June 2, 2021 article in the Financial Times entitled “The death of the growth vs value stock debate”. In the article, she states:
I will admit there is a certain superficial comfort in sticking with what we know, or what we think we know. But let us acknowledge this much: the value versus growth debate is over — not because one style has at long last vanquished the other, but because the “competition” between the two is based on a forced dichotomy driven more by perception than reality.
A Proxy for Risk-Reward. OK, we know what “growth vs. value” is really trying to describe. It is used as a proxy for risk-reward, specifically, where a stock lands on the risk-reward spectrum. We think it fails in this regard, especially over the long term. Perhaps it had more relevance in the 70’s when balance sheets of even large cap stocks often held hidden gems of value. So, value investing used to be akin to house flipping in a beaten down neighborhood or bidding on storage units after their owner dies, as opposed to a synonym for buying stocks with low P/E’s, which is what it seems to mean today.
Today, we see software-based businesses could be better described as a “safe utility” than actual electric utilities. Visa (V) and Versign (VRSN) come to mind. Getting back to the question we started with about owning the stock of a software company vs. that of a utility, we assert that higher multiple stocks considered “pure growth” may be safer than the average actual utility where distributed solar is becoming a real competitive threat. In our view, ten years out, the odds that revenue from the likes of ServiceNow (NOW) and Salesforce being lower than it is today is smaller than it is for any electric utility. And, let’s not talk about the “stability of banks and insurance companies”. Now, that does not necessarily make Salesforce and ServiceNow good stocks to buy, but we think they are safer in terms of the long-term business fundamentals than many stocks that are marketed as “safer” value stocks that are risk of substantial disruption and actual revenue decline – if viewed only from the perspective of “growth vs. value”
Of course, we screen and rank stocks based on multiple variables, including revenue and EPS growth rates, P/E and P/FC multiples, among many other criteria. We just don’t think it’s a good idea to give those stocks those labels. Further, rather than look only at the point forecast for growth or the multiple, we consider the solidity of our own opinion, the expected variance around our own estimates, and other risk factors that are likely to increase beta but may not generate alpha. We try to root those risk factors out of our portfolio while maximizing returns by focusing simultaneously on the business and its valuation. Of course, that does not mean we always catch our biases or avoid mistakes. In order to be good at equity investing, mistakes are unavoidable. Yet, we want to execute cognitive routines that help make better stock selection and equity investment decisions.
Exploring Other Frameworks. To that end, we have developed several differentiated frameworks beyond what we see as a “growth vs. value trap” in order to analyze and describe the businesses and stocks we are evaluating. In future notes, we will dive deeper into these frameworks and our Investment Criteria that are shaped from our time at Sands Capital, but also by learning from investors we admire like the team at AKO Capital, Mohnish Pabrai, Buffett/Munger, Sleep/Zakaria (Nomad), and Baillie Gifford – you will see a mix of those who describe themselves as “growth” and “value” investors among this group.
[1] “Style versus substance: Why I’m not concerned about the ‘growth or value’ debate”, article published on July 9th, 2021.
[2] “Demystifying the False Choice of Value and Growth Investing”, published on the appliedfinance.com website in November 2020.
[3] From the November 2021 investor newsletter for Evolutionary Tree Capital Management
