Value vs Growth
How would you describe your investment style? The first way people usually describe their style is value vs. growth. But what does this distinction really mean?
Growth investors, as the name implies, invest in companies with great growth prospects that usually sell at a premium to the market P/E or P/B (Price/Earnings and Price/Book). They invest in companies like: Nextel, UnitedHealth Group, Tyco, AES, InterActiveCorp, Amazon.com, J.P. Morgan Chase, Google, and Aetna. (Disclosure: I own shares of AES as of this writing.)
Value investors, on the other hand, traditionally invest in companies with low P/E and P/B. They invest in companies with lesser growth prospects that sell at a lower price relative to current cash flows.
However, these distinctions are not as clear cut as people would have you think. For example, the companies mentioned above as growth companies are the top nine holdings in Legg Mason Value Trust – arguably the most successful value fund in history. Is the fund mislabeled? Or are the labels “value” and “growth” misleading? I argue that that latter is correct.
The descriptions “value” and “growth” are overused and confusing. P/E, P/B, and Div yield are of little use in defining real value. Value is the present value of future cash flows, and as such, growth is an intrical part of the value equation. (Mathematically speaking, assuming constant growth, Value = CF/(discount rate-growth). So the higher the growth rate, the higher the value of the security.)
“Most analysts feel that 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 as a form of intellectual cross-dressing. We view that as fuzzy thinking…Growth is always a component in the calculation of value, constituting a variables whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” (Warren Buffett, Berkshire Hathaway annual report, 1992)
Despite the constant conversation otherwise, value and growth are not opposites, but are very positively correlated. Intelligent “value” investors see the value in growth. And intelligent “growth” investors see the value in a reasonable valuation. So the next time someone asks whether you are a value a growth investor, you can do what I do, and give them a very confused look and stumble through a lengthy explanation.
