Investors have long debated the merits of growth versus value investing. Rather than rehashing those points, we wanted to share our perspective on why we believe the combination of the two is more powerful than strictly focusing on just one. We don’t see value and growth as opposing factors, but rather intrinsically linked.
Why does your investment style even matter? It’s important to have an investment philosophy that guides your decision-making and provides you with a high probability of successful outcomes through a consistent and repeatable process. Our beliefs may be different than others, and that’s fine. There is no one perfect way to invest, no matter what the get-rich-quick books claim! While market history has shown that both growth and value styles have merit, each one on its own has challenges.
AT WHAT COST?
Pure growth investing minimizes the importance of what you pay for the business, focusing almost solely on the future growth outlook. Our biggest issue with only looking at investments through this lens is the minimal weight placed on the potential downside, in addition to having to put significant trust in future forecasts. The stock market is littered with failed examples of great growth stocks with unsustainably high valuation multiples causing investors pain as their future growth trajectory slows.
BEWARE THE VALUE TRAP
Strict value investors focus on the price they pay, but often at the expense of favorable business fundamentals. We certainly appreciate the focus on managing downside risk, but businesses that are not growing can become what are known as “value traps”. Value traps are cheap stocks that stay cheap because their business fundamentals remain weak.
A BALANCED APPROACH
We attempt to minimize the downfalls of each style while capturing their positive merits. Given that our process is centered on risk management, valuation plays a significant role, but not at the expense of fundamentally high-quality businesses. The combination of both growth and value has performed well on the upside and, just as importantly, provided downside protection in challenging markets.
MICROSOFT – FROM GROWTH STOCK TO VALUE STOCK AND BACK
Theories are nice but they don’t generate returns. We’ll use Microsoft as a real-life illustration. Microsoft is a highly regarded company; when we think of high-quality businesses it is certainly at the top of the list, with strong management, persistently high growth rates, a monopolistic business model, excellent balance sheet, returns on capital, etc. Over time, Microsoft has acted as both a growth stock and a value stock.
Microsoft saw great growth in the late 1990’s as revenues and earnings surged. At this time, Microsoft and many other similar businesses became the domain of the growth investor. The shares exploded, leaving value investors and the broader market in the dust… until the shares ran out of steam. This wonderful business became wildly expensive at its 2000 peak, trading at a P/E multiple of nearly 80x compared to the market’s long-term average of roughly 15x. The growth investor argued the valuation was irrelevant as the company’s bright prospects dwarfed any concerns. That was a mistake; the share price collapsed over 60% and took over 15 years to get back to 2000 levels.
Source: Capital IQ
Consider this irony – earnings did increase dramatically from $0.77/share in 1999 to $2.59/share in 2016! It was irrelevant given the carnage that ensued. The lesson is that growth alone is not enough; what you pay for that growth needs to be part of the equation. Valuations can get stretched so far that all possible good news years into the future has already been factored into the share price. Even great companies can make for bad stocks.
Microsoft’s valuation fell precipitously through the 2000’s, below the level of the overall market. Value-based investors were able to buy shares at less than 10X earnings, and it remained at this low valuation for years. At the time, Microsoft was bashed as a “value trap” as the business went through challenges before regaining its growth trajectory.
We initiated a position in 2007 as the valuation became attractive and our analysis suggested the business was still of high quality. We had to hold on tight through the financial crisis bear market of 2008-2009 but were rewarded with a near 500% increase in the share price over the ensuing decade. We ended up selling the holding in August 2020 as the shares traded back up into the mid-30x P/E level, nearly twice the multiple of the overall market.
To conclude, there is no holy grail in investing. Building a portfolio of companies that can compound growth into the future (ie. quality) while maintaining an eye on downside protection has been a pretty reasonable guidepost throughout history.