If you want growth, stick to value.
The value investing part of your portfolio can serve as the long-term growth component of your overall asset plan. There’s no requirement to differentiate between value investing and growth investing sections of your portfolio because a thorough value investing approach incorporates growth into its calculations.
How Growth is Part of Value
First things first; value investing is a philosophy, a method of investing in companies that are cheap relative to their intrinsic value. A value investor is like the most persistent bargain hunter in the world, scouring local newspapers for coupons, or signing up for multiple credit cards just to grab the bonuses.
Value investors are on the hunt for mispricing in the market and intrinsic value is the key to that search. These investors are looking for companies that fly under the radar, or are underpriced due to the irrationality of the market. Being able to accurately assess intrinsic value is likely the number one item on every value investor’s Christmas list. That’s because if you know what a company is truly worth, you know to buy it when the market is undervaluing it.
One arrives at intrinsic value through a thorough analysis of the fundamentals of a business, evaluating its business model, economic moat, earnings history, and importantly, growth. Warren Buffett himself says that “growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous”.
You can have Your Cake and Eat it too.
Apple is a good example – on the face of it, it doesn’t seem like a value stock, but in 2015, after the launch of the iPhone 6, the company had grown 48% over the last quarter. That represents massive growth, above-average, and industry beating at the time. At the same time, the company was trading at a 25% discount to the overall market (based on P/E).
It’s funny, there are countless studies which examine the distinction between value stocks and growth stocks but growth has been a part of the value equation since the beginning. The father of value investing, Benjamin Graham, set down a simple investment checklist for those wanting to invest in stocks. Ben Graham was the first to champion the approach of buying undervalued companies and holding them until they realized their true value. This pioneer of value investing recommended investing in businesses with healthy assets relative to liabilities and positive earnings over the trailing 5 years, along with a minimum of 3% annual growth rate in the last 10 years.
Comparing Value Investing and Growth Investing Portfolios: A Value Portfolio Grows Faster than a Growth-Oriented Portfolio
Value kicks ass. Over time. All the time.
Historically this holds true, and the spread between the returns of value and growth stocks is known as the value premium. Traditionally the explanation for the existence of this premium is that value stocks are somehow riskier but there might be behavioral and cognitive explanation for it as well. Investor expectations play a large part, where unrealistic expectations set the stage for disappointment down the line, which fuels sell-offs and ultimately inferior returns. Investors may also bid the prices of popular growth stocks up, lowering returns.
According to the study by Merrill Lynch and the Bank of America, value stocks have outperformed growth stocks over a 90 year period starting from 1926, returning 17% on average versus 12.4% for growth.
It’s possible to get stuck debating distinctions but a growth-oriented portfolio just means that the stocks selected are expected grow rapidly in the long run, and we’ve shown that that is a consideration that value investors already make.
Having a value investing mindset means that you focus on valuing business by estimating how much cash you can take over the rest of that investment’s life. It explains why stocks that are bid up can end up returning less as your margins get squeezed. Growth for growth’s sake is speculation.
If you still need convincing just remember the success of some of the world’s most famous value investors. Famously, Warren Buffett returned 1,826,163% over 50 years at the helm of Berkshire Hathaway, representing a compound annual growth rate of 21.6%. Joel Greenblatt, another well-regarded value investor, returned an annualized 40% between 1985 and 2006 using his “magic formula”.
Leave it Alone
The best thing to do is to leave your value portfolio alone.
Value investing is not about throwing off income or speculation – it’s about patience, letting the market catch onto its irrationality and mispricing of companies so that your investments can realize their true potential.
An increase over time in share price doesn’t mean the market will force a value stock to reach its intrinsic value either. Intrinsic value can appreciate over time as earnings grow and the company becomes more profitable.
Another consideration is that when an investor buys a company below intrinsic value, the relative dividend yield tends to be quite high. As earnings and cash flow improve and increase, dividends may grow with it. This helps fuel the outperformance of a value-oriented portfolio.
For undervalued businesses, market value catches up to intrinsic value over time. There can be ups and downs in between but a value investor must hold on; there are studies that show that value investing strategies are less reliable over short time horizons because of the unpredictability of financial markets. Reacting to short-term volatility will ensure that you destroy your returns.
Value investing forces investors to take steps to limit capital loss while positioning themselves for excellent capital appreciation over time. Value investing can and does outperform a growth-oriented portfolio over time, because the approach focuses on taking advantage of mispricing in the market rather than relying on momentum, which can quickly fizzle out.
Value investors do well to set themselves up for success and allowing for a long time horizon helps them realize that success.
Jiva Kalan is a writer whose work has been featured on DailyFinance, the Wall Street Survivor, Plousio and Financial Choice.