—A brief look at value versus growth investing—
The debate on whether value stocks are “better” than growth stocks has been going on forever. From a long-term return perspective, the evidence appears to be favoring value stocks. But when you stop and think about it the question that pops to mind is really “What’s the difference between ‘value’ and ‘growth’? Aren’t they basically identical from an analytical point of view?”
Yes they are. An extremely simple example should suffice. We have two companies, CoVal and CoGro, and their stocks have the following economic and valuation parameters:
Earnings per share (EPS) $2.00 $2.00
Annual desired return 10% 13%
Annual growth in EPS 0% 10%
Stock price $20 $67
Price/earnings ratio (P/E) 10x 33x
The desired return for CoGro is slightly higher because it is involved in businesses that are judged riskier and that are expected to grow relatively fast. The stock prices are derived using the simple present value formula for a growing annuity (for CoVal, $20=2.00/[0.10-0.00], and for CoGro $67=2.00/[0.13-0.10]).
At these prices, provided the assumptions are borne out in the future, each set of shareholders should receive what they “asked” for in required return and should be satisfied with their choices. Shareholders of CoVal will be happy to pay 10x earnings and shareholders of CoGro will do the same at 33x earnings.
Enter the glass-half-full-half-empty analogy. The numerical analysis says little about uncertainty, though the higher desired return for CoGro is in part protection for this risk. The uncertainty hinges on the realization of the declared growth assumptions, and this means a “growth” investor will be more exposed to getting hammered than a “value” investor, who will focus on opportunities that already embed a certain amount of pessimism in their pricing. For growth investors the glass is half full; for value investors it is half empty.
How does a half empty glass compare to a half full one? From CoGro perspective, should EPS future growth decline to 5%, 1/2 the original 10%, the value of the stock will decline by 63% to $25 with a P/E of 13x. The same deceleration in EPS growth for CoVal (implying an actual 5% decline in earnings) will lead to a 33% loss in price to $13 and a P/E of 7x. CoGro shareholders need to have strong faith and a steady stomach to weather surprises.
An investor who sees a half empty glass is simply taking a more prudent approach to investing; one where respect for the natural randomness of our environment is put above the enthusiasm generated by even the most detailed analyses. Paying full price for expectations that may turn even marginally wrong is indeed a risky business.
Photo source: own picture, with Dorothea in the background, 15th August 2004.