- “The central principle of investment is to go contrary to the general opinion on the grounds that if everyone agreed about its merit, the investment is inevitably too dear, and therefore unattractive.” – John Maynard Keynes

Many money managers feel they must distinguish themselves as either “growth” or “value” investors. While an apparently benign distinction, this simple act can have unintended consequences. This article will address conventional definitions of growth and value and then look to the market oracles for a dose of worldly wisdom.

Value investing: The strategy of selecting stocks that trade for less than their intrinsic values. Value investors actively seek stocks of companies that they believe the market has undervalued.

Growth Investing: A strategy whereby an investor seeks out stocks with what they deem good growth potential. In most cases a growth stock is defined as a company whose earnings are expected to grow at an above-average rate compared to its industry or the overall market.
(Definitions taken from Investopedia)

The difference between the two approaches might best be illustrated by an example at the far end of the value and growth spectrums:

Take two companies with differing future prospects: Company A and Company B.

Company A: Analysts love this company, and rightly so: this company has emerged as a monopoly in a new industry. Profits grow at a rate of 40% a year. In industry parlance, company A is a ‘growth stock’

Company B: This is a poor company in a poor industry. Some years it makes losses, other year’s miniscule profits. It’s barely surviving. Nevertheless it does have one redeeming feature; cash on the balance sheet makes up a significant proportion of market capitalization. This holds possibilities as a pure value investment.

At this point we might be asking ourselves which is the better investment: Company A or company B? Looking at the limited information available to us, it is obvious that company A is the superior business.

However, it does not then follow that company A is the better investment and here’s why: we do not have information on the second, and vitally important element of the investment equation: Price. Without knowing what each company sells for on the open market, we are unable to make a fair and reasonable assessment of investment merit. Furthermore, we have no way of knowing whether the growth or value approach will yield better results. Now is probably the time to insert something intelligent from Warren Buffett:

‘But how, you will ask, does one decide what [stocks are] "attractive"? Most analysts feel they must choose between two approaches customarily thought to be in opposition: "Value" and "growth" ... We view that as fuzzy thinking ... Growth is always a component of value [and] the very term "value investing" is redundant.’ Warren Buffett, Berkshire Hathaway (BRK.B) annual report, 1993

Charlie Munger, Buffett’s partner, has added, “all intelligent investing is value investing”.
The lesson here is that investors should be cautious about defining themselves as growth or value investors. Doing so may inadvertently have the effect of pigeon holing one’s outlook of securities markets, and the opportunity set available to them. In Buffett’s words: "growth and value investing are joined at the hip". It should logically follow that the best investment is the one that, taking all factors into account, promises the highest rate of return with minimal risk of losing your capital.

There is one important addition to this discussion and that is: There is much to be said for specialisation in the investment field. Having an edge over other market participants is an oft understated but powerful factor in investment outperformance. This might be an informational advantage – having better or more insightful information, an analytical/interpretational advantage – “It’s not what you look at that matters, it’s what you see.” (Thoreau), and not least, a temperamental advantage – having the ability to ignore emotion and the crowd, and objectively assess the facts as they truly exist.

So, when is it appropriate to distinguish between growth and value?

Another very famous investor, Peter Lynch, pioneered a hybrid of growth and value investing with what is now commonly referred to as a "growth at a reasonable price (GARP)" strategy. Here we see that the two approaches can be synthesized in the way Buffett describes.

Successful growth investing, which more often than not will bring with it longer holding periods, requires two distinct elements:

1) The business must have a legitimate long-term competitive advantage.
2) The business most possess the ability to grow earnings on a long-term basis.

Conversely, to be successful in the long term, it is incumbent upon the value investor to sell average companies (Like company B) when the market price approaches or exceeds fair value.

All investors need to pay attention to the price they pay for equities. Companies that hold large competitive advantages and exhibit steady growth can be poor growth propositions if they are “priced to perfection” just as ‘value propositions’ must incorporate a significant disparity between price and discerned value. All investments: growth, value or other, should be bought with a Margin of Safety.

Conclusion:

The stock market may be likened to the field of horse racing. Most punters are focused on picking the best horse in the race. The error here is in assuming that the best horse comes with the best odds. Quite naturally, these punters compete with everyone else who is similarly focused on the presumed winner.

In contrast, very few people bet on the horse that is the most mispriced. Over time, those who come out first at the track will be the ones who consistently look for and then exploit the differential between price and value.

Investing in horses isn’t all that different from investing in securities. The great investors are those who wait patiently for that rare occasion when the best horse in the race is, for one reason or another, mightily mispriced. When the world offers them this opportunity, they bet heavily.

Interesting fact: Though Ben Graham was considered a bargain hunter, and pure value practitioner, his best investment was GEICO - at the time a young insurance company that is now one of the largest in America. His return on this stock alone was more than 250 times the original investment.