Value or growth

Watching business channels during a bull market is quite a scintillating experience. The investment community quickly put on their smiley faces and go about explaining the rationale for the current market run. Words that get thrown about include contrarian, growth, value among others. Value investing, a style pioneered by Benjamin Graham in the 1930s, involves picking up shares when they are trading below what they are supposed to be worth.

Graham also popularised the idea of stock being represented by a company. What a company is worth can be estimated by parameters such as its book value, replacement cost, and cash per share and so on. Growth investing, the diametrically opposite, involved paying a premium price for a business, perceived as having great growth potential.

Blending styles


Value investing involves buying assets worth a rupee at 50 paisa and selling them when the market acknowledges the underlying asset value. The possibility for such arbitrage exists only for active and informed investors who scour through balance-sheets looking for such stocks, which Warren Buffett referred to as the cigar butt approach to investing — stocks which akin to a used cigar which have a puff or two left in them (indicative that a stock may yet have value left in it).

Such an approach does pay off in a dull market; such opportunities diminish in a bull market or in a market where a large number of investors actively seek such opportunities. With too many people chasing these opportunities, it gets more difficult to find them.

Value investing in its modern avatar has been associated with picking up businesses at low price-earnings (P/E) multiples, price-to-sales (P/S), price-to-book (P/B) or other such ratios. Value investors have traditionally taken a strongly quantitative view of a company. Metrics such as P/E, P/S, P/B values are indicative of cash flows and financial information at a specific point. These values, ‘high’ or ‘low’, are merely a starting point to investigate a prospective investment.

Growth investing has been taken to the illogical extreme of disregard for the price paid, if the prospect for growth looks promising. But if you want to invest effectively, blending these two ‘styles’ may be the right thing to do.

If you pay a ridiculously high price for growth, even stellar growth may not recoup the price you paid. Conversely a low price is no guarantee for success, if the business you invested in goes bust or does not have enough puff left.

In growth investing, success would entail buying part of business which is capable of growing at a minimum cost to investors. The latter is an oft-ignored component. Buffett in his 2007 annual letter highlighted three types of companies:

The company which grows its earnings with minimum capital expenditure;

The company which grows its earnings with capital expenditure, but the pace of earnings growth outpaces capital expenditure;

The company whose earnings growth lags the pace of its capital expenditure.

No prizes for guessing which one of the above makes for the most desirable investment.

Cost of growth


Investors should not confuse increased earnings from increased capital expenditure, with increased earnings from increased efficiency.

The cost of growth is the vital figure. If a company spends a rupee generating a rupee of growth, growth may have no impact on the stock price!

Growth and value may, therefore, have to be put together for effective investing. The environment, economics and management of the business are other components. None of these are independent of the others.

Investing is essentially an act of buying a share of a business and its future cash flows. It involves taking a view of the future cash flows, their sustainability and the cost of generating those flows.

Your call on the sustainability of a business comes from understanding ‘intangible’ aspects such as brand, demand elasticity and institutional culture. The only way to derive value from investing is in understanding how growth happens; this is the point where growth and value cease to be standalone elements.