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Why I prefer value to growth

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July 30, 2010 – Comments (15)

I always have a lot of time to think on my morning commute into work.  Today I started thinking about why I invest the way I do.  I wondered to myself why I so strongly prefer value stocks over growth stocks.  There's lots of people out there who do fantastically by investing in lottery ticket stocks, unproven technologies, companies with high P/E ratios, etc...  Heck The Motley Fool has an entire newsletter, Rule Breakers, that has outperformed the market by 28% over the past several years using this strategy...so growth investing clearly works if done correctly.

I think that my natural inclination to invest in value stocks stems more from my personality than anything.  As much as anyone wants to be an emotionless, robot investor it is difficult to completely remove emotions from the process of vetting stocks.  The way I invest actually reminds me about a story that I read about the famous Oakland Athletics' General Manager Billy Beane in Michael Lewis' outstanding book Moneyball.

The part of the book that I'm thinking about is not about Beane the GM, but Beane the player.  Beane was an extremely talented, highly touted baseball player coming out of high school.  The New York Mets drafted him in the first round of the 1980 MLB draft.  Despite his immense talent, Beane couldn't handle the tremendous amount of failure that inherent in the game.  Even the most talented, successful major league All Stars only succeed approximately 30% of the time at the plate.  One has to have a certain mindset to deal with being unsuccessful 70% of the time that they do something.

That's my problem with investing in growth companies and why I stick to value.  I absolutely can't stand losing money.  I don't mind all that much if a stock that I have invested in underperforms the S&P 500, as long as it's in the green.  But seeing a permanent huge red mark in my portfolio drives me absolutely bananas.  I can live with stocks that are in the red, where the catalyst or catalysts that I was expecting to happen when I invested in the company are still likely to happen.  Heck, it's natural for stocks to fall by 10%, 20%, or even 50% before things eventually work out the way you thought they would.  The day-to-day fluctuation in stock prices doesn't matter much to me, but the permanent loss of capital absolutely disgusts me.  Huge red numbers provide a significant drag on the performance of a portfolio.

My OCD-lite obsession with not losing money, aka doing no harm, has lead me to invest in companies with cheap valuations.  Now that does not always necessarily mean that a company's P/E ratio is low.  I look at lots of different metrics when investing, including liquidation values, cash on the books, cash flow, EV / EBITDA, etc...  But generally speaking for me to be interested in a company, it has to be cheap.

Ideally, I like companies that pay dividends as well.  I much prefer dividends to share buybacks. They just provide an added margin of safety.  Here's an example from the real-world where dividends would have saved an investor a significant amount of pain.

Let's say that one had been a BP shareholder for a number of years.  I don't know the specifics of what British Petroleum did with its money over the years, but I know that it paid a solid dividend and I assume that bought back stock. Anyone who received dividends from the company and chose not to reinvest them, as I often do, had a huge cushion that they could use to absorb the tremendous drop in the company's share price.  Back in 2007 BP's price per share was around $60 or so.  Today it has fallen to around $38. That's a loss of $22/share.  However, the company paid out something like $13 in dividend between then and when it suspended its payments.  That means that the total loss that one sustained by investing in the company over that time period was really only $9/share instead of $22.  The numbers look even better for shareholders who have owned BP stock for even longer than that.  What happened to all of the money that BP used to buy back shares when it was trading at $50 or $60?  It was a waste.  Not a complete waste because there's fewer shares outstanding, but still.  I'll take cash in my hand all day and night over share buybacks, which are often nothing more than a way for management to mask the dilutive options that they are lining their own pockets with.

Unless a company is mind-blowingly cheap and is trading near what I believe to be its liquidation value, I also need some sort of catalyst or catalysts that I believe will cause its share price, or at least its earnings to significantly increase at some point in the future.  You can say that I look for free embedded call options when I invest in companies.  

Behind every stock there is a real company with a story.  I want to understand that story as well as possible before I commit real money to it.  All of that Discounted Cash Flow (DCF) analysis that tries to guess what sort of free cash flow a company will report ten years from now is great and many people do well with it, but I personally would rather be approximately right than exactly wrong in investing.  

I look for cheap companies that have catalysts.  If I feel as though an opportunity is potential winner, I pull the trigger.  I don't know how anyone can predict what a company's earnings, etc... will be like years from now.  You can only guess if there are factors in place that will enable a company to be more successful at some point down the road than it is today.

Anyhow, that's my deep thoughts for the morning.  I'd love to hear about others' investment philosophies as well.  There's definitely more than one way to be successful in investing.  What works for you?

Deej 

15 Comments – Post Your Own

#1) On July 30, 2010 at 10:47 AM, vriguy (78.17) wrote:

Well said. 

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#2) On July 30, 2010 at 11:16 AM, TMFDeej (99.26) wrote:

Thanks vriguy.

Deej 

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#3) On July 30, 2010 at 12:08 PM, Tastylunch (29.33) wrote:

 I'd love to hear about others' investment philosophies as well.  There's definitely more than one way to be successful in investing.  What works for you?

Hmmm well I've always had decent success with GARP and usually a version of that as my core strategy. I prefer my stocks to be operated well.

Value investing to me is fun but not as safe as it is appears. There are too many dumb things mgt can do to prevent the realization of value almost indefinitely.I do like it and use it, but I alwyas try to amke sure there are likely catalysts to unlock that value in the next 12 months. I typically do not have a long holding period on value stocks. In a no growth economy like this I've been using value more and more. Good GARP plays are not plentiful right now. In practice I prefer Piotroski vaklue plays to liquidation or special sitautions. Piotroski picks seem safer to me since you know the company is improving and I've had greater results with it.

like you I generally do not like buybacks much .I always keep some of my port in decent yielding divd stocks (which are basically my only true LTBH positions). I have more than typical right now since yield outside of equities is hard to come by at the moment.

I do momo investing occassionally, but that's basically a swing trade for me. I doubt any momo stocks I've held have been longer than 18 months.But I've also learned that momo investing only works in strongly trending markets. This year and 2004 would have been two lethal years to try it for most. You'd get whipsawed to death. I will say if you are doing momo you do want to see buybacks then as it reduces float and keeps the squeeze going. Long term I think it's bad for the company, but the position trader it's definitely good.

I'll short sell when I think we are in strongly trending bear market. That i've found has been my greatest juice to my performance. Being short some names in 2000 and 2008 really helped my portfolio outperform the market  and greatly reduced my drawdown. Shorting is too risky in my experience to do much of in choppy or bull markets. Shorting imo is basically like fighting gravity. The market is designed to favor bulls as it should be.

and then lastly I very occassionally daytrade when I see opportunities in it and I have the time.  Pump & dumps are fun to short if you can get borrows fast enough. :)

I'm alright with failure, I played a lot of baseball so htting 300 is fine by me if the hits are big enough. It used to bother me when I first started but then I reduced position sizes and that made it alot easier to swallow.

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#4) On July 30, 2010 at 12:11 PM, Tastylunch (29.33) wrote:

so I guess I do a bit of everything which is probably not advisable, but I kinda have to to keep myself interested.

Just something I know about myself.

 oh and CAPS is one of my idea labs so don't think I manage my risk anywhere nearly as poorly as I do there. I'd be pretty poor if I let myself go -700% on a shorts in rl, but in CAPS I have little incentive to call it a day on bad picks and move on. Blasted accuracy rating. :)

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#5) On July 30, 2010 at 2:27 PM, TMFDeej (99.26) wrote:

Thanks for sharing your thoughts Tasty.  With a score of 98, you're obviously doing something right here in CAPS even with letting your losing bets run.

I love your conviction on the Las Vegas Sands -868 :).

See you around.  Have a great weekend.

Deej 

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#6) On July 30, 2010 at 2:44 PM, alphadogg (39.96) wrote:

how do you define value?

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#7) On July 30, 2010 at 4:25 PM, TMFDeej (99.26) wrote:

That's an excellent question, alpha.  I suppose that value means different things to different people.  It can even mean different things for different stocks.  A stock that appears expensive in terms of its P/E ratio might actually be cheap on an EV / EBITDA basis.  The same goes for an expensive stock P/E-wise that has amazing cash flow.

P/E ratios can some times be distorted by all sorts of things.

I am even willing to consider companies that have no earnings at all "value" plays if with a very, very conservative estimate I believe that they are trading below their liquidation value or if they are trading for less than the cash that the have on the books (and aren't burning through it too quickly of course), or have some sort of hidden assets that I believe will eventually be unlocked.

I guess that I'm trying to say that "value" is a vague term that can cover a number of different types of situations.  To me though a stock has to scream that it's cheap in some manner in order for me to consider it a value play.

It might be easier to look at this in terms of what stocks I consider to be un-value, to make up a word :).  These are stocks like CRM, OPEN, AMZN, NFLX that are trading at extraordinary multiples to earnings and many other metrics.  Even worse than that are speculative stocks of companies that have never earned a penny and have no potential to do so any time soon, such as many biotechs, RLD, TSLA, etc...  Some of these companies will inevitably end up being home runs for investors, but I'll gladly sit on the sidelines and watch others swing for the fences.

That's probably as clear as mud, but I have an excuse...it's almost happy hour on a Friday :).

Thanks for reading and have a great weekend. 

Deej 

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#8) On July 30, 2010 at 8:38 PM, alphadogg (39.96) wrote:

interesting.  I am new to trying discover value opportunities, I like it better than growth because it seems to be easier to pin down a tangible value on the stock, which gives you a better idea of what to expect, and when to exit.  All of my recent picks in the past week or 2 are my new value strategy I am trying.  check them out if you want

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#9) On July 30, 2010 at 10:15 PM, bullnada (< 20) wrote:

I like value and growth. Imagine if any of these public companies told the truth!!  It would be great. I feel that anyone who thinks they are investing are dreaming.You are Gambling....  I am creating a company that is built on truth period. If it fails it deserves to.  Could you imagine a company that told the truth? I may even just sale truth stock.I will be rich... I keep the dream alive with this site but the more I watch the more I see how much you all are shooting in the dark..  Can anyone say they understand this madness? Yes I have lost big. I dont want others to eat the pill I have had to swallow. Are any of you making money over a 10 year period in the market?

 

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#10) On July 30, 2010 at 10:22 PM, WallstreetKnight (45.62) wrote:

I could tell you in two words why you preferred value to growth after the 3rd sentence:

"There's lots of people out there who do fantastically by investing in lottery ticket stocks." 

 Risk Adverse.

 

That said, nice post. 

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#11) On July 30, 2010 at 10:42 PM, ChrisGraley (29.65) wrote:

Great blog Deej!

When I first started investing heavily, I was strictly a value investor.

Before I invested in anything, I would ask myself "What would Jesus (Graham) do?"

Later in life, I learned that there were a lot of other investment styles that worked too. GARP seems to work. CANSLIM seems to work. That's when I learned that there is a time and a place for everything. I still love and prefer value investing because "It love you long time!", but I learned that even value investing can turn against you in an insane market. I always thought that if I bought below liquidation value, that I can never lose money, but in an insane market, what happens is that value play just sits there below liquidation value until the market eventually corrects. It doesn't go bankrupt, because it's undervalued and it doesn't go up either because people are too scared to take advantage of that fact in a crazy market.

What I lose is opportunity cost. I used to say that "I'm in it for the long term!" over and over again, until I realized that defending my position wasn't making me any money in the short term.

Over the last couple of years, I've heard many bloggers on this site say that value investing is dead. It's not. It's alive and kicking! Both value investing and small cap growth investing do their best when you buy at the bottom. I'm not an expert in Macroeconomics, but the bottom for me is when I feel like jobs are being created. When I get that feeling, I'm going to invest about 75% Value and 25% small cap growth.

Other than GARP or CANSLIM, I'm still trying to learn other investment strategies.

I invest in options now more than I invest in the stock market right now. I invest in commodities more than anything now, and given my viewpoint on the planet, I don't think that will ever change at this point.

I've been studying FOREX trading, but I always seem to trade options instead of currency when I get FOREX signals. I've been really dissapointed with the FOREX books that I've bought though and that probably has a lot to do with it.

If anyone knows of any FOREX books that aren't preaching that I can get rich if I just use a ton of leverage, please tell me.

I'm also looking more at technical analysis and momentum investing. I do believe that technical analisys works, but I see too many tech guys looking at the same chart and having opposite opinions. I haven't condemed momentum investing yet, but my opinion so far is that it's like jumping on to a moving train when you could have bought a ticket at the station.

Again, if you guys could recommend a couple of books, I would appreciate it.

So my private opinion is that value investing works and it will always work. There are a lot of things that work just as well though at times.

If I want to maximize my reward and minimize my risk, I should understand all of them.

Once I started studying new techniques, it opened new windows to wealth. I still love value plays above everything else, but now I can make money while I'm waiting a few years for that value play to reward me.

I know you are responding to the growth is better than value post a couple of days ago Deej, but i prefer both growth and value depending on what the market puts on the table.

With tremendous respect for a great blog post,

Chris

 

 

 

 

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#12) On July 30, 2010 at 11:34 PM, TMFBabo (100.00) wrote:

Moneyball is one of my favorite books, hands down.  I enjoyed Billy Beane the GM's player picking methodology the most.  I was high on stock screening when I read it, so I found it fascinating that he basically screened for prospective draft picks in ways that other people found absurd. 

When I still played fantasy baseball, I developed a method for picking pitchers that included K/9, K/BB, and HR/9 ratios.  In my opinion, these were the stats that showed the true skills of a pitcher without factoring in uncontrollable things like quality of infield defense, BABIP (sometimes you're just unlucky), etc.  Using only ratios, I also made my rankings injury-adjusted.  Upon reading Moneyball, I was again thrilled to find out that Beane was very similar in his pitcher rankings as well. 

This book, an enjoyable read for any baseball fan, was especially enjoyable for someone interested in valuing (or at least screening for) stocks by the numbers. 

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#13) On July 31, 2010 at 3:24 AM, Mstinterestinman (23.05) wrote:

I'm a growth Investor but its a disciplined approach I believe in Garp or Growth at a Reasonable price. If it has a high PE it has to be growing revenue,cash flows and earnings faster than what the market is asking in a way imo practicing garp is the same in a way as Value investing you are buying a piece of a company for less than what its worth. Buffet himself even said disciplined investing has no special name.

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#14) On July 31, 2010 at 10:52 AM, Dobbes (< 20) wrote:

I don't have a preference for either growth or value.  I've been burned and rewarded from both.

Recent examples: I grabbed oil sector stocks during the BP debacle, and even piled on to DNDN during the runup (the cynic in me got me out early, and then I flipped to short after they hit FDA troubles).

I think the important thing is to recognize what are good reasons to pull the trigger and take a position.  Value, growth, it doesn't matter, as long as the thesis is practical.

I prefer dividends to buybacks as well. Cash is one of my favorite asset classes (small joke), and its always nice to have a wad of it laying about if there is a good opportunity.

 

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#15) On July 31, 2010 at 4:31 PM, walt373 (99.85) wrote:

I think part of the reason I like it is my personality. In daily life, I've never felt compelled to follow the crowd, and I take pride in my independent nature. Sometimes the majority is just very wrong, and I think having a skeptical mindset is a potential edge in those cases. Most of the people I see attempting to exercise that edge in the market are value investors. Being right is another matter, but at least the potential is there. I think there are a lot of people who would not really be willing to stand in the minority, and I see that I would be willing, so I try to take advantage of that freedom.

The great thing about value investing that anyone can appreciate is that it's rock solid, because it's fundamental to the stock market. Unlike other higher-level trading or investing systems (where you have to outsmart other market participants, who can change their behavior to adapt), value investing will never experience "system death" because it's the nuts and bolt of how capitalism happens in the stock market. Obviously the businesses themselves change and investors have to learn how to value new business models, but the value of any stock is always going to be the sum of all discounted future cash flows, period. Value investing deals in absolutes and that is a source of confidence that you can't really get with other investing styles.

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