Why I prefer value to growth
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
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