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Wired for Value or Growth?



July 18, 2013 – Comments (0) | RELATED TICKERS: NFLX , BKNG , ISRG

Board: Value Hounds

Author: ultimatespinach

What is hard for a value investor to get a handle on is the notion fundamentals and cheap valuations are not the only things that create opportunity. But is there anything stopping us except temperament from looking further afield?

Hi Kat. What you call temperament I call brain wiring. This is my pet theory to explain almost everything from partisan political antipathy to the cognitive disconnect between "growth" and "value" investors.

With respect to the latter, I find at least two distinct kinds of hard wiring that I like to think will be defined and labeled by virtue of sophisticated brain mapping a century (or less) from now.

Many value investors, including Warren Buffett, have observed that once the principles of value investing are explained to a person, she either "gets" them intuitively right away or does not. Buffett and others who bury themselves in annual reports and say the language of accounting "speaks" to them are people whose minds work naturally in quantitative spheres. Small quantitative discrepancies leap out from the page long after many others' eyes have glazed over. When I read one of your deep dives into a company's filings on these boards, I get the sense your brain works this way. These numbers speak to you and you follow them to figure out the story.

The best of the growth investors seem to me to do pretty much the opposite, starting with stories that instinctively make sense to them and then checking the numbers for backup. Their brains seem to work more naturally in qualitative spheres. Peter Lynch, in my reading, was a story guy, meaning someone who related to narratives that began with ideas rather than events. He seemed to have an instinct for distinguishing between concepts that made sense and were scalable and those that didn't or weren't. Then he would look at the numbers to back up or undercut his case.

For all the crap David Gardner takes from more traditional thinkers, I think it's pretty hard to dispute that he has some kind of instinct for what comes next, especially in internet, gaming and entertainment, that could almost be described as visionary. This is not an acquirable skill, I don't think. When you look at how early he was on so many of the big names of the past twenty years, from AOL back in the day to Amazon, Marvel, Priceline, Netflix, Intuitive Surgical, and the list goes on, it's pretty much a roster of the big Lynchian multibaggers of the past generation. Most of us would have said, many of us did say, many of us still say most of them are too expensive and were too expensive all along, but in retrospect, knowing what happened, many of us would go back and buy them anyway.

Now, it needs to be pointed out that David Gardner gets to make an awful lot of picks to find those few rockets. He doesn't run a portfolio, he just churns out new names every month. This is no way to run an individual portfolio, so it's an unfair model to hold out there, particularly for novice investors who subscribe for the first time to one of his letters. But that's another subject.

The question you're asking is whether it's possible to bridge this gap -- see things through a growth investor's eyes if you're naturally a value investor, and vice-versa. I think Lynch came pretty close with his "Growth At a Reasonable Price" (GARP) formulation. I think it's possible to evaluate growth stocks with traditional value metrics in order to determine whether you're getting a decent entry price, but the valuations are almost always higher than a true value investor would consider. By the same token, the application of valuation metrics is considered missing the point by the growth investor.

Applying valuation metrics to successful growth stocks, especially popular momentum stocks, can produce two very different results.

One is you get out too soon. It was OK at earnings multiples in the 30s, but when it gets to the 60s, the instinct is very strong to take profits before the bubble bursts. I did well with Baidu and Chipotle, multi-baggers both, but I left money on the table getting out of both. On the bright side, I was able to sleep.

The other possible result is that some exaggerated sense of value inexplicably comes into play and you are rewarded for your rationality, as if reason herself took pity. I bought Rackspace Hosting at some ridiculous multiple and sold it not long after at a more ridiculous multiple. I interrupted a bullish thread on the RAX board behind the wall 11 months ago to argue that 80 times trailing earnings was too much to pay and, in fact, a pretty good place to sell. Which is what I did with my shares at about $54, for a modest profit. RAX continued to roar up to almost $80 and triple-digit multiples, which made me feel pretty stupid. Then, in the space of about three months, it collapsed from $75 to $35. It's about $44 today, which still represents an earnings multiple of almost 60.

So I don't know if it's possible to truly have a foot in each camp, but I sort of try. I outsource the intrepid numbers work that doesn't come naturally to me to smarter people like Buffett, Einhorn, Gayner, Tisch, Flatt, Berkowitz, etc. Then I take shots on a few stocks based mostly on what I think of as value, even if I'm sometimes applying it to growth names.

Bottom line, I think your brain wiring makes the decision for you. You are unlikely to devote significant capital to an idea you can't wrap your brain around. Still, I'd love to see you take a deep dive into the numbers of an out-of-fashion growth name sometime -- say, Intuitive Surgical right now, going into an earnings announcement it has preannounced will be disappointing -- and see if you find value there. 

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