INVESTING FOR VALUE AND GROWTH

Transcription

1 INVESTING FOR VALUE AND GROWTH CIO White Paper by David B. Pinkerton July Falcon Private Bank Ltd. Pelikanstrasse 7 P.O. Box 76 8 Zurich, Switzerland Phone + 7 Fax +

2 JULY INVESTING FOR VALUE AND GROWTH Successful long term investing requires patience, the ability to live with a contrarian point of view and having the discipline to avoid overpaying. In order to avoid emotional decision-making, it is crucial to have objective criteria for buying and selling stocks. There are generally two main approaches that are used for picking stocks - growth investing and value investing. As the name suggests, growth investing is about buying stocks with substantial future potential. Usually, growth companies show above average revenue growth or the perception of potential growth and hence, they typically trade on changing valuations based on changes in the perception of this future potential. In contrast, value investing focuses on stocks that are perceived to be temporarily priced lower than they are worth longer term because of some misunderstanding of their income statements or balance sheets. Buyers of value stocks tend to focus on companies that have existing cash flow or assets that, for some reason, are believed to be undervalued; whereas buyers of growth stocks tend to focus on companies that have future cash flow or assets that are perceived to be undervalued. Accordingly, great growth stock investors need telescopic vision to see this future potential of the company or its shares, whereas value investors need more microscopic vision to examine existing balance sheets and income statements to identify unrecognised value more effectively than the market. Depending on the market conditions, relative performance potential of growth versus value go in cycles, where one can be favoured over the other. This paper outlines the differences between both investment approaches, analyses which approach has outperformed the other in a historical context and draws some conclusions about the future and which style might have an advantage over the other. GROWTH INVESTING Growth oriented investors are focused on companies that are perceived to have substantial expansion potential. These companies are often relatively new or have new, meaningful products and are bought on such future optimism. Therefore, growth investors buy these shares even though the share prices might have high priceto-earnings (P/E) ratios, but they do so on the belief that earnings will eventually catch up to potential valuation excesses. In effect, successful growth stock investing is about seeing the potential before other people do and not over paying for it. Once such potential is fully appreciated, or reflecting overly optimistic expectations, growth investors sell the shares at inflated prices or they form long term positions in portfolios to capture the longer term fundamental tailwinds. As these companies devote large parts of their earnings toward further expansion, investors are usually not focused on their current dividend yields. Growth investing is considered a more aggressive form of investing and growth stocks can be more volatile than value stocks because perceptions on this future growth potential change frequently and in wide degrees. The risks with this style of investing are that it is tempting to become overly enthusiastic about upside and, in the process, get seduced by a sexy growth story and end up overpaying for that potential. Therefore, the risk of growth stock investing is that you could get in too late or be last in as opposed to first in. Growth stock valuations are broadly affected by interest rates and more so than value stocks, because their valuations are, in effect, the discounted net present value (NPV) of longer tail earnings streams. Therefore, a rise in interest rates lowers the P/E ratio on these stocks more aggressively. Growth stocks command a premium valuation in a low interest rate environment because of this NPV calculation, but also because when rates are low, economies are in a slower growth mode and investors pay a premium for growth earnings streams. In addition, it is believed that during periods of rising inflation, some growth companies have the ability to also raise their prices in tandem with inflation, so earnings can actually be expansionary. VALUE INVESTING Value investors search for stocks that are temporarily undervalued, due to a market misunderstanding of a perceived problem surrounding a stock, or simply because they believe it is unjustifiably discounted relative to its longer term value potential. This is similar to growth stock investing in that they are both looking for something that is presently undervalued relative to its future value. But the difference is that value investors focus on existing assets and cash flows more so than growth investors. They do not generally look for robust growth as a reason to buy a stock, but rather, they see simply undervalued but lower growing assets/revenues. Some reasons why value stocks can be discounted could be, for example, legal problems, balance sheet issues (write-offs), management transitions or business/revenue model transitions that might not be fully understood by the market. Value investors attempt to buy these stocks on these dips during these cloudy periods and hope that when the Falcon Private Bank Ltd. Pelikanstrasse 7 P.O. Box 76 8 Zurich, Switzerland Phone + 7 Fax +

3 JULY clouds have lifted and the opaque situation becomes more clear, the market will place a higher valuation on the shares. The risk of this approach, unlike in growth stock investing, is that you can get into a stock too early, meaning you buy before all the bad news is out or before all the other sellers have exited the position. In effect, buyers enters a stock during what they believes is a small rainstorm, but that rainstorm turns in to a hurricane and the shares get pummelled even more later on: Summary Characteristics of Growth and Value Investing GROWTH INVESTING Stocks with high future revenue growth potential Generally high P/E ratios Examples: tech companies or smaller and emerging companies Risks: overpaying - buying too late Source: Falcon Private Bank. VALUE INVESTING Stocks with stable/good cash flow per share Generally low P/E ratios Examples: consumer durable companies and other companies with recession resilient earnings (boring products) Risks: overpaying - buying too early Relative Performance Index 997= Period Period Period Period Period Growth Stocks Value Stocks Source: Bloomberg. Metrics: from Russell Growth Index (RLG) and Russell Value Index (RLV). Periodic Relative Performance of Growth and Value Stocks Period Period Period Period Period Dotcom Bubble Dotcom Crisis Housing Boom Lehman Crisis QE-Era Bull Bear Bull Bear Bull Performance Value Growth Value Growth Value Growth Value Growth Value Growth.% 8.8% -6.% -6.8%.% 8.8% -.% -.7%.8% 8.% Source: Bloomberg. Data as of July,. HISTORICAL PERSPECTIVE Each of these two investment approaches/styles regularly cycles in and out of favour, and one style can massively over- or underperform the other. Looking at historic bull and bear markets allows us to identify certain factors that might be explanatory of the reasons for this and therefore provide a basis for forward prediction. The next chart shows the relative performance of both growth and value stocks in the US over different time periods. For example from 997 to (period ), growth began to significantly outperform value, until the burst of the dotcom bubble in. Mostly because of the financials within this index, value stocks then massively outperformed growth stocks (period ). In effect, value stocks ran into bubble territory up until the financial crisis of 8. Then, during this crisis (period ), both indices corrected but the correction in value was much more severe than in growth stocks. What is interesting to us is that since the market bottom of 9, both value and growth have held a fairly tight race relative to one another with growth slightly outperforming value. We would ascribe this to the notion that the main driver of shares post 9 has been US quantitative easing (QE) that has acted as a tide that lifted all risk boats. Growth stocks have been driven by some new technology introductions (such as social media and biotech stocks) and the value side has been supported by improving conditions in financials and healthcare, which have been leaders in using low rates to finance share repurchases. The first observation from the table above is that the extent of appreciation/depreciation in a single bull/bear market is different for growth and value stocks most of the time. Bubble conditions or excess performance of one style is the cause of a subsequent correction and underperformance and the next bull market is usually led by the last bull market s laggards. The next chart is simply another way of looking at the relative performance of each style relative to one another. Relative Performance Relative Performance (%) % % % % % % -% -% -% -% -% -6% Value Stocks Outperformance Growth Stocks Outperformance Source: Bloomberg. Note: performance is calculated as -year rolling returns. Metrics: from Russell Growth and Value Indices. Falcon Private Bank Ltd. Pelikanstrasse 7 P.O. Box 76 8 Zurich, Switzerland Phone + 7 Fax +

4 JULY CURRENT VALUATION Another important factor to analyse regarding these two styles is to see if one style is massively over/undervalued relative to the other. As is always the case, valuations are expressed through a variety of metrics and it is important to look at them relative to time and averages (i.e. is growth overvalued based on its past history?) and also, to compare valuations of growth stocks versus value. (i.e. are growth stocks massively overvalued relative to value stocks?) The following charts show several financial metrics for valuations of both growth stocks and value stocks for four valuation metrics of the Russell Growth Index and the Russell Value Index. Historic P/E Ratio PE Ratio Growth Stocks Value Stocks Source: Bloomberg. As of July 6,. Metrics: from Russell Growth and Value Indices. Dividend Yield Dividend Yield Value Stocks Growth Stocks Source: Bloomberg. As of July 6,. Metrics from Russell Growth and Value Indices. Dividend yields have been stable since the Lehman collapse. As noted above, value stocks pay more of their earnings in dividends than growth stocks, which conserve capital for new product development (R&D) and other corporate purposes. Besides, shareholders of growth companies invest for capital appreciation longer term and probably would not reward a growth company that expanded its dividends. What is interesting about dividend yields is that they are stable (i.e. have not risen or are falling substantially) while interest rates have fallen pretty substantially over this time period. So the spread of dividend yields versus interest rates is relatively high today. Net Debt to EBITDA The P/E ratio of growth stocks is slightly above pre-lehman collapse levels, but still low compared to the levels of the dotcom bubble. The P/E ratio of value stocks is at average levels compared to its history and this also does not adjust the P/E ratio for the fact that over this history, interest rates were substantially higher than today. So one could argue that P/E ratios for both growth and value stocks could be justifiably higher than they are today. Enterprise Value to EBITDA Net Debt/EBITDA Value Stocks Growth Stocks EV/EBITDA Growth Stocks Value Stocks Source: Bloomberg. As of July 6,. Metrics from Russell Growth and Value Indices. A similar conclusion can be drawn when looking at enterprise value (EV) to EBITDA. However, the EV to EBITDA of value stocks has reached record levels. Source: Bloomberg. As of July 6,. Metrics from Russell Growth and Value Indices. The fourth chart illustrates the financial risk of US Corporates as measured by the net debt to EBITDA. One can see in the chart above that pre financial crisis, total leverage was approaching 6 times EBITDA. For value stocks and since 9, it has been coming down to where it is today, which is under times. Net debt to EBITDA usually is always lower in growth companies, because their absence of repeatable cash flow means that they rely on equity financing more so than debt financing. HISTORY FROM THE 96s NIFTY FIFTY ERA During the late 96s there was a group of stocks that became known as the Nifty Fifty. These were considered to be must have premier growth stocks, such as Coca Cola, Xerox and IBM, which Ratio of the price of a stock and the company s earnings per share. It is calculated as the last price divided by the trailing months earnings per share. Periodic enterprise value as a multiple of earnings before interest, taxes, depreciation and amortisation (EBITDA). Ratio calculated by dividing the dividend per share estimate based on the current fiscal year. This measure computes the company s ability to pay off its debt by utilising the EBITDA. Falcon Private Bank Ltd. Pelikanstrasse 7 P.O. Box 76 8 Zurich, Switzerland Phone + 7 Fax +

5 JULY were all rapidly growing due to market expansions and new product cycle growth. At the time, these stocks commanded exceptionally high P/E ratios. It was not considered unreasonable to pay to times earnings for these quality companies, while US equities on average, commanded a P/E ratio on average of 8 times. This was a period when growth materially outpaced value. Ultimately, both value and growth stocks got clobbered in the 97 bear market and really, all stocks traded sideways to a slight uptrend, as inflation got out of control in the late 97s, and we saw interest rates peaking at 8% in 98. The quest to contain inflation by the Federal Reserve Chairman, Paul Volker, in 98 marked the beginning of a year decline in rates and an explosive bull market of the 98s and 99s. CONCLUSIONS Growth and value investing are two distinct approaches, each having its own characteristics and drivers for success. Great value stock managers often do not make great growth stock managers and many times managers get labelled or categorised by their style. For this reason, it is advantageous to maintain an open architecture platform so as to allow access to the best managers in each style. Since the financial crisis there has not been a huge advantage of growth versus value, but it has been slightly advantageous to be overweight growth. Growth stocks tend to perform better in a rising interest rate environment or during periods of contained inflation. Once inflation is high and interest rates are rising or already high, the higher P/E ratios of growth stocks get crushed. This is what ended the Nifty Fifty bubble in 97. Total financial leverage in stocks, as reflected in the net debt to EBITDA ratio above is not historically high. The higher debt levels of 7 have been coming down up until the last few years and it is not at elevated levels. As a result, the re-leveraging of corporate balance sheets is continuing today, driven by relatively low borrowing costs for companies with strong cash flows (value stocks). Some stocks and companies are hybrids. This means that they have a value stock element and a growth stock element. Think of Apple, which has certain product franchises that generate very strong repeatable cash flows, and other elements, which make it a growth stock by virtue of some of its new product introductions. DISCLAIMER This CIO White Paper is published by the CIO Office of Falcon Private Bank Ltd., Zurich. This document has been prepared solely for information purposes and for the use of the recipient. It represents the personal opinion of the author, CIO David Pinkerton, as of the date cited and may change at any time and it does not necessarily represent the view of Falcon Private Bank Ltd. The distribution of this document as well as certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but we make no representations or warranties, expressed or implied, as to its completeness and accuracy. Opinions do not imply recommendation. Certain information may contain forecasts, prognosis and other future statements; they do not represent any actual result and are mainly based on theoretical assumptions, which are retroactively applied on historical financial information. Forecasts and estimates are current only as of the date of this publication and may change without notice. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Any transaction should be considered only if you are fully aware of the risks involved and are in a position to bear any financial losses. Before making any investment decisions, you should consult your own financial, legal, business, tax and other advisors. The development of the values mentioned in this document originates in the past. Past performance is no guarantee for future performance. The information used in this document has been provided as a general market commentary only and does not constitute an offer of or an invitation to any person to buy or sell any product, or make any kind of investment. CIO Office Falcon Private Bank. All rights reserved. Falcon Private Bank Ltd. Pelikanstrasse 7 P.O. Box 76 8 Zurich, Switzerland Phone + 7 Fax +