Value Vs. Growth: a False Dichotomy

INVESTING InvestorView Value vs. Growth: A False Dichotomy

he distinction between “value” and “growth” has long been one of the primary means for defining equity secu- Trities and investment strategies. Since gaining traction in the late 1980s and early 1990s, this categorization has become famous in both academic and commercial circles and exhibits Author amazing staying power. Despite the method’s simplicity and broad use, Brown Brothers Harriman (BBH) does not believe categorizing stocks in this way is helpful when building port- folios. In our opinion, the value/growth dichotomy attempts to draw precise boundaries between stocks and funds where, in reality, none exist. While traditional investing nomenclature Thomas Martin, CFA Senior Investment Analyst suggests that value and growth investors pursue two different outcomes, all fundamental investors would agree that their end goal is the same regardless of philosophy: to buy an asset for less than its intrinsic value. In this article, we therefore argue that the difference between “value” and “growth” has less to do with objective and more to do with means.

Brown Brothers Harriman Quarterly Investment Journal 1 The History and Use of Value vs. Growth To understand the use of value and growth in investing today, Despite the academic and commercial underpinnings of value and it is important to touch on the origin of the terms. We trace the growth, these terms would have nowhere near the recognition most common definition to three different roots. they do without managers choosing to benchmark themselves against these indices and the investment consulting industry mon- • First, in 1987, Russell created the first style indices, launching itoring managers based on their value vs. growth characteristics. the Russell 1000 Value and Growth Indices, against which For example, a simple Morningstar screen using the popular many self-proclaimed large-cap value and growth funds chose Russell family of style indices reveals there are 239 funds totaling to – and still do – benchmark themselves. $522 billion in assets that list the Russell 1000 Value Index as their primary benchmark. In total, over $1.2 trillion in fund assets • Second, in 1992, Morningstar produced its famous Style Box. benchmark themselves against a capitalization and style-specif- In addition to market cap, it used value, core (or blend) and ic benchmark. Unsurprisingly, the creation of the “value” and growth to categorize stocks and funds. “growth” terminology has resulted in what Wall Street does best: the manufacturing of product for product sake. Morningstar Style Box

FUND INVESTMENT STYLE Morningstar Fund Screener – Funds Benchmarked Against a Value Blend Growth Value/Growth Index (# funds / total fund assets) Value Growth Large Large Cap (Russell 1000 family) 239 / $522 billion 258 / $474 billion

Mid SIZE Small Cap (Russell 2000 family) 139 / $142 billion 126 / $104 billion

Data as of October 10, 2017.

Small

Interestingly, none of the equity strategies we invest in at BBH, either managed proprietarily or with an outside partner, uses a growth or value index to benchmark performance. This is not • Third, also in 1992, economist Eugene Fama (already re- a surprise, given that BBH and our partners are not believers in nowned for his work on the efficient market hypothesis for the value vs. growth investing framework. which he would later win a Nobel Prize) co-wrote a series of papers1 with Kenneth French introducing the value premium2 as an important factor in describing security returns. These The False Distinction results spawned a large amount of academic literature as to the As mentioned, we believe characterizing stocks and funds as either reason for “value” outperformance, all of which only further value or growth does not add meaningful insight into a manager’s served to elevate the value vs. growth phenomenon. However, risk or return profile, as it seeks to draw precise boundaries where the long-term return differential between these two groups none exist. At the most basic level, because all stocks can trade at (as defined by academics) has narrowed to the point where bargain prices relative to their intrinsic value, applying the term the conclusions from earlier studies are now under question. “value” only to stocks that are cheap on the basis of historical According to commonly used definitions, a value stock is one accounting earnings (which can be manipulated in a variety of that has a lower-than-average valuation as measured by various ways) or current balance sheets is not appropriate. Instead, in financial ratios, such as price-to-book or price-to-earnings (P/E).3 our opinion, all good investing is (or should be) value-oriented Growth stocks, on the other hand, are defined by their historical investing. That is, all businesses, whether fast- or slow-growing, and projected growth in revenues, earnings and/or cash flows – cyclical or highly predictable, should be purchased with reference which, as the name suggests, tend to be above average, resulting to the gap between current market price and a conservatively in premium multiples. Of particular note is that these figures calculated estimate of the business’s intrinsic value.4 Thus, when are calculated on the basis of accounting measures, and most we say we are value investors, we are not implying we only in- of the data is historical in nature. As we will discuss later, while vest in “value” stocks as defined by the index manufacturers. there may be some merit in distinguishing between extremely Instead, we are stating that we seek to buy assets at less than highly valued, fast-growing companies and deeply discounted they are intrinsically worth. In our opinion, anyone seeking to companies undergoing significant change or restructuring, most buy something for more than its worth in anticipation of profit- businesses are not adequately described by either of these profiles, ing from non-fundamental market sentiment is a speculator, not and forcing them into one of these boxes is inherently imperfect. an investor. These market participants can be found in the momentum and short-term trading tribes.

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Because a company’s intrinsic worth is determined by dis- • Being a dominant competitor in its industry that is becoming counting its future cash flow stream, a discount to intrinsic more relevant over time value framework (carried out by calculating either the NPV5 • Earning strong returns on the capital employed in the or IRR6) is the only way to assess whether there is currently business with a long runway for reinvestment any value available in a potential investment. Capturing this value by buying at a discount to intrinsic value (e.g., purchas- • Possessing a competitive advantage that allows it to consis- ing a 60-cent dollar) is a universal goal – but how and where tently reinvest capital at high rates of return (a moat) that value comes from can vary from manager to manager • Having a solid management team with strong capital allo- and stock to stock. For example, an undervalued “growth” cation skills company is often available at a discount because the market underestimates the duration or magnitude of future cash flow • Possessing loyal customers where the business has a degree growth and returns on capital, whereas an undervalued “value” of pricing power company may be discounted because the market overestimates the duration or magnitude of various secular or cyclical head- A company with a combination of these characteristics should winds, governance issues or other temporary challenges that be able to grow its intrinsic value over time in a more predictable are resulting in lower-than-average growth and returns on manner (that is, with a narrower range of outcomes) relative capital. It is crucial to note that “intrinsic value” investing to the average company. It is vital to stress the importance of applies equally in either case. In both, the investor is seeking this expected intrinsic value growth trajectory, as it represents to accurately project the future trajectory and duration of the the largest mitigant to any potential capital loss. The continu- cash flow stream and how that stream is valued relative to its ous compounding of business value usually offsets, over time, current price. This is one of the primary reasons the value vs. a potential mistake made on the initial valuation of a business growth framework fails in our mind – it is an all-quantita- (assuming the mistake was not massive). tive, backward-looking metric that only begins to scratch the surface of the relevant factors that might help meaningfully categorize investments.

Anecdotally speaking, many of our managers that ascribe to a value-oriented investment philosophy have successfully found value in companies that would screen as “growth.” Alphabet (Google), for example, has been held by our large-cap equity strategy Core Select for some time; while the company is included in “growth” indices, our equity team has found enduring value (as described by a gap between the stock price and intrinsic value) in this holding for many years.

The key factors in determining value go far beyond numbers. As Edward Chancellor says in Capital Returns, “Traditional valuation measures say nothing about the specific context of an investment – for instance, a company’s business model, its industry structure, and management’s ability to allocate capital – which determines future cash flows.”

The BBH Lens: Quality vs. Discount to Intrinsic Value If not value vs. growth, then what?

At BBH, we believe a better taxonomy is one that distinguishes investments based on quality and discount to intrinsic value. While one cannot always precisely define quality, as it is often more art than science, a high-quality company often hits on one or more of the following key themes:

Brown Brothers Harriman Quarterly Investment Journal 3 At BBH, we believe a better taxonomy is one that distinguishes investments based on quality and discount to intrinsic value.”

Quality is only half of the equation, however, as even high-qual- value but made up of cyclical companies with lower returns on ity investments become risky when overvalued. An investor capital, we would most likely allocate more capital to the first who buys a high-quality business at a price that is greater than relative to the second, all else equal. Obviously, there are other its intrinsic value could lose money in the event that the stock considerations, but this framework does play a large role in how price falls back toward its intrinsic value. Because there is always we assess opportunity sets. uncertainty about a business’s future prospects – and thus its intrinsic worth – buying at a discount to intrinsic value is the hallmark of value investing: It allows an investor a margin of Conclusion safety that lowers the chance of permanent capital impairment. As value-oriented investors ourselves, we believe investors can As Howard Marks said in a 1994 memo, “There is no security generate solid risk-adjusted returns from a combination of growth that is so good it can’t be overpriced, or so bad it can’t be under- and intrinsic value convergence (or the narrowing of the discount priced.” Even in the extreme example of a bankrupt company between share price and intrinsic value per share); thus, we pay liquidating itself, that too can still be a good investment if it little attention to the generic value and growth labels applied to is trading substantially below its intrinsic value, which in that many managers. case would be its liquidation value. Within our quality/discount to intrinsic value framework, “deep value”7 investing is simply Chancellor summarizes the value vs. growth debate well: “The a reflection of an investor’s tolerance for lower-quality, less ‘value/growth’ dichotomy is false – at least, to a true value predictable businesses and a larger appetite to generate returns investor, whose aim is not to buy stocks which are ‘cheap’ on through the upward movement of price to value rather than an accounting measures (P/E, price-to-book, etc.) and to avoid those upward movement of value (or quality) over time. which are expensive on the same basis, but rather to look for investments trading at low prices relative to the investor’s When evaluating a manager, BBH focuses on understanding his estimate of their intrinsic value.” We could not agree more.  or her views on business quality and intrinsic value framework – Holdings information should not be considered a recommendation to pur- in other words, how he or she defines “quality” and how much chase or sell a particular security, and there is no assurance, as of the date of valuation factors in to the investment process. Evaluating the publication, that the securities remain in a manager’s portfolio. combination of these two items allows us to get a sense for the 1 Source: Fama, Eugene F., and Kenneth R. French. “The Cross-Section of risk/reward profile of the strategy. In addition, with consistent Expected Stock Returns.” The Journal of Finance 47, no. 2 (June 1992). application of a discount to intrinsic value framework across 2 Value premium: the concept that value stocks outperform growth in the our strategies, coupled with a good understanding of the levels long run. of conservativism used in our managers’ projection assumptions 3 Other ratios and factors, such as dividend yield, also are considered. (terminal growth rates, cost of capital, time horizon, terminal multiples, etc.), we can compare the opportunity sets across all 4 These valuation methods do not apply to early-stage or non-revenue-gener- ating companies. of our strategies in a more insightful bottom-up process. 5 NPV: net present value.

Ultimately, this allows us to form an understanding of how the 6 IRR: internal rate of return. quality vs. value lens influences a manager’s portfolio construction 7 Deep value managers target out-of-favor companies often experiencing well- process, which in turn affects our own portfolio construction known issues, or business transformation, that trade at distressed prices. decisions. For example, if we were to compare a portfolio that is The market may overreact to weak near-term growth or return on capital prospects to such an extent that the shares trade off to a level where merely estimating an aggregate 25% discount to intrinsic value composed closing the price-to-intrinsic value gap results in an attractive return, even if the of predictable companies with high returns on capital to a port- company is not able to grow that value over time. folio that is estimating the same aggregate discount to intrinsic

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