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. 2 Brown Brothers Harriman Quarterly Investment Journal InvestorView 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.

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