Why investors should prioritise growth over value

This debate has raged for years and is now very topical again given the not unreasonable view that growth shares look expensive when compared with their profits and cash flows.

The last decade has seen a huge outperformance of the shares of companies that are seen as dependable growers. Despite the high prices of them,  there are good reasons for thinking that this may well continue for some time to come.

The appeal of value investing

The term “value investing” is something of a misnomer. Ask any investor who is buying a share and you won’t find one that says that they don’t think the share price is going higher. How you try and achieve that result may be different.

What most people understand by value investing is the purchase of shares that look statistically cheap when comparing their share price to things such as profits, assets or dividends. The approach was introduced to the wider investing  community by Benjamin Graham in the 1930s with his book Security Analysis and to the general public in the 1950s with the investment classic, The Intelligent Investor. 

Since then, famous professional investors such as David Dreman, John Neff and Seth Klarman have written books extolling the virtues of buying cheap stocks. Warren Buffett, a student and former employee of Graham made a lot of money with this approach in the 1950s and 1960s before changing his investment approach. 

One of the main attractions of value investing has been its emphasis on minimising the risk of losing money which appeals to those who don’t like taking risks. 

The simple argument goes that the price of a value share is so low that the worst-case scenario is already priced in. A small improvement in expectations of future profits can see big share price gains. Mohnish Pabrai, a modern day value investor sums this situation up nicely when he describes it as like tossing a coin with two outcomes of “heads I win and tails I don’t lose much”. 

Value investors argue that growth stocks are too expensive – by this they mean that the expectations of future growth are too high – and that if future profits disappoint the risk of losing money is too risky.

Yet blindly buying cheap stocks has proven to be a poor strategy in recent years. This is because many cheap shares have become cheap for a reason. They are often associated with struggling businesses with uncertain futures. Looking at this another way, you could argue that the price of the share has to become very cheap in order to compensate the investor for the risks that they are taking on.

The UK stock market is full of very cheap looking shares. The most obvious candidates are in areas such as leisure and travel related businesses. These could prove rewarding for the patient investor but it is possible that their previous customers’ spending habits have changed for good as a result of the economic lockdowns seen across the world and that past profits are a poor guide to what a business is capable of earning in the future. If the profits are likely to be much lower than before then the shares could still be too expensive and represent a classic value trap.

For example, Marks and Spencer (MKS) shares may look very cheap relative to its profits and cash flows but what is the future of its business? Its free cash flow per share has halved over the last decade and its share price has fallen by more than two thirds.

Its high street locations now look horribly exposed to a world where more people work from home more often. Its food business may eek out some growth, but it’s likely that its clothing and homewares business will continue to shrink as the competitive position of them continues to weaken. 

For value investing to pay off there usually needs to be some kind of catalyst to realise value. This might take the form of a turnaround plan, a takeover or breaking up the business by selling off some parts of it. Without a catalyst, shares often remain cheap or get cheaper.

The other problem with value investing is what happens after the value has been realised or the value recovers. Where are the future gains to the investor going to come from? Often there isn’t any and the investor has to find another share to reinvest in.in  A growing business on the other hand can keep on appreciating in value.

Why growth can deliver much better long-term results

While Benjamin Graham is famous for value investing he actually made more money from a growth stock – the insurance company GEICO - than pretty much all his value investments combined.

The sustainable growth in profits and cash flow over a long period of time increases the intrinsic value of a company (assuming interest rates don’t go up a lot at the same time) which can be boosted by reinvesting and compounding the growth. It is this effect which can deliver very strong returns for investors providing they do not pay too much for them.

By identifying companies with products and services that have the capability to grow over the long term it is possible to do very well from owning their shares. Growth does not have to be stellar either. Companies that are capable of delivering modest but reasonably predictable growth have proven to be excellent investment since the global financial crisis. 

Companies in areas such as consumer staples with modest growth have been seen as low risk “bond proxies” where the returns to investors are higher than bonds to start with but with some growth on top. Investors have been prepared to pay very high prices for these shares which offer peace of mind and steady growth with hopefully a low outcome of a bad result.

Paying up for growth has paid off

Many value investors refuse to pay up for growth. This has backfired on them in a big way as they have waited years for their portfolio of cheap shares to become more expensive whilst those with steady growth have reaped the benefits of paying higher valuations.

Some UK Quality Growth Stocks over the past decade

Source: SharePad

Hindsight is a wonderful thing but looking at the valuation of companies that are seen as quality growth stocks a decade ago shows that anyone looking at them in today’s world of low interest rates would realise many were actually quite cheap. 

A 10-year government bond offered a yield to maturity of 3.1 per cent back then with starting free cash flow yields comfortably higher than that. Growth in free cash flow per share  and a fall in gilt yields to just 0.2 per cent today has seen some very handsome returns. The FTSE All-Share index in comparison has delivered total returns of 70 per cent since then.

Share prices in many cases have increased a lot faster than the growth in free cash flow per share. This can be explained by the fall in gilt yields, but some investors now feel that these kind of shares are too expensive – their free cash flow yields are too low. The counter argument is that in a low interest rate world where very few people expect rates to increase, the premium over government bond yields is still decent. With more steady growth investors should make much more than owning bonds.

The experience of this in the US has been even stronger as there have been more quality growth stocks that have delivered stronger growth.

Some US Quality Growth Stocks over the past decade

Source: SharePad

The likes of Apple (US:AAPL) and Visa (US:V) have grown their free cash flow per share by more than 500 per cent over the past decade which has seen their share prices move up by more than 1,000 per cent. Free cash flow yields are now much lower but a 10-year US treasury offers a yield of just 0.7 per cent with no prospect of growth in cash flows. Apple and Visa are unlikely to deliver the same stellar returns to investors over the next decade but may still offer much better returns than other investments.

Business quality and growth is much more important than valuation

Over the past few years there has been a growing acceptance amongst investors that they can pay high valuations for high quality businesses and still do well. Some might say that this is because the shares of such companies have become overvalued and a bubble has developed. Not so long ago this would have been my view, but I’m less convinced now. 

There is merit in this view but it can also be argued that businesses with very strong competitive positioning that can do things that few competitors can while continuing to grow are less risky than weaker businesses. These shares therefore deserve to trade on high valuations.

Where I do agree with more cautious investors is that the room for disappointment in these highly valued companies is now very slim. If future profits disappoint then investors could get badly burned.

How investors should play the growth theme

One way is to look for companies posting big increases in profits and preferably where these increases are better than investors expected. This is the classic characteristic of a momentum share where once profits growth starts to accelerate they keep on doing so for a while. This tends to bring investors and traders flocking to the shares and can lead to big increases in the share price while the good times last.

It can also be a very risky approach as you have to be very confident that you can sell out at a higher price. If the good news suddenly dries up then the share price can fall a long way.

The key message here is the need for growth. Without it and the expectation of more to come you will not tend to get the big gains.

Games Workshop (GAW) could end up being a very good long-term investment if we look back in 10 years’ time. There’s no doubt that it has been an excellent short- and medium-term one as well. The chief reason for this is that it has been growing strongly and consistently more than people have expected. Five years’ ago it was making just £16m in operating profit. During the last year it has made £108m. Despite a blip during the March 2020 lockdown chaos, it has been a stunning performer.

When you get a company in a situation like this valuation considerations tend to go out the window as momentum traders pile into the shares. Valuations can and do look very high, but you can still make money if profits continue to grow faster than expected.

The problem with momentum investing is it tends to end. Few companies can keep shooting the lights out on profit growth for years and eventually growth slows. When this happens there are fewer new buyers for the shares out there and the share price can resemble Wile e Coyote going over a cliff.

Fevertree Drinks (FVR) is a great example of this in recent years. It had a portfolio of very fast growing mixer drinks – a key feature to look for with growth companies – that were a big hit with consumers. This led to a series of positive profit surprises and a rapidly rising share price and then the momentum stopped towards the end of 2018. The shares were left on a very high valuation without further profit forecasts to support it.

Longer-term investors need to take a different approach. As I wrote last week in this column, you must move away from obsessing about numbers and look for dynamic businesses that are doing something to profitably exploit a long-term growth trend that not many others are likely to exploit.

Researching these companies can be a time consuming business but also a rewarding one. I now look for companies that not only have good products and services, but above all else are totally committed to their customers and have deep levels of engagement with them. This has always been important, but ever more so in a world of technological change.

To reduce your risk then businesses with profitable growth are better than ones that are losing money and burning lots of cash. Companies such as Ocado (OCDO) in the UK and Tesla (US:TSLA) in the US have seen fantastic share price performance despite this, but I feel they are likely to be an exception rather than a rule.

Have growth investors become reckless speculators?

Finally we come to the last piece in the jigsaw. How much should investors pay for growth stocks? 

If you look at many fast growing companies on the UK market you will see that their valuations are high and free cash flow yields are low or non-existent. If you were buying these companies outright then you would be getting a very low starting rate of return on your investment and would need lots of growth to get it to a more respectable level.

UK Growth stocks and forecast free cash flow yields

Source: SharePad

This is a strong argument against these kinds of companies and you can be forgiven for thinking that the shares are almost seen as a buy at any price. This has led some to say that growth investors aren’t really investing at all – they are buying stories and speculating that they will pay off.

I think there is some truth in this, especially in some parts of the technology sector.

However it may be a view that will continue to be defied. Good businesses have a habit of delivering consistent growth and by doing so become more valuable over time. 

There will be periods of time when the share price – and valuation – gets ahead of business performance. That said, in a world of low interest rates, low economic growth and a scarcity of outstanding companies, growth stocks can continue to flourish – as long as the growth comes through.

With a value investment there is often no growth to drive the underlying value of the business higher which explains a lot as to why they have underperformed and why investors should also place a higher emphasis on growth rather than value. Could it be that some value investors are guilty of speculating in the shares of poor businesses?

The key valuation risk to growth stocks would be a return of inflation as the value of their future cash flows is based on the assumption of higher profits years in the future. High inflation can reduce the present value of these in a big way. If inflation does not return and growth shares can offer higher returns than bonds and higher returns than inflation then investors can grow the buying power of their money by owning them, which is what investing is all about.