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Robert Abbott
Robert Abbott
Articles (775)  | Author's Website |

Book of Value: Adding Growth to a Defensive Portfolio

Proceed carefully, whether you opt for safe growth or risky growth

In recent chapters of “Book of Value: The Fine Art of Investing Wisely,” Anurag Sharma has discussed the creation of portfolios, including core portfolios, based on defensive valuations. One component of defensive investments is that the prices paid must be less than intrinsic values, which provides a margin of safety.

But what if you want to add growth stocks to your core portfolio, in hopes of landing higher returns? Sharma proposed two routes to this goal, what he called “safe growth” and “risky growth.”

Safe growth refers to the acquisition of undervalued growth stocks when the market temporarily misprices them. Risky growth involves investing in the turnaround of good companies or investing in companies that are leaders in new sectors.

Safe growth

Within the safe growth category, the author makes a further distinction between “value mispricing” and “panic mispricing.”

Value mispricing occurs when the market incorrectly prices a stock below its estimated intrinsic value. Whatever the degree of undervaluation by the market, there is an opportunity for growth. Sharma used the example of a stock trading at $20 while its intrinsic value is closer to $50. If the investment thesis for the stock can’t be disconfirmed, then there is an opportunity for a relatively fast capital gain. Once the divergence between price and value has been eliminated, the growth potential will be trimmed back to the level of operational growth.

The second type of value mispricing occurs when companies with a history of steady growth are hit with bad news, driving down their stock prices temporarily. I would think of Wells Fargo (NYSE:WFC) as an example. The mispricing began in September 2016 and since has been hit with several other bad news stories that led many investors to flee and drag down the stock price. Yet, by all accounts, it is and has been an otherwise sterling financial institution. Warren Buffett (Trades, Portfolio) and Berkshire Hathaway (BRK.A)(BRK.B) still appear to have confidence in it; Wells Fargo was the fifth largest holding in the Berkshire portfolio, worth more than $17 billion, at the end of the first quarter of 2020.

Let’s go back for a moment to the example above, a stock trading at $20 but worth about $50. If it has a historical growth rate of 12% per year, then that company could be worth $100 in just six years. Implied here is the rule of 72 (72 divided by x% interest rate); in this case, it would be 72/12% = six years to double, and two times $50 = $100. Annual average growth of 12% would give a strong boost to any portfolio. However, investors can’t count on that growth rate to continue in the future and would need to go through the disconfirmation process regularly.

Panic mispricing refers to the reduced prices that pull down good companies when the whole market takes a tumble. At this point, in early April 2020, we can look back at about six weeks of panicked selling across the board and find many bargains, at least compared to what was available just a couple of months ago.

Again, this provides an opportunity to buy at attractive prices. Sharma reminded his readers that intrinsic value is driven by long-term prospects, and especially by the expectations about future cash flows. If companies continue to have strong fundamentals, then their valuation should remain stable, even while their stock prices are taken for a ride. For value investors, these are times of opportunity, as long as investors remember “A defensive orientation and the disconfirmation approach remain indispensable.”

Risky growth

What if a once strong company got into trouble and its fundamentals began to erode? At the same time, what if there was a possibility the company could right itself again? Turnarounds are where investors make difficult choices about risky growth.

Investors have many such opportunities. Some of them were successful turnarounds, including Apple (NASDAQ:AAPL) and Netflix (NASDAQ:NFLX). Among those who didn’t make it were Blockbuster and the American Italian Pasta Company, to name just a few among the many.

Among the factors that affect a company’s return to success or plunge into bankruptcy are strong brands and market positions. Apple’s turnaround was a good example. Sharma also observed that cautious investors should look only for companies that are embedded in stable or growing markets. They also should have a strong competitive position, even if it has been weakened by recent events.

Management is a key factor in turnarounds. Such remediation may be needed because existing or previous management has failed to execute well on company plans. Or perhaps the plans themselves were not adequate. The author also pointed out that turning around big companies is not a simple task, because of their complex operating structures and “byzantine” politics. Strong leadership is essential, and investors thinking of buying stock should have strong quantitative analytical skills in this regard.

The second area of risky growth comes by way of new companies emerging in new niches or industries. Think of the early days of Walmart (NYSE:WMT) and Home Depot (NYSE:HD). Indeed, every single company in the S&P 500 was once a small company. Of course, for every success, there are many, many others that failed, at the expense of their investors.

Investors often get burned in this area because they are focused on the stock price and not the business economics. They can also lose money when they get caught up in unrealistic expectations about future growth and earnings. That was quite common in the dotcom and financial crashes.

“In short, growth investing relies greatly on qualitative analysis, on judgments about the sources of value creation and the quality of the leadership in charge of executing a well-articulated strategy,” Sharma wrote. In other words, leave the turnarounds and other risky growth strategies to the well-qualified.

Conclusion

Even investors with defensive, valuation-based core portfolios may wish to add some yeast from time to time. That can be done with the judicious application of growth strategies.

In “Book of Value: The Fine Art of Investing Wisely,” Anurag Sharma divides growth opportunities into two groups, safe growth and risky growth. In the safe-growth category there are mispricings of either individual stocks or of the market as a whole. On the risky side there are corporate turnarounds and new companies emerging in new industries or sectors. Regardless of the group chosen, investors must exercise diligence and care.

Disclaimer: This review is based on the book, “Book of Value: The Fine Art of Investing Wisely”, by Anurag Sharma, and published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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