The word “growth” is a complex one in the investing world, meaning both a style of investing—in contrast to value investing—and a characteristic of stock behavior. In “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment,” author Sven Carlin took a look at the function of growth in the value investing world.
Tool 8: Growth as a component of value
To begin, Carlin discussed value and growth investing as styles; as he noted, academic researchers believe value stocks outperform growth stocks in 10-year returns. He also pointed out this research involves the broad market, while intelligent investors can make more sophisticated assessments when analyzing individual stocks.
The big institutions that make up Wall Street fail to correctly assess the relationship between value and growth, arguing growth stocks are priced higher, have higher earnings growth and are more volatile. But, according to the author, the opposite is true. And further, “The differentiation comes from lack of sophistication as there shouldn’t really be a difference between growth and value because growth is a key component of value.”
For backing, he turned to Warren Buffett (Trades, Portfolio)’s 2000 letter to shareholders: “Market commentators and investment managers who glibly refer to 'growth' and 'value' styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component – usually a plus, sometimes a minus – in the value equation.”
The moral of the story is that the “modern value investor” should see growth as a key component of value, and thus include it when calculating intrinsic value. At the same time, investors should be aware growth can destroy value as well as enhance it.
What is the difference between creating and destroying value? Carlin notes, “Growth that destroys value burns cash and is not profitable while growth that creates value simply continuously replicates a business model that works with healthy returns on capital.”
For an example of growth that creates value, he used Starbucks (SBUX, Financial) between 2010 and 2017. In that period, it more than doubled revenues and tripled earnings. That outperformance was possible because Starbucks had opened new stores, increased its margins and bought back its shares—leading to an annual return on invested capital of about 25% per year.
On the other hand, Blue Apron (APRN, Financial) grew its revenues 10-fold from 2014 through 2017—but its negative cash flow also increased 10-fold—thus destroying value. This GuruFocus chart illustrates the problem:
Blue Apron is a meal-delivery service; its subscribers receive original recipes and delivery of ingredients, along with cooking instructions. In 2016, Consumer Reports gave it a rating of very good, but the news was not good on the financial front, as shown in this table:
How, then, can investors adjust their calculations to incorporate the contribution, positive or negative, of growth? To begin, they need to estimate future growth rates. But estimating future growth rates is difficult since the future is unknown. As a result, Carlin recommended a conservative approach.
In the case of Starbucks, he noted Starbucks’ management reduced its long-term, expected growth rate in July 2017 to 12% from a previous range of 15% to 20%. Taking a conservative approach, the author suggested there is a far greater likelihood the company will generate 5% per year than 12% per year over the coming decade. A conservative approach also means a better margin of safety. There is also the potential bonus, 10 years out, of seeing returns that far exceeded the conservative promises when the stock was purchased.
Still, Carlin argued for caution, saying investors must check cash flows to determine whether value is being created or being destroyed. Obviously, investors should shy away from situations where there is a possibility value will be destroyed by growth. If the stock passes this hurdle, then investors should next check margins; they will likely increase with greater scale, and vice-versa.
Investors should also research risks that might affect continued business expansion, including issues such as market share, higher input costs and so on. To this list, I would add the strength of the moat, since strong moats (competitive advantages) protect pricing power and margins.
Finally, Carlin expected that the best value investments were those that offer growth at a reasonable price. While book values may show little promise, companies with strong growth rates, below-market valuations and steady business models should deliver strong returns in the long term. As the author put it, “At the end it all boils down to comparing intrinsic values with conservative estimations for both value and growth.”
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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