This post contains my personal notes from the book: Benjamin Graham and The Power of Growth Stocks by Frederick K Martin.
VALUE VERSUS GROWTH
The philosophy of investment in growth stocks parallels in part and in part contravenes the margin-of-safety principle. The growth-stock buyer relies on an expected earning power that is greater than the average shown in the past. Thus he may be said to substitute these expected earnings for the past record in calculating his margin of safety. In investment theory there is no reason why carefully estimated future earnings should be a less reliable guide than the bare record of the past; in fact, security analysis is coming more and more to prefer a competently executed evaluation of the future. Thus the growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment— provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid. – Benjamin Graham in “The Intelligent Investor”.
The debate between value investing and growth investing has been there for a long time, but the most successful investors consider the difference between the two as redundant and unnecessary. Consider these statements by the world’s greatest investors:
All intelligent investing is value investing – to acquire more than you are paying for. You must value the business in order to value the stock.- Charlie Munger
But how, you will ask, does one decide what’s “attractive?” In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening). – Warren Buffett
- Growth company: A growth company is a company that grows faster than the average company over the long run and earns a satisfactory return on its investor’s capital.
- Value company: A value company is a mature company that is growing more slowly than the average company. It will include companies with no long-term growth whatsoever.
- Growth stock: Should be defined as the stock of a growth company. Often defined as a stock with P/E and P/B greater than market average( which is wrong).
- Value stock: Should be defined as the stock of a value company. Often defined as a stock with P/E and P/B less than market average( which is wrong).
SHOULD YOU INVEST IN VALUE OR GROWTH COMPANIES
Graham gives us the answer. He says:
It seems only logical that the intelligent investor should concentrate upon the selection of growth stocks….but the matter is actually more complicated. Obviously stocks of this kind are attractive to buy and own, provided the price paid is not excessive.
SIMILARITIES AND DIFFERENCES BETWEEN GROWTH COMPANY AND VALUE COMPANY INVESTING
UNDERSTAND THE POWER OF COMPOUNDING
Look at the figure below:
Compounding works over time, not over the short run. Even seemingly small differences of 1% over 40-50 years can result in 40-50% difference in wealth.
Yes, this is true. But what is its practical application.
- Let us say you want to achieve 9% per year compounded over 50 years. This is your goal.
- To achieve this what target return should you aim for so that you have a reasonable chance of achieving your goal?
To find this, you have to understand market history. Over 50 years one of these two events is definitely likely to occur:
- The first event is a one-year 50% decline in market value.
- The second event is a 10 year period of no-return. That mean, over ten years , you will not make any money.
If any of these events occur, then the long-term return will decrease by 2%.
So, if your goal is x% per year over the long run, your target should be X+2%. This is before fees, expenses and trading costs. So you should choose a modest return and invest in good stocks and not trade often if you want to reach your goal.
CALCULATING YOUR INVESTMENT PERFORMANCE
The simple formula to calculate a return is:
Return %= Ending value-(beginning value+ net contributions-net withdrawal)/ Beginning value X 100
More detailed methods are dollar weighted return and time weighted return which you can learn through the links. The return you actually get is from the formula above. Sharpe ratios and the like are misleading for the long-term investor and should be generally avoided.
WHY ARE GROWTH STOCKS BETTER THAN VALUE STOCKS
With value stocks, there is no growth in the company. The dividends you get, if they are reinvested in the same company will give a lesser yield if the price goes up and the long-term return will go down. So you have to keep looking out for new opportunities.
With a growth stock, there is no reinvestment risk. And the chance of dividend growth is also higher, which increases your return. And you do not need to trade often. You will profit because the intrinsic value of the company will continue to grow with time. And if you can find a number of these good companies, then you just need to buy and hold them for ever.
So, buying growth stocks is better because:
- You need to make fewer decisions and fewer trades.
- Time is your friend. You just need to stick with it for the long run.
- Sometimes, a single big idea may make your day. This is possible only with growth stocks and not with value stocks.
- You have a better chance of earning double-digit annual returns.
GRAHAM’S VALUATION FORMULA
Graham formula: 8.5 + ( 2 x growth) x earnings per share = intrinsic company value per share
- No-growth company: P/E=8.5
- Average growth company(5%): P/E=17.5
- Fast growth company(10%): P/E=28.5
Other formulas are:
- PEG ratio: Intrinsic value = growth rate x earnings per share
- DCF approach: Intrinsic value = EPS year 1/Hurdle rate-Growth rate
Graham’s formula does not take into account two things:
1. Positive effects of nonoperating assets or negative effects of nonoperating liabilities
2. Does not take into account interest rates
Graham proposed a new formula that took into account interest rates:
Intrinsic value per share = EPS x (8.5 +2g) x 4.4/y where g=growth rate and y= yield on AAA corporate bonds.
- If interest rates=6.6%= P/E decreases by 1/3
- If interest rated=8.8%=P/E decreases by 1/2
You cannot take into account recent interest rates. You have to forecast interest rates into the future. That is difficult. If you take recent interest rates, then in a rising interest rate environment you will overestimate value and in a decreasing interest rate environment you will underestimate value. So be aware of the interest rated but do not adjust P/E ratios downwards unless you think interest rates are going to be high for a long period of time.
Two important things to be aware of are:
- EPS= Normalised earnings per share, not current earnings per share
- Growth rate= Average annual growth rate expected over the next 7-10 years
To calculate normalised earnings you have to adjust for:
- Economic cycle: If recession, adjust upwards, if boom adjust downwards
- Industry cycle:If recession, adjust upwards, if boom adjust downwards
- Investment cycle: If heavy investment, adjust downward
This link can also help you to normalise earnings. You can also normalise earnings by using normalised revenues and normalised operating margins.
HOW TO VALUE GROWTH AND VALUE COMPANIES USING GRAHAM’S FORMULA
1. Value company: Calculate today’s intrinsic value and compare with current price.
2. Growth company: Calculate today’s intrinsic value. Calculate intrinsic value in 7 years time. Use growth rate of 7% or a P/E of 22.5 from year 7 for all companies. This means there are 4 steps:
- a. Determine the company’s normalised earnings per share.
- b. Forecast the company’s long-term earnings per share growth rate.
- c. Calculate normalised earnings per share seven years from now using (a) and (b).
- d. Calculate the future intrinsic value using Graham’s formula by using a 7% growth rate or P/E 22.5.
- e. If you have a range for the values you can calculate a range for the intrinsic value.
A GEM: CHAPTER 39 OF SECURITY ANALYSIS(1962 EDITION): NEWER METHODS OF VALUING GROWTH STOCKS
This a gem. You can read this here.
THE PURCHASE DECISION
Before purchasing a stock, you need to answer the following:
1. What is the company worth today( based on Graham’s formula)? = Intrinsic value today
2. What is the company worth in 7 years time( based on Graham’s formula)?=Intrinsic value in 7 years time
3. What is your hurdle rate?=Average compounded annual return that you hope to earn from your investments= Your actual goal to achieve your objectives + 2%. You have to keep this constant at all times and for all investments.
4. Whether you will achieve your hurdle rate if you buy the stock at the current market price?
Stocks are volatile because of the following reasons:
- Human nature and physiology: imperfectness, biases due to our own experiences, fear and greed, physiological chemicals( increased dopamine when stocks go up, mortal danger when stocks go down)
- Transaction driven brokers: retail brokers, investment bankers and analysts all of who work with a short-term focus which essentially is unpredictable.
- Individual company announcements-the quarterly announcements
- Changes in national economic policy
- Economic crises
All of this can give us a good opportunity to buy stock at a favourable price. Growth stocks are volatile, therefore they give us more opportunity to buy at a good price. It is always wise to invest gradually, and not buy everything at the same time.
BUILDING A MARGIN OF SAFETY
The keys to building a margin of safety for growth stocks are:
1. Know what you own: You have do a thorough research before you invest.
2. Develop reasonable estimates of true value: Most companies grow at nominal GDP rates(5-6% in US). Growth rates above 10% are rare and growth rates above 20% are extremely rare and transient. Therefore it is important to normalise the earnings and conservative estimate profit margins, revenues and earnings. Consider the range of probable outcomes. Remember that trees do not grow to the sky. Reduce the growth rates after seven years to 7% or less. Do not have a growth rate of more than 20% initially when calculating intrinsic value.
3. Set a reasonable hurdle rate: A hurdle rate of 12% is an ambitious one. But if you decide to keep it, stick with it through thick and thin. By using a hurdle rate, you can decide the maximum purchase price. Pay that fair price or less to buy the stock.
Research, reasonable projections and a reasonable fair price are the key to margin of safety.
IDENTIFYING A GREAT GROWTH COMPANY WITH SUSTAINABLE COMPETITIVE ADVANTAGE
The great growth company has the following features-
It has a defensible business model that helps it to consistently increase future cash flows and thereby the intrinsic value of the company.
It has sustainable competitive advantage. The key to a great company is whether it has a durable competitive advantage or not. This competitive advantage takes two forms:
1. Competitive barriers that keep potential competitors out of the market. These barriers are:
- Regulatory barriers: Direct( intellectual property laws, fees, licensing requirements and capitalisation requirements) or Indirect( subsidies, targeted tax breaks and government favouritism, such as protection from law suits). These include approval by government agencies( like FDA approval), by private standard bodies(like Dolby), patents, and subsidies.
- Asset barriers: Favourable access to hard assets, geographic location or proprietary intellectual property.
- Scale-based barriers: “Low-cost producer” position in the market, attained as a result of the efficiencies associated with increased size.
2. Handcuffs on customers that make them reluctant to switch to an alternative supplier. This is customer captivity. It takes three forms:
- Hard switching costs: More money needed to switch
- Soft switching costs: Intangible benefits of the product which prevents the customer from making the switch
- Network economics: Each incremental customer increases the overall value of the network.
Potential signs of competitive advantage are:
- High and stable market share
- Steady market share gains
- Low frequency of exit or entrance of industry competitors
- Persistent pricing power
- Materially higher operating margins than direct competitors
- Loyal customers and low customer churn
- High repeat purchases
- Brand transferability to new categories
- Strong consumer routine or habit
- Long product cycles
- Robust domain expertise
- Proprietary manufacturing or business processes
A sustained superior return on invested capital is a key sign of competitive advantage. It has been shown that high ROIC quintile of stocks outperforms the market and low ROIC stocks.
Dangerous competitive advantage myths are as follows:
- A hot new product
- A smart and charismatic CEO
- Efficient execution
Competitive advantage can be dissipated by:
- Structural changes in an industry
- Regulatory and political changes
- Disruptive technology
- Neglect or strategic distraction on the part of management
- No dedication to operational excellence
Sustained operational excellence is indicated by:
- Clarity of mission
- Relentless pursuit of perfection
- Freedom within a framework
- Coaching against the game
- Rigorous intellectual honesty
- Infectious passion
- Servant leaders
- Large addressable markets
Most big market opportunities are due to five broad forces:
- Broad shifts in lifestyle and social trends
- Government intervention
- Product innovation
- Disruptive technology
Growth can be bad when growth is costly, produced unattractive return on capital or improper diversification. Growth is never linear. It ebbs and flows. One cannot be precise about growth: one can only make a reasonable assessment of market opportunity and the potential for the company to gain market share.
The company should also benefit the shareholder and they should get to keep the value created. The company owners and managers should be good stewards, think long-term, align their interests with those of shareholders, have a reasonable incentive plan which does not take money away from the shareholder( reasonable base salaries, financial payouts linked to long-term performance metrics, no special prerequisites and incentives that encourage stock ownership). They should have good capital discipline( reinvest in core business, invest in other businesses only if it makes sense and prudently repurchase shares). They should return capital to shareholders via dividends if they cannot make better use of it. They should not use cash to buy sub-par businesses and should be transparent.
In summary, the key characteristics of the great growth company are:
- Defensible business model
- Sustainable competitive advantage
- Operational excellence
- Large addressable market
- Good Stewardship
PUTTING THE PRINCIPLES INTO ACTION
We need to remember:
- Investing successfully takes time and patience.
- There is no foolproof system for picking stocks.
- You don’t have to get it right every time to achieve success in the market.
- Do not hug the index.
- Do not trade too often.
- Do not trust anyone who calls himself a expert.
- Remember the three important concepts: Margin of safety, Mr. Market and The Power of Compounding
The whole investment strategy can be summarised as follows:
- Be mindful of the power of compound interest.
- Identify companies with a sustainable competitive advantage
- Use Graham’s formula to set a value for the company. Growth companies require estimation of the intrinsic value today and seven years out. Value companies require estimation of the intrinsic value only once, today.
- Set a hurdle rate of about 2% above your long-term desired return
- Build in a margin of safety. Do this by knowing what you own, developing reasonable forecasts and setting a reasonable hurdle rate. A 12% hurdle rate may be ideal for aggressive investors.
- Take advantage of Mr. Market to buy at fair/cheap prices
- Follow the strategy to build a position in a company over Time
- Invest for the long-term
- Overcome outside influences.