Value Investing vs.

Growth
Investing
GMO: The Value vs. Growth Dilemma
Fundamental Analysis - Investment Decision
Process

Estimated Value <

Estimated Value >
Market
Market
Price……..Don’t
Price…….Buy
Buy
 Approaches to Fundamental Analysis

Bottom-up, stock valuation, stock

Top-down, three-step approach
picking approach

Difference between the two approaches is the perceived importance of economic and
industry influence on individual firms and stocks
Top-Down, Three-Step Approach
Decide how to allocate
investment funds among
Economic analysis countries, and within
countries to bonds, stocks,
and cash

Determine which industries

will prosper and which
Industry analysis industries will suffer on a
global basis and within
countries

Determine which companies

in the selected industries
Company analysis
will prosper and which
stocks are undervalued
4
 Economies and Markets

Security markets reflect what

A strong relationship exists
between the economy and
the stock market
is going on in an economy
because the value of an
investment is determined by
• its expected cash flows
• required rate of return
Stock prices reflect
expectations of earnings,
dividends, and interest rates

Stock market reacts to

Stock prices consistently turn
various leading indicator
before the economy does
series
 Knowing Economic Outlook
Economic growth
Capital market were
means higher sales No two business
impacted by business
and earnings for cycles are same
cycles
businesses

To know the stage of Cycle had peaks and Length and depth of
the cycle? troughs cycles can be irregular

Phase of cycle
• early, middle, and late
phase of expansion,
• Early and late phases of a
contraction
 Cyclical Indicator Categories
Leading Indicators Coincident Lagging Indicators
Indicators
Avg. weekly hours of Non agricultural Avg. duration of
production employees employment
• Reach peaks or troughs
workers
Leading before corresponding peaks
Initial claims for Personal income Trade inventories to sales
Indicators or troughs in aggregate unemployment less
economy activity insurances transfer payments

Manufacturer's new Industrial Changes in index of labor

orders production cost
per unit of output
Coinciden • Coincide with the peaks and Vendor performance Manufacturing and Average prime rate
t troughs in the business cycle trade sales changed by
banks
Indicators
New orders for non Commercial and industrial
defense capital loans
goods outstanding
Authorized new private Ratio of consumer
• Experience their peaks and
Lagging troughs after those of the
housing units installment
credit outstanding to
Indicators aggregate economy personal income
Yield curve slope Change in consumer price
index
for services
Stock prices
• Economic series that do not
Selected fall into one of the three
M2

Series main groups Index of consumer

expectations
 Knowing Economic Outlook
Economic Series Stock Market Fixed Income Market
GDP Positive Negative
(sales increases) (higher interest rates and
lower bond prices)
Inflation negative negative
Unemployment rate Lagging indicator
Has close linkage with inflation due to change in money supply
Industrial production Positive Negative
and capacity utilization (expected interest rate high)
Composite leading index Depends on in which phase the business cycle is
(CLI)
Interest rates Effect of interest on expected negative
cash flow makes the difference
Monetary and fiscal policy Indirect influences
 Industry and Business Cycle

Basic
Industries
Excel

Consumer
Consumer peak Staples Excel
Durables
Excel

Capital Goods
trough Excel
Financial Stocks
9
Excel
 Industry and Business Cycle

Increase in…merger, loan demand,

End of recession Financial services
housing construction, security offerings

Consumer durable,
Increase in consumer confidence,
Capital goods
Begin in recovery personal income, modernizing
renovating [Companies with high DOL
and DFL benefit]

Peak Increase in inflation Basic industry

Pharmacy, Food and

Spending declines, weak domestic beverages,
Recession
currency [defensive industry,
industry with more export]
 Behavior of Macroeconomic Variables
in Short Run and Long Run
Variable Short Run Effect Long Run Effect

Output growth Driven by demand side factors Driven by supply side factors

Unemployment rate Cyclically adjusted

Inflation Inflation momentum, price shocks, Depends on money supply growth

supply/demand balance rate vs. output growth rate

Demand and supply of funds vary Demand and supply of funds,

Interest rates much more in short run, Public sector demand for funds,

Move to offset inflation rates, too

much deviation in FOREX rate may
Exchange rates cause current account out of
balance
Short Run Influences of Key Macro
Variable

Change Influence
Increase in aggregate expenditure, or Raise employment and output, increase
Simulative fiscal policy inflation, raise interest rates, appreciate the
domestic currency

Simulative monetary policy Decrease interest rates, causes a

depreciation in domestic currency, raise
employment and output, increase inflation
Price shocks Increase inflation, raise interest rates, lower
output and employment
 Industry Life Cycle
Stage Features

Modest revenue growth

Projected profits are high
Current profits may be negative
Pioneering stage Venture capital is the major source of financing
High inventory turnover
Low liquidity
Large amount of debt

Few firms dominate industry

IPO tends to occur
Growth stage Profit margins increase dramatically
ROA tends to be relatively low
Debt is still high
 Industry Life Cycle

Stage Features

Revenue increases at 15 to 20 percent

ROA tends to increase
Mature growth
Debt ratio tends to decrease

Revenue and profit margin grow close to over all economy

Maturity and stabilization Debt ratio stabilizes at a lower rate
Last for a longer period

Emergence of substitute products

Decline Profit margin tends to diminish
Demand for product declines
17
 Industry Life Cycle

Stage Revenue Profit Margin Earnings

Pioneering stage low negative negative

Growth stage increase positive Increase dramatically

Mature growth Grows at steady rate increase Tremendous growth

Maturity and Remains constant Remain stable or Remain stable or

stabilization decline slightly decline slightly
Decline decline decline Decline at more rapid
pace

18
 Classification of Industries

Type of Industries Features

Earnings grow at very high rate
Independent of overall economic performance
Results of some major technical changes or innovations
Growth Industries
Historical example: television, drugs, computers,
Recent examples: cellular industries, mobile phone industry,
internet industries
Closely tied to economy
Industries producing goods that can be primarily postponed
Cyclical Industries
Example: general categories of consumer products and manufacturing
related products
Least impacted by economic downturn
Defensive
Example: food related goods and services, shelter-related goods and
Industries
services, consumer nondurable's, utilities, and financial services

19
Industry Classification
Concentrated
industries
Based
Based on
on nature
nature
of
of competition
competition
Fragmented
Fragmented
industries

Agriculture

Based on nature
Manufacturing
Manufacturing
of activity

Services

Industrial
Industrial and
and
commercial
buyers market
Based on market
Consumer buyers
market

Price level basis

Product
Product features
features
basis
basis
Based on product
Production
process basis
Based
Based on
on
distribution
channels
Different
Different supplier
supplier
basis
Based on
geographical…
Stages of Industry Analysis

Macro analysis Micro analysis

• Business cycle and industry • Valuing an industry
sectors
• Structural economic changes and
alternative industries
• Evaluating and industry’s cycle
• Analysis of the competitive
environment in an industry
Economic Variables and Industries
Inflation Interest Rates
• Inversely related to stock market • Banks benefit from volatile interest
• Industries benefit from high inflation rates
are..
• Natural resources industries
• Industries with very high DOL and
DFL

International Economics Consumer Sentiment

 Industry Life Cycle

Stages Sales Profit

Pioneering development Modest Very small or negative

Rapidly accelerating industry Grow at increasing rate Very high

growth (even more than 100%)

Mature industry growth No longer accelerates Begins to decline to

normal levels

Stabilization and market maturity Correlate with economic Slightly below competitive
(longest phase) series level

Deceleration of growth and decline Declines because very low Continue to squeezed
demand
 Company Analysis

Assessing a Financial ROE and

firm’s growth statement Dupont
and riskiness analysis analysis

Stock valuation Holding period

using the P/E return
method calculations
25
26
Investing in Grown Ups
 Value Investor

Investors interested
Invests in low PE
in buying stocks for Required
stocks is a value
less than what they Reputation
investor
are worth
 Following in the Benjamin
Graham tradition

You screen for stocks that have

characteristics that you
Passive Screeners
believe identify under valued
stocks

You are hoping to find market

mistakes through the screens

Value Investing Approaches

Invest in companies that
others have given up on,
either because they have done
Contrarian Investors
badly in the past or because
their future prospects look
bleak

Investing in poorly managed

and poorly run firms but then
Activist Value Investors
try to change the way the
companies are run
Value Investing Approaches – Passive
Screeners
You screen for stocks
Following in the that have
Benjamin Graham characteristics that you
tradition believe identify under
valued stocks

You are hoping to find

market mistakes
through the screens
 Value Investing Approaches – Contrarian
Investors

Invest in companies that

others have given up on,
either because they have Implicitly assuming that
done badly in the past or markets over reacting
because their future
prospects look bleak
Value Investing Approaches –Activist Value
Investors

Investing in poorly
managed and poorly
run firms but then try
to change the way the
companies are run
Father of Value Investing

Graham’s best claim to fame comes

from the success of the students
who took his classes at Columbia
Finding cheaper companies University. Among them were
Charlie Munger and Warren Buffeg.
However, none of them adhered to
his screens strictly.

Mark Hulbert who evaluates

A study by Oppen heimer concluded
that stocks that passed the Graham investment newsletters concluded
that newsletters that used screens
screens would have earned a return
similar to Graham’s did much beger
well in excess of the market
than other newsletters

However, attempt by James Reato

run an actual mutual fund using the
Graham screens failed to deliver the
promised returns
 Ben Graham’s Screens
1. PE of the stock has to be less than the inverse of the yield on AAA
Corporate Bonds
2. PE of the stock has to be less than 40% of the average PE over the last 5
years - Mean Reversion
3. Dividend Yield > Two-thirds of the AAA Corporate Bond Yield
4. Price < Two-thirds of Book Value – Ok for Manufacturing companies
5. Price < Two-thirds of Net Current Assets – Conservative Criteria
6. Debt-Equity Ratio (Book Value) has to be less than one
7. Current Assets > Twice Current Liabilities
8. Debt < Twice Net Current Assets
9. Historical Growth in EPS (over last 10 years) > 7%
10.No more than two years of negative earnings over the previous ten years
Warren Buffet

Supported by
Charles Manger

Had invested
insurance premium
money in stocks

Started as Textile
firm
Buffet Mystique
 Buffet’s Tenets – Business Tenets

The firm should have a

consistent operating The firm should be in a
history, manifested in business with favorable
operating earnings that long term prospects
are stable and predictable
Buffet’s Tenets – Management Tenets
As evidenced by the
The managers of the way he treated his own
company should be stockholders, Buffet
candid put a premium on
managers he trusted

The managers of the

company should be
leaders and not
followers
Buffet’s Tenets – Financial Tenets

The company should Buffet used a modified

have a high return on version of what he
equity called owner earnings

Owner Earnings = Net

The company should
income + Depreciation
have high and stable
& Amortization –
profit margins
Capital Expenditures
 Buffet’s Tenets – Market Tenets

In keeping with his view of Mr.

Market as capricious and
Use conservative estimates of
moody, even valuable
earnings and the riskless rate
companies can be bought at
as the discount rate
attractive prices when
investors turn away from them
 Four Widely Used Value Screens
Price to Book • Buy stocks where equity trades at less than book value
or at least a low multiple of the book value of equity
Ratios
Price Earnings • Buy stocks where equity trades at a low multiple of
equity earnings
Ratios
Revenue • Buy stocks that trade at low multiples of revenues
Multiples

Dividend Yields • Buy stocks with high dividend yields

 Screening Template
Screen for • You use a pricing multiple (PE, PBV, EV/EBITDA) to find cheap stocks

Cheapness
Screen for Low • You try to remove those stocks that look cheap but are risky, using your
preferred proxy for risk
• This proxy can be a price-based one (standard deviation, beta), an accounting
Risk measure (debt ratio) or a sector screen (no tech stocks...)

Screen for High • You also want to get companies that have, in not high growth, some growth in
them. So, you may put in a minimum growth requirement.
Growth
Screen for High • Finally, you also want to remove companies that reinvest badly (earning low
returns on investments)
Quality Growth
Determinants of Success at Passive Screening

Have a long time • All the studies quoted look at returns over time horizons of five years or greater
• In fact, low price-book value stocks have underperformed high price-book value
horizon stocks over shorter time periods

Choose your screens • Too many screens can undercut the search for excess returns since the screens
may end up eliminating just those stocks that create the positive excess returns
wisely

• The excess returns from these strategies often come from a few holdings in large
portfolio
Be diversified • Holding a small portfolio may expose you to extraordinary risk and not deliver
the same excess returns

Watch out for taxes

• Some of the screens may end up creating a portfolio of low-priced stocks, which,
and transactions in turn, create larger transactions costs
costs
 Determinants of Success at Contrarian
Investing
• Investing in companies that everybody else views as losers requires a self
Self Confidence confidence that comes either from past success, a huge ego or both

Clients/Investors • You either need clients who think like you do and agree with you, or clients
that have made enough money of you in the past that their greed
who believe in you overwhelms any trepidiation you might have in your portfolio

• These strategies require time to work out. For every three steps forward,
Patience you will often take two steps back

Stomach for Short • The nature of your investment implies that there will be high short term
volatility and high profile failures.
term Volatility
Watch out for • These strategies often lead to portfolios of low priced stocks held by few
institutional investors. The transactions costs can wipe out any perceived
transactions costs excess returns quickly
 Investing on Hope? Growth
Investing & Small Cap Investing
History of Apple Stock
Bonus and Split History

FY Face Value Split/Bonus Shares

1993 10   1 Stock Price = 98
1994 10 bonus 1:1 2
1997 10 bonus 1:1 4
1999 10 bonus 1:1 8
2000 5 stock split 2:1 16
2004 5 Bonus 3:1 64
2006 5 Bonus 1:1 128
2015 5 Bonus 1:1 256
2018 5 Bonus 1:1 512

Current Stock Price = 665

Total worth of one share bought in IPO = 512 x 665 = INR 3,40,480
Return = 3474%
 Growth Investor

An investor who buys The difference lies

An investor who buys In other words, both
growth companies mostly in where they
high price earnings ratio value and growth
where the value of think they can find these
stocks or high price to investors want to buy
growth potential is being bargains and what they
book ratio stocks under valued stocks
under estimated view as their strengths
 Growth Investing
Small Cap • The simplest form of growth investing is to buy smaller companies in
terms of market cap, expecting these companies to be both high
growth companies and also expecting the market to under estimate
Investor the value of growth in these companies

• Presumably, stocks that make initial public offerings tend to be

IPO Investor smaller, higher growth companies

Passive • Like the passive value screener, a growth screener can use screens -
low PE ratios relative to expected growth, earnings momentum - to
Screener pick stocks

Activist Growth • These investors take positions in young growth companies (even
before they go public) and play an active role not only in how these
Investor companies are managed but in how and when to take them public
Determinants of Success at Growth Investing

Pick your companies • Good venture capitalists seem to have the capacity to find the combination of ideas and
management that make success more likely
(and managers) well

• The rate of failure is high among private equity investments, making it critical that you
spread your bets
Diversify • The earlier the stage of financing – seed money, for example – the more important it is
that you diversify

Support and • Venture capitalists are also management consultants and strategic advisors to the firms
that they invest in
supplement • If they do this job well, they can help the managers of these firms convert ideas into
management commercial success

Protect your investment • As the firm grows and attracts new investment, you as the venture capitalist will have to
protect your share of the business from the demands of those who bring in fresh capital
as the firm grows

• Having a good exit strategy seems to be as critical as having a good entrance strategy
Know when to get out • Know how and when to get out of an investment is critical to protecting your returns
In Passive Investing, History has Picked a
Winner...
 Reconciling the Contradiction
• The companies that are scrutinized by growth investors, for the
most part, tend to be smaller and less followed than companies
Selection Bias followed by value investors
• Hence, there is a greater chance of finding mispricing

• Value companies are generally easier to value than growth

Valuation companies
• Thus, an investor who can bring valuation skills to the table can
Difficulty take more away from that table, with growth stocks than with
value stocks

Sector/Company • High growth firms are often in nascent sectors, where having a
Specific knowledge of the sector (biotechnology, social media etc.) can
provide an advantage to investors
Knowledge
The Pitfalls in Growth Investing

Scaling • As companies grow, they get bigger, but as they get bigger, it gets
more difficult to keep growing
• If you under estimate scaling problems, you will have trouble with
Factor your growth investments

Cost of • Growth, by itself, can be good, bad or neutral for value

• It depends on how much the company pays (in investments) to get

Growth that growth

• Since most investors in growth stocks have given upon on trying the
Momentum value those stocks, because of the uncertainty inherent in them, the
momentum game is likely to dominate how these stocks get priced

Game • That, in turn, may cause the pricing gap to increase over -me, rather
than decrease
Scaling Up is Hard to do
Thank you