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Investing

February 22, 2012

Growth versus value investing

A new book about Benjamin Graham suggests we rethink the value versus growth investing debate. Not a bad idea in today’s volatile markets.

Let’s say you have $1,000 to invest, and you’ve decided you want to make a bet on one company. Two retailers have caught your attention. Company A is an established market leader with 30 years of success under its belt, and it continues to earn strong revenues. Not surprisingly, it’s trading at a premium relative to its competitors because investors want to own a piece of its success. Company B has been in the business almost as long. Until two years ago, it was among Company A’s strongest competitors. But then an aggressive expansion plan failed and the stock price took a hit. Company B’s share price has been trading at a discount relative to its competitors ever since. Management is telling investors they have a new strategy, but analysts are quick to point out how difficult it can be to grow a retail chain.

Which investment looks better to you? Obviously I haven’t given you enough information to do a proper analysis, but the two scenarios do illustrate the difference between what’s described as a growth stock (company A) and a value stock (company B).

A growth stock is a company that is growing quickly and/or consistently. It’s been doing well. It is expected to continue to do well. And its share price is expected to rise as a result of that success. That last point is important, because not all successful companies see their share price rise steadily.

Remember that the price of a company’s stock is not just a result of what the firm has done to date; it reflects what investors believe the company will earn in the future. So the challenge for growth investors is to estimate future rates of growth, understanding that past performance is not indicative. In fact, an investment is a bet that the company will not just continue to grow, but grow more than investors expect it to.

A value stock is one that is thought to be underpriced relative to its actual potential value. In our scenario, company B has been oversold as a result of the failed expansion two years ago. It has a bad reputation among investors relative to other companies in its industry right now, and so they’re being overly pessimistic about the company’s ability to produce earnings in the future.

Value investors seek companies trading at a 33% or better discount relative to what they believe the stock is worth. In other words, they’re cheap. The trick of course is not only to find these investments, but to identify those cheap stocks that are going to rise in price as other investors come to realize there is greater value there.

All of this means research. When done properly, that means poring over the company’s financial statements, reviewing its management team, looking at its competitive position and that of other companies in its industry. It means looking at the state of the industry itself and of the region or regions in which the company does business.

Benjamin Graham wrote the book on security analysis. Literally. At least he co-wrote it, with David Dodd. Security Analysis, first published in 1934 – along with The Intelligent Investor, originally published in 1949 – helped earn Graham the nickname Dean of Wall Street. Warren Buffett, whom Graham famously mentored, called The Intelligent Investor “the best book about investing ever written.”

The books contributed significantly to Graham’s reputation as the father of value investing, an approach he developed with Dodd in the years leading up to the release of Security Analysis. He contributed a great deal more though, as Benjamin Graham and the Power of Growth Stocks argues. Published last fall, author Frederick Martin makes an argument that he himself recognizes is “almost heretical.” While the man never fully endorsed growth investing – at least not at the expense of his value philosophy – Graham did come to see merit on the growth side. In making his argument, Martin challenges the reader to rethink the traditional growth versus value debate.

It’s a technical, yet practical book. Perhaps its greatest contribution is that it republishes a lost chapter from the 1962 edition of Security Analysis that Graham wrote called Newer Methods for Valuing Growth Stocks. The book as a whole has been well received though, in part because the writing is understandable and engaging.

It’s also a useful reminder, in today’s volatile capital markets, of the importance of good old fashioned research.

 

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