“In our opinion, the two approaches (value and growth) 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?”      Warren Buffett Letters to investor, 1992.

Some investors say one should only invests in a stock if it shows increased profit from this quarter compared to the previous one, and they will continue to buy if the quarterly earnings continues to rise, and vice versa, the stock should be sold if the profit decreases for one or two quarters. Hence analysts and investors alike often watch the quarterly announcement closely and act according to the quarterly earnings report. In actual fact, with so many analysts and investors watching the market like hawks, often the share price has already reflected to certain earnings expectations, and unless earnings “beat the Street”, share price may not rise even if there is an improvement of earnings. There may even be some “whisper earnings estimates” which are not widely disseminated, are the ones already built into the price of the stock. However, for true value investors, they generally invest based on price versus value and the long term growth of the companies.

One of the nice features of the stock market is the range of choice investors have when making investment decisions such as the choice between growth stock and value stock. Many growth investors would swear that they would only invest in growth stock, and value investors in value stocks. But what are the differences between a growth stock and a value stock?

Generally, a growth stock is one that is expected to generate earnings at a rate that far exceeds their industry's average. Growth stocks will generally reinvest most of their profits back to their business with the hope that will further increase profits. Value stocks, in contrast, are stocks that appear to be underpriced by the market. This may include companies that have low price to earnings ratios, low price-to-book, low price-to-cash flows, high dividend yields etc., and stocks which prices are trading way below their intrinsic values. Investors believe such stocks are "bargains." Investing in these stocks involves identifying excellent companies with a history of stable earnings and cash flows, and high return on capitals. They also say this strategy is a better one.

So which investing strategy has been proven with a higher return? This has been a sensitive discussion. Nevertheless, I think it is an important discussion, isn’t it? Let’s get some facts, some solid facts, rather than just empty talk.

Back to History

Imagine your grandfather who had migrated to San Francisco to dig gold. He started to invest in the US market in 1950 with $2000, at the dawn of the computer age. He intended to leave all the money from that investment to you as a legacy in 2012. He was given two firms to choose from with the forecast of growth given by Paul the Octopus as shown in Table 1 below. The companies are IBM and Standard Oil of New Jersey (SONJ), or ExxonMobil now.

Source: Stocks for the Long Run, Jeremy Siegel

 As you can see, IBM beat SONJ in every aspect of compounded annual growth rate (CAGR) by wide margins. The CAGR of the computer sector was 16.1% versus the oil sector of a declining CAGR of 9.1%. Company wise, IBM’s CAGR in revenue, dividend and earnings were also substantially higher than that of SONJ.

For simplicity, assuming both firms had a revenue of $1m and EPS of $1 in 1950. IBM’s revenue and earnings per share (EPS) would grow to $683m and $683 respectively after 62 years; whereas SONJ only to $112m and $112 respectively. Both firms did very well, but the difference is huge with EPS of IBM grew at more than 6 times that of SONJ.

Which company you think your grandfather should invest in? The answer appears to be very clear but please pause and give it a thought first before you advance to the next section.

Your grandfather didn’t actually know what to do then. So to save him from cracking his head, he invested $1000 into each of these two stocks, and instructed the broker to reinvest all the dividends back to the respective stock as the market was very volatile then like now and he had “no eyes see”. In 2012, your grandfather went to the broking firm and withdrew all the money invested in the stocks. From IBM, the total annual return and total value of his investment was 11.2% and $722000 respectively, and surprise, the total return of his investment in SONJ was higher at 12.3% per year. The total amount of his investment in SONJ was $1.33m, about twice that of IBM. Why? Wasn’t the growth of earnings of IBM much higher than SONJ?

Table 2 summarized the comparison of the returns of the two companies and you can see though IBM’s share price appreciated more at CAGR of 9.6%, than that of SONJ at 7.6%. However, SONJ has a higher dividend yield at 4.7%, more than double that of IBM. The total return of SONJ at 12.3% is 101 basis points a year higher than that of IBM of 11.2%.

Source: Stocks for the Long Run, Jeremy Siegel

“The price you pay determine your rate of return”     Warren Buffett

The answer is: Valuation, the price you pay for the earnings and dividends you receive. Table 3 below shows the price you pay for IBM at an average PE ratio during the period at 25.1 is relatively too high when compared to the 14.1 of SONJ, and the dividend yield of SONJ is twice that of IBM. Individually, at the high growth in earnings of 11.1% for 62 years, IBM at a PE ratio of 25.1 was still not considered as expensive, as you can see its total compounded annual return at 11.2% was in line with the long-term return of the broad market.

Source: Stocks for the Long Run, Jeremy Siegel

So shouldn’t a stock with higher expected growth rate sell at a higher valuation? Of course it should, but that is only the first-level thinking. But one needs second-level thinking; that is how much higher should it be? This still brings us to the concept of value investing; that “The value of a firm is the sum of expected future cash flows generated by the firm discounted to the present value”.

In our case, IBM has fulfilled its consistent higher growth in the last 62 years and if investors had paid the same, or just slightly higher PE ratio as that of SONJ, the return from IBM would be substantially higher as we can induce from its considerable higher growth in earnings as shown in Table 1 above.

In IBM’s case, the high growth expectation actually materialized. But in most cases investing in stocks in the US, the problem is the “growth” we are talking about is the future expected growth, a consensus forecast figure given by analysts, which is very difficult to predict. The growth estimate, especially those with very high rates often does not last long enough to justify the high PE.  Even analysts got their forecasts wrong most of the time. So how good is your forecast of growth? And how is your forecast relates to the reasonable price of the stock you should pay?

What Empirical Studies Show

There have been numerous studies in the US on the subject of value versus growth investment strategies, covering different time periods and different stock universes.  The most common variables which were tested were price-to-book, price-to-earnings, and price-to-cash flow.  Other variables that were tested included price-to-sales, earnings growth rates, sales growth rates, and dividend yield.  Stocks with a low price relative to book value, earnings, cash flow, or sales were considered to be value stocks while those with high ratios and growth rates were considered to be growth stocks.  Stocks with high dividend yields were also considered to be value stocks.

The results of almost all studies were consistent.  When value portfolios were compared to growth portfolios, the value portfolios outperformed the growth portfolios.  The value portfolios were also compared to a benchmark index and outperformed the benchmark in all studies.  This held true for all of the variables in the various studies that were used to identify value stocks.  Several studies compared investment returns after different time periods.  The studies also show that the higher return of value stocks are not the result of taking higher risks. Outside of the US, Chan (1991) find significant value premiums for the Japanese market. In 1998, Fama and French (1998) document that value stocks outperform growth stocks in 12 out of 13 major markets in the world. They concluded that “the higher average returns on value stocks in United States are local manifestation of a global phenomenon”.

Return of some Growth stocks in Bursa

I have written about how to identify quality growth stock in the link below:

http://klse.i3investor.com/blogs/kcchongnz/70874.jsp

I have also mentioned about some high growth companies in this link here:

http://klse.i3investor.com/blogs/kcchongnz/63777.jsp

The return of those companies are tabulated in Table 1 in the Appendix. Guan Chong Berhad in about three years ago was a high flier. Its revenue grew from about 500m 5 years ago to 1.44b in 2012, or a CAGR of 24%. Its profit grew in tandem from 1.4 sen per share to 8.2 sen, or a CAGR of 56%. Its share price was about RM1.80 then.  Since then its share price has retreated to just 80 sen now. It growth faltered after 2011 and investors who paid a high price suffered a total loss of 56% now as the general market was about flat during the same period.

KNM’s share price performance is the same as that of the broad market during the last three years. However, we should not forget that its share price has dropped from an adjusted price of more than RM8 from 2008 to just 47 sen now. The same happened to London Biscuits, another stock with the high historical growth in revenue and profit.

Those companies which did not have past high growth record but with very high future expected growth like Smartag, Amedia and Hibiscus fared much worse in their share price performance with losses all above 50% the last three years. Why? Their high expected growth given by many professional analysts and the management were never materialized. In actual fact, all of them are even breeding with losses every year. Investors suffered a double whammy, paid a high price for a high forecast growth, and the expectation was never materialized.

What about the return of the value stocks in Bursa?

Returns of value stocks in Bursa

This I can only rely on the return of my longest portfolio started in January 2013 as published in i3investor in the link below and as shown in Table 2 in the Appendix.

http://klse.i3investor.com/servlets/pfs/13147.jsp

Table 2 in the Appendix shows the portfolio of 10 value stocks returned an average of 95% in the two and a half year period up to 17^th August 2015, after some recent steep corrections, as compared to the flat performance of the broad market in the same period. There are three three-digit return stocks in Pintaras (+166%), SKP Resources (+310%) and Prestariang (+352%). These stocks, with plenty of cash in their balance sheet, and zero debt, were selling at single digit PE and EV/Ebit at that time. There are only two losers, each with negative return of less than 20%.

In actual fact, Pintaras, SKP Resources and Prestariang ended up to qualify as growth stocks with their high growth in earnings, without me having to consider this during my initial stock selection. They are actually growth stocks but selling at cheap price, but with value as the prime consideration.

My experience on growth and value stocks in Bursa have shown some very clear results, that value investing trump growth investing by a wide margin. There is actually no comparison at all. Well, this is my own experience. Your experience may not be the same as mine.

What is/are the plausible reasons for the conclusions of these research?

Reversion to the Mean

Attempts to explain the persistent advantage of value stocks over growth stocks focus on reversion to the mean. In investing, it is the future which matters though I have argued that the past can be a good guide. In pricing a security, investors and analysts naturally take into consideration the expected future growth rates of the company.  As future growth rates are difficult to predict, investors and analysts often extrapolate from recent past growth rates.  While growth stocks initially experience higher growth rates than value stocks, the higher growth rates do not last long enough to justify the higher price/earnings multiples which growth investors have been willing to pay. This process of estimating growth tends to ignore the tendency of corporate profit growth to revert to the mean because of the nature of the capital markets.  Industries which are experiencing high growth rates tend to attract competition and capital investment by other firms.  This competitive process eventually results in lower returns on equity and lower earnings growth rates.  Conversely, industries with low growth rates do not attract much new capital investment and management may attempt to achieve higher earnings by operating more efficiently.  Thus, the earnings growth rates of both high and low growth companies tend to revert to the mean.

Will the Value Investing Advantage Continue?

Most investors tend to put excessive weight on the recent past in attempting to predict the future. This is a common judgment error and may explain investor preference for growth stocks.  Fund managers and institutional investors also prefer growth stocks as they are more glamour to invest in, and are willing to pay a premium for them because they appear to be "prudent" investments.  They are easy to justify to the investors of their funds, who erroneously equate good companies with good investments. Due to human psychology and the nature of the industry, this out-performance of value stocks over the growth stocks will persist in the future.

Summary

The results of almost all studies were consistent. Value investing strategies outperformed growth strategies.  This held true regardless of which variable was used to identify value stocks.  None of the studies found evidence to support the view that value strategies involve more risk.

It has been difficult to find high growth value stocks for a long time already. With the recent political, sharp drop in Ringgit, GST, and 1AMD problems at home, plus the external factors of rate hike, Shanghai melt down, Yuan depreciation and China slow down, Greece financial problem etc. affecting Bursa, it appear that the time to scout for high growth value stocks for investment to build up long-term wealth is right at the corner again.

Are you interested to learn how to scout for value stocks, and maybe even better, quality high growth stocks selling at bargain prices? Please contact me for an online investment course at

ckc14training@gmail.com

Tis goeth down to a fundamental aspect that “An investment in knowledge pays the best interest”        - Benjamin Franklin

K C Chong

Appendix

Table 1: Lemons return

Table 2: Return of Value Stocks