A 10,000 foot view of Value vs. Growth Investment Philosophy
“The margin of safety is intended to protect the investors physical and emotional capital against threats such as imprecision, bad luck, and the general vicissitudes of the economy and stock market.”
The establishment of a Value Investing methodology is generally attributed to the pioneering work of Columbia Business School professors Benjamin Graham and David Dodd. In 1934 Graham and Dodd authored Security Analysis a text that is widely considered the seminal work on the subject. In Security Analysis Graham and Dodd established the idea of a margin of safety, which when applied in a disciplined fashion, reduces risk and provides security of invested capital. Graham later authored The Intelligent Investor which brought the value investing concepts contained in Security Analysis to the individual investor in a more digestible format.
In its original form value investing, as Graham and Dodd described it, was focused on the quantitative aspects of security value, such as book value and more recent approaches such as free cash flow. Conceptually, purchasing a security for a price below what it is worth, for example a discount to its book value, provides for the margin of safety Graham and Dodd discuss and constitute a basic framework and foundation of the value investing process. The margin of safety is intended to protect the investors physical and emotional capital against threats such as imprecision, bad luck, and the general vicissitudes of the economy and stock market. [1]
The general premise of a value investing philosophy is rooted in inefficiencies of the market and the opportunities that are created by the markets mispricing of securities. The market price of a security can certainly reflect the underlying value of the firm; however, at times markets will misprice a security and therefore provide the investor an opportunity to purchase below fair value and with the attendant margin of safety. Additionally, the value investor focuses keenly on a specific definition of risk that has the potential to diverge from how most investors may quantify it. Risk should be viewed as the potential for loss of capital. The volatility of a security’s share price and the assessment of risk as defined by a value investor need not be inextricably linked as is the case with CAPM. Not surprisingly, Graham and Dodd support an approach within which “analysis is concerned primarily with values which are supported by the facts and not with those which depend largely upon expectations.” (Graham, 1940) It follows then that market volatility, and share price movement contrary to the analyst’s assessment, need not undermine the premise for investing in the first place, assuming no negative fundamental changes have occurred.
The Growth Investor is primarily concerned with increases in revenue, reported net income, market share, subscriber growth and the like. As contrasted with the value investor, a growth investor may be far more concerned with the news of the day, the latest product launch, or quarterly earnings report. An important point of differentiation is the focus on earnings and momentum vs quantifiable assessments of value such as described above. Reported net earnings, which may drive share price momentum in a growth issue, are subject to accounting measures which may obscure actual performance while positively impacting future expectations. As Graham and Dodd summarize “the recurrent excesses of its advances and declines are due at bottom to the fact that, when values are determined chiefly by the outlook, the resulting judgements are not subject to any mathematical controls and are almost always carried to extremes.” As a result, the growth investor may be more susceptible to falling in love with a story that is almost entirely qualitative this contrasted with the value investor who would look for quantitative support for any subjective assessments and take care to guard against the possibility for negative outcomes as a result; “The analyst must take possible future changes into account, but his primary aim is not to profit from them but to guard against them”. (Graham, 1940)
Finally, the Growth at A Reasonable Price (GARP) investment strategy attempts to straddle the line between Graham and Dodd and a pure growth investment methodology which, in theory, has no regard for valuation or quantitative metrics other than increasing market price, an acceptable rate of favorable earnings reports, and rising expectation of compounding sales and reported net income projected into the future. GARP was made famous by Peter Lynch the revered manager of the Fidelity Magellan fund between 1977-1990. The hybridized GARP method borrows the focus on growing sales, earnings, subscriber growth etc. from the growth investment strategy and interjects elements of quantitative reality, a hallmark of value investing, into the methodology. Growth at a Reasonable Price by definition assumes that growth at any price is the obvious alternative. Graham and Dodd agreed with this assessment regarding the intellectual soundness of a growth investing program; “The market made up new standards as it went along, by accepting the current price-however high- as the sole measure of value. Any idea of safety based on this uncritical approach was clearly illusory and replete with danger. Carried to its logical extreme, it meant that no price could possibly be too high for a good stock, and that such an issue was equally “safe” after it had advanced to 200 as it had been at 25.” (Graham, 1940) P/E to Growth or (PEG) is an invention which seeks to bridge the gap albeit insufficiently in my estimation.
Whereas value, growth, and GARP strategies are used routinely by investment professionals and individuals all over the world, the evidence supporting Graham and Dodd’s value investment method is overwhelmingly supportive of such an approach providing for the most profitable outcome when applied with the discipline outlined in their text.
Works Cited
Graham, B. &. (1940). Security Analysis 6th Edition. New York: McGraw Hill.
[1] As stated by Seth A. Klarman in his preface essay - Security Analysis 6th Edition
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