Most analysts feel they must choose between two investing approaches customarily thought to be in opposition: “value” and “growth”. But the Warren Buffett Letters (available in our resources section) make it clear that 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.
Buffett’s 1992 letter points out that although growth often has a positive impact on value, such effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless growth. For these investors, it would have been far better if Orville Wright had failed to get off the ground at Kitty Hawk: the more the industry has grown, the worse the disaster for owners.
So growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.
What kind of businesses are these in which growth hurts or benefits investors? Bruce Greenwald, director of the Heilbrun Center for Value Investing at Columbia Business School, provides an enticing answer:
If a firm operates with no competitive advantages, or with no barriers to entry in any given industry, returns above the cost of capital will attract new entrants whose competition will eliminate those higher rates of return. Without barriers to entry, competition will sooner or later force the rate of return downward until it equals the cost of capital. Since the most common competitive condition is a level playing field, for most firms return on capital is nearly equal to cost of capital. For these firms, growth adds zero to shareholder value. For firms that are on the wrong side of barriers of entry, outside and looking in, the cost of capital exceeds return on capital, so growth destroys shareholder value. Only in markets where a company enjoys a sustainable competitive advantage, protected within its franchise by barriers to entry, will returns on capital be greater than the cost of capital.
So the basic relation between value and growth comes down to this: Only growth created through a competitive advantage creates value.