The Relation between Value and Growth

April 6, 2009 · 4 Comments

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.

Categories: Value Investing

4 responses so far ↓

  • Jason // April 6, 2009 at 4:57 pm | Reply

    Nice post and nice new layout. It’s very clean and easy on the eyes.

  • ValueHuntr // April 6, 2009 at 5:02 pm | Reply

    Thanks Jason, I’m trying to brand the site.

  • widemoat // April 7, 2009 at 12:52 am | Reply

    I’m with you. “Value” investing strikes me as a redundant description. A consistently growing company at a fair price may be a bargain; a stagnant bunch of assets could be as well.

    What I think some people mean by “value investing” is asset-based investing (a la Graham) where balance sheet analysis is key. “Growth investing” then becomes about free cash flows.

    I see no reason why the smart investor shouldn’t be analyzing both for each investment

  • Sivaram Velauthapillai // April 7, 2009 at 12:46 pm | Reply

    I think most investors, including the pure growth investors, understand what Greenwald is quoted as saying. The problem is that it’s extremely difficult to say what is sustainable growth except in hindsight (Is Google’s growth and its moat sustainable? who knows.) Those leaning towards growth generally pay up for what they perceive as an ever-expanding moat.

    Warren Buffett is more of a growth investor than many people realize. What he does is to find a growth company and then buy it when it is really cheap (he doesn’t do this as often now though.) I would consider companies like American Express in the 60’s, or even Washington Post in the 70’s to be growth-type stocks.

    My opinion is that most growth-oriented investors buy a growth company even if it is not cheap; conversely, I feel that many value-oriented investors completely ignore many growth companies because they don’t feel it’s ever cheap. Holy Grail of investing is to get both sides right.

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