Reese: Growth & Value Not an Either/Or

In the latest edition of his Hot List newsletter, Validea CEO John Reese says that investors too often fall prey to the idea that growth and value are opposing concepts. In reality, he says the best stocks include aspects of both value and growth plays.

“In the dozen or so years I’ve spent studying history’s most successful investment strategies, I’ve found that paying too much attention to such style-box distinctions can be harmful to your returns,” Reese writes. “And, when it comes to growth vs. value, I’ve found that an ‘either/or’ approach often misses the boat.”

Reese says he was recently reminded of this while reading one of Warren Buffett’s past letters to Berkshire Hathaway shareholders. In that 2000 letter, Reese explains, Buffett wrote that “market commentators and investment managers who glibly refer to ‘growth’ and ‘value’ styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component — usually a plus, sometimes a minus — in the value equation.”

“Indeed,” Buffett said, “growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years.”

“To Buffett,” Reese writes, “growth and value aren’t polar opposites; instead, the rate at which a company is growing is just one factor involved in determining the true value of a stock. A company can be growing like gangbusters, but if its shares are overpriced, or it is using large amounts of leverage to produce that growth, it’s likely not worth your attention.”

Reese says Buffett isn’t the only guru who thinks along those lines. “In fact, most of the investors upon whom I base my Guru Strategies used a mixture of growth-related variables and valuation-related variables,” he says. “Growth-focused Martin Zweig, for example, also used the price/earnings ratio in his analysis of stocks — he was willing to pay a premium for growth, but not too much. John Neff was a self-described ‘low-P/E investor’ but he also wanted companies to be growing earnings at a nice, sustainable pace (my Neff-based model looks for growth between 7% and 20% per year). Peter Lynch actually incorporated growth and value into one innovative variable — the P/E/Growth ratio, which divides a stock’s P/E by its historical growth rate. The rationale: The faster the rate at which a company is growing earnings, the more you should be willing to pay for every dollar of those earnings.”

Reese points to a couple Hot List holdings that exemplify the concept of growth and value coexisting, including AstraZeneca. “On the surface, AstraZeneca appears to be a clear value stock — it sells for just 7.6 times trailing 12-month earnings, and it’s yielding about 8%,” he says. “But the company also has an impressive growth story. It has increased earnings per share in 8 of the past 10 years, and in the financial-crisis-marred years of 2008 and 2009 it grew EPS by 12% and 24%, respectively.”

AstraZeneca is an example of very well-rounded stock that is solid across a number fundamental levels, “which are the types of stocks that tend to do well over the long haul,” Reese writes. “By using both growth and value metrics, you can identify these type of plays. If you constrain yourself to looking at only growth variables or only valuation metrics, however, you run the risk of getting saddled with two types of stocks that can cause big damage to your portfolio: hot, overpriced growth stocks that have unrealistic expectations priced into their shares (think back to the tech bubble); and so-called ‘value traps’ — stocks that appear to be cheap, but which are really dogs (think about some of the weaker financial firms whose shares appeared cheap during the ’08 collapse — and then went to zero as the firms crumbled under the weight of their debt).”

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