Value vs. Growth: A False Dichotomy

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1 INVESTING InvestorView Value vs. Growth: A False Dichotomy The distinction between value and growth has long been one of the primary means for defining equity securities and investment strategies. Since gaining traction in the late 1980s and early 1990s, this categorization has become famous in both academic and commercial circles and exhibits amazing staying power. Despite the method s simplicity and broad use, Brown Brothers Harriman (BBH) does not believe categorizing stocks in this way is helpful when building portfolios. In our opinion, the value/growth dichotomy attempts to draw precise boundaries between stocks and funds where, in reality, none exist. While traditional investing nomenclature suggests that value and growth investors pursue two different outcomes, all fundamental investors would agree that their end goal is the same regardless of philosophy: to buy an asset for less than its intrinsic value. In this article, we therefore argue that the difference between value and growth has less to do with objective and more to do with means. Author Thomas Martin, CFA Senior Investment Analyst Brown Brothers Harriman Quarterly Investment Journal 1

2 The History and Use of Value vs. Growth To understand the use of value and growth in investing today, it is important to touch on the origin of the terms. We trace the most common definition to three different roots. First, in 1987, Russell created the first style indices, launching the Russell 1000 Value and Growth Indices, against which many self-proclaimed large-cap value and growth funds chose to and still do benchmark themselves. Second, in 1992, Morningstar produced its famous Style Box. In addition to market cap, it used value, core (or blend) and growth to categorize stocks and funds. Morningstar Style Box Despite the academic and commercial underpinnings of value and growth, these terms would have nowhere near the recognition they do without managers choosing to benchmark themselves against these indices and the investment consulting industry monitoring managers based on their value vs. growth characteristics. For example, a simple Morningstar screen using the popular Russell family of style indices reveals there are 239 funds totaling $522 billion in assets that list the Russell 1000 Value Index as their primary benchmark. In total, over $1.2 trillion in fund assets benchmark themselves against a capitalization and style-specific benchmark. Unsurprisingly, the creation of the value and growth terminology has resulted in what Wall Street does best: the manufacturing of product for product sake. FUND INVESTMENT STYLE Value Blend Growth Large Morningstar Fund Screener Funds Benchmarked Against a Value/Growth Index (# funds / total fund assets) Value Growth Large Cap (Russell 1000 family) 239 / $522 billion 258 / $474 billion Mid SIZE Small Cap (Russell 2000 family) 139 / $142 billion 126 / $104 billion Data as of October 10, Small Third, also in 1992, economist Eugene Fama (already renowned for his work on the efficient market hypothesis for which he would later win a Nobel Prize) co-wrote a series of papers 1 with Kenneth French introducing the value premium 2 as an important factor in describing security returns. These results spawned a large amount of academic literature as to the reason for value outperformance, all of which only further served to elevate the value vs. growth phenomenon. However, the long-term return differential between these two groups (as defined by academics) has narrowed to the point where the conclusions from earlier studies are now under question. According to commonly used definitions, a value stock is one that has a lower-than-average valuation as measured by various financial ratios, such as price-to-book or price-to-earnings (P/E). 3 Growth stocks, on the other hand, are defined by their historical and projected growth in revenues, earnings and/or cash flows which, as the name suggests, tend to be above average, resulting in premium multiples. Of particular note is that these figures are calculated on the basis of accounting measures, and most of the data is historical in nature. As we will discuss later, while there may be some merit in distinguishing between extremely highly valued, fast-growing companies and deeply discounted companies undergoing significant change or restructuring, most businesses are not adequately described by either of these profiles, and forcing them into one of these boxes is inherently imperfect. Interestingly, none of the equity strategies we invest in at BBH, either managed proprietarily or with an outside partner, uses a growth or value index to benchmark performance. This is not a surprise, given that BBH and our partners are not believers in the value vs. growth investing framework. The False Distinction As mentioned, we believe characterizing stocks and funds as either value or growth does not add meaningful insight into a manager s risk or return profile, as it seeks to draw precise boundaries where none exist. At the most basic level, because all stocks can trade at bargain prices relative to their intrinsic value, applying the term value only to stocks that are cheap on the basis of historical accounting earnings (which can be manipulated in a variety of ways) or current balance sheets is not appropriate. Instead, in our opinion, all good investing is (or should be) value-oriented investing. That is, all businesses, whether fast- or slow-growing, cyclical or highly predictable, should be purchased with reference to the gap between current market price and a conservatively calculated estimate of the business s intrinsic value. 4 Thus, when we say we are value investors, we are not implying we only invest in value stocks as defined by the index manufacturers. Instead, we are stating that we seek to buy assets at less than they are intrinsically worth. In our opinion, anyone seeking to buy something for more than its worth in anticipation of profiting from non-fundamental market sentiment is a speculator, not an investor. These market participants can be found in the momentum and short-term trading tribes. 2 Brown Brothers Harriman Quarterly Investment Journal

3 InvestorView Because a company s intrinsic worth is determined by discounting its future cash flow stream, a discount to intrinsic value framework (carried out by calculating either the NPV 5 or IRR 6 ) is the only way to assess whether there is currently any value available in a potential investment. Capturing this value by buying at a discount to intrinsic value (e.g., purchasing a 60-cent dollar) is a universal goal but how and where that value comes from can vary from manager to manager and stock to stock. For example, an undervalued growth company is often available at a discount because the market underestimates the duration or magnitude of future cash flow growth and returns on capital, whereas an undervalued value company may be discounted because the market overestimates the duration or magnitude of various secular or cyclical headwinds, governance issues or other temporary challenges that are resulting in lower-than-average growth and returns on capital. It is crucial to note that intrinsic value investing applies equally in either case. In both, the investor is seeking to accurately project the future trajectory and duration of the cash flow stream and how that stream is valued relative to its current price. This is one of the primary reasons the value vs. growth framework fails in our mind it is an all-quantitative, backward-looking metric that only begins to scratch the surface of the relevant factors that might help meaningfully categorize investments. Being a dominant competitor in its industry that is becoming more relevant over time Earning strong returns on the capital employed in the business with a long runway for reinvestment Possessing a competitive advantage that allows it to consistently reinvest capital at high rates of return (a moat) Having a solid management team with strong capital allocation skills Possessing loyal customers where the business has a degree of pricing power A company with a combination of these characteristics should be able to grow its intrinsic value over time in a more predictable manner (that is, with a narrower range of outcomes) relative to the average company. It is vital to stress the importance of this expected intrinsic value growth trajectory, as it represents the largest mitigant to any potential capital loss. The continuous compounding of business value usually offsets, over time, a potential mistake made on the initial valuation of a business (assuming the mistake was not massive). Anecdotally speaking, many of our managers that ascribe to a value-oriented investment philosophy have successfully found value in companies that would screen as growth. Alphabet (Google), for example, has been held by our large-cap equity strategy Core Select for some time; while the company is included in growth indices, our equity team has found enduring value (as described by a gap between the stock price and intrinsic value) in this holding for many years. The key factors in determining value go far beyond numbers. As Edward Chancellor says in Capital Returns, Traditional valuation measures say nothing about the specific context of an investment for instance, a company s business model, its industry structure, and management s ability to allocate capital which determines future cash flows. The BBH Lens: Quality vs. Discount to Intrinsic Value If not value vs. growth, then what? At BBH, we believe a better taxonomy is one that distinguishes investments based on quality and discount to intrinsic value. While one cannot always precisely define quality, as it is often more art than science, a high-quality company often hits on one or more of the following key themes: Brown Brothers Harriman Quarterly Investment Journal 3

4 At BBH, we believe a better taxonomy is one that distinguishes investments based on quality and discount to intrinsic value. Quality is only half of the equation, however, as even high-quality investments become risky when overvalued. An investor who buys a high-quality business at a price that is greater than its intrinsic value could lose money in the event that the stock price falls back toward its intrinsic value. Because there is always uncertainty about a business s future prospects and thus its intrinsic worth buying at a discount to intrinsic value is the hallmark of value investing: It allows an investor a margin of safety that lowers the chance of permanent capital impairment. As Howard Marks said in a 1994 memo, There is no security that is so good it can t be overpriced, or so bad it can t be underpriced. Even in the extreme example of a bankrupt company liquidating itself, that too can still be a good investment if it is trading substantially below its intrinsic value, which in that case would be its liquidation value. Within our quality/discount to intrinsic value framework, deep value 7 investing is simply a reflection of an investor s tolerance for lower-quality, less predictable businesses and a larger appetite to generate returns through the upward movement of price to value rather than an upward movement of value (or quality) over time. When evaluating a manager, BBH focuses on understanding his or her views on business quality and intrinsic value framework in other words, how he or she defines quality and how much valuation factors in to the investment process. Evaluating the combination of these two items allows us to get a sense for the risk/reward profile of the strategy. In addition, with consistent application of a discount to intrinsic value framework across our strategies, coupled with a good understanding of the levels of conservativism used in our managers projection assumptions (terminal growth rates, cost of capital, time horizon, terminal multiples, etc.), we can compare the opportunity sets across all of our strategies in a more insightful bottom-up process. Ultimately, this allows us to form an understanding of how the quality vs. value lens influences a manager s portfolio construction process, which in turn affects our own portfolio construction decisions. For example, if we were to compare a portfolio that is estimating an aggregate 25% discount to intrinsic value composed of predictable companies with high returns on capital to a portfolio that is estimating the same aggregate discount to intrinsic value but made up of cyclical companies with lower returns on capital, we would most likely allocate more capital to the first relative to the second, all else equal. Obviously, there are other considerations, but this framework does play a large role in how we assess opportunity sets. Conclusion As value-oriented investors ourselves, we believe investors can generate solid risk-adjusted returns from a combination of growth and intrinsic value convergence (or the narrowing of the discount between share price and intrinsic value per share); thus, we pay little attention to the generic value and growth labels applied to many managers. Chancellor summarizes the value vs. growth debate well: The value/growth dichotomy is false at least, to a true value investor, whose aim is not to buy stocks which are cheap on accounting measures (P/E, price-to-book, etc.) and to avoid those which are expensive on the same basis, but rather to look for investments trading at low prices relative to the investor s estimate of their intrinsic value. We could not agree more. Holdings information should not be considered a recommendation to purchase or sell a particular security, and there is no assurance, as of the date of publication, that the securities remain in a manager s portfolio. 1 Source: Fama, Eugene F., and Kenneth R. French. The Cross-Section of Expected Stock Returns. The Journal of Finance 47, no. 2 (June 1992). 2 Value premium: the concept that value stocks outperform growth in the long run. 3 Other ratios and factors, such as dividend yield, also are considered. 4 These valuation methods do not apply to early-stage or non-revenue-generating companies. 5 NPV: net present value. 6 IRR: internal rate of return. 7 Deep value managers target out-of-favor companies often experiencing wellknown issues, or business transformation, that trade at distressed prices. The market may overreact to weak near-term growth or return on capital prospects to such an extent that the shares trade off to a level where merely closing the price-to-intrinsic value gap results in an attractive return, even if the company is not able to grow that value over time. 4 Brown Brothers Harriman Quarterly Investment Journal

5 NEW YORK BEIJING BOSTON CHARLOTTE CHICAGO DENVER DUBLIN GRAND CAYMAN HONG KONG JERSEY CITY KRAKÓW LONDON LUXEMBOURG NASHVILLE PHILADELPHIA TOKYO WILMINGTON ZÜRICH This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ( BBH ) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ( EEA ), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. Brown Brothers Harriman & Co All rights reserved. October PB Expires 10/31/ _17