Philosophy and Strategy in Investing
Sanjit Deepalam, Dartmouth Business Journal
In the investing world, investors are always trying to find an edge to beat the market. One of the fundamental ways many investors try to find this edge is by deciding between a growth investing strategy or a value investing strategy. Growth investing involves buying shares at a relative premium in companies that are growing quickly. Typical examples include stocks like Amazon and Tesla. Value investing involves buying stocks that are undervalued compared to what their results indicate. Examples include Goldman Sachs immediately after the financial crisis and Coca-Cola in the early 1990’s. Value stocks usually sell at low multiples and are not in business sectors that are popular or trending.
Many people have spent a lot of time analyzing the two styles of investing and their results over time to try and discern which strategy is superior. Their results and conclusions often contradict one another. The debate was put back into the spotlight when David Einhorn, a value investor and founder of Greenlight Capital, commented on the debate in one of his quarterly letters last year. Einhorn said that growth stocks had been outperforming value stocks and the market as a whole over the past few years, and that he worried that “the market has adopted an alternative paradigm for equity value.” He also stated that he didn’t know when value investing would yield superior results again.
The letter made waves in the finance community. Many took it to mean that he felt that value investing was no longer a viable way of achieving good returns in the market. Einhorn later clarified himself, saying that he still believes that value investing is the best way to invest and that his fund still uses this style of investing, but that he didn’t know when it would be very effective again. Nevertheless, his remarks highlight a fundamental and unavoidable debate in the world of investing.
It’s relatively easy to see why growth investing makes sense: growth is good for business. Companies like Amazon and Tesla are expensive by normal measures, but they’re also important companies that offer products and services that people love. The thesis for investing in these companies is that the value of their business will grow as the company continues to grow quickly. As Einhorn points out, a shareholder of Amazon, Facebook and Tesla would have earned a great return in recent years. As LPL Financial reports, growth stocks have outperformed value stocks by as much as 50 percent over the past decade, a huge and remarkable return.
However, there are a couple pitfalls to this kind of investing. First, growth stocks typically become popular and increase in price after they demonstrate their growth. By the time most investors catch on, much of their profit margin has disappeared as people have bought into the stock. This also ties into a second pitfall with this kind of investing: the lack of contrarianism. Every trade made in the stock market represents a disagreement between someone selling a stock because they don’t want it and someone buying a stock because they do. This obviously happens when growth stocks change hands, but the people that are selling the stock have probably already made a big gain and are choosing to cash in on their winnings, leaving much less to whomever buys the stock. However, as mentioned earlier, the performance of growth stocks and some growth companies can’t be denied.
Value investing began as a philosophy espoused by Ben Graham and David Dodd in the early 20th century but has grown immensely popular over the past few decades as the result of its most famous practitioner: Warren Buffett. In short, value investors are bargain hunters. They look for companies that are undervalued; to the general investing community, this means that a stock is selling for a low P/E or P/B ratio. As shown by the success of Buffett, Einhorn and others, value investing can be a very profitable strategy. The idea of buying a share in a company at a discount and waiting for the rest of the market to catch on to the bargain is a low-risk way of investing. In addition, a value investor’s focus on the company’s performance in the present moment as a measure of its value also reduces risk. It’s much easier for investors to discern whether companies will continue to perform as they are than it is for them to predict their rate of growth years into the future. Despite value investing’s success over many decades, however, it has not been the most profitable strategy over the past decade. Value investments have made money, but as shown earlier, they’ve been handily beaten by growth stocks. All investors want to invest in the companies that give them the greatest return, and the ones that have looked for those returns in growth stocks have done better in recent years.
It’s clear, after going through the advantages and disadvantages of each type of investing, that there is no outright winner. However, what’s less clear is that the debate itself is fundamentally flawed. The problem is that investors have historically confused strategy with philosophy. When people debate these two styles, they debate them as strategies – the growth strategy involves identifying companies with a strong growth history and potential and lots of public visibility, while the value strategy involves identifying companies with low P/E and P/B ratios. What people ought to be doing is analyzing the two philosophies. Philosophy involves understanding what one wants in an investment and why a particular style of investing works, while strategy involves the methodology with which an investor finds investments that fits a particular philosophy. The growth philosophy is to find businesses that are growing at a quick pace that with profitability on the horizon and the value philosophy is to treat stocks as shares of a business and only buy at discounts to intrinsic value. Having a solid understanding of the philosophical side of an investment style provides the bedrock for formulating a solid strategy. The debate over which style of investing is superior is flawed because many investors skip over philosophy and jump straight to strategy.
When framed this way, the debate gets much clearer, and investors realize something crucial: philosophy is essential to strategy, since it creates the foundation for good strategy. Not making this distinction forces people into making rushed decisions. For example, many investors perform top-down research, which involves identifying a trend or quality in the market and looking for companies that fall into that trend or have that quality. In this case, growth investors could just screen every stock in the market and invest in those that are growing revenue at a certain percentage and value investors could just screen for companies that are trading with a low P/E ratio. However, the people that buy stocks based on this methodology aren’t staying true to either philosophy. Just because a company is growing quickly doesn’t mean that it can turn that growth into profit, and a company that is selling at a low P/E ratio might be doing so because it’s a horrible business. It’s extremely easy to fall into this trap and lose sight of why someone looked for value stock or a growth stock in the first place.
A bottom-up approach, where investors go from company to company identifying the ones they like: either based on profitable growth or undervalued assets, would be a more appropriate way to go. This approach would force investors to focus on philosophy first and thereby avoid making investments that seem great but really aren’t.
Understanding this distinction also helps reinforce the idea that it’s unclear which style is “better”. Value investing, despite what some seem to believe, is still extremely profitable for well-managed funds like Allan Mecham’s Arlington Value, which was up 29 percent last year and Mohnish Pabrai’s Pabrai Funds, which has returned over 1100 percent since 2000, have done well employing a bottom-up approach and a strong understanding of value philosophy. Einhorn’s fund has averaged a 16 percent return net of fees since 1996. These funds are evidence that value investing is still a very profitable philosophy if applied with patience and deliberation, as opposed to a haphazard strategy. The same is true for growth investors. Sequoia Capital, for example, has become the most respected venture capital fund in the world despite investing in new technology start-ups because it has a strong understanding of philosophy and a great strategy.
In the investing world, investors are completely reliant on how many opportunities they can identify and exploit. So, it’s easy to understand why investors want to rush to identify opportunities based on a stock’s popularity or P/E ratio. It’s impossible to really know which type of investing is better, since that would require going through each stock in the stock market, identifying its investment merit and then seeing if it’s a growth or value stock. But this is the point. Investors ought to first understand a philosophy well, and then employ that philosophy in a strategic way. The greatest investors, from Ray Dalio to Warren Buffett, have demonstrated that the deliberate application of a philosophy is the best way to consistently achieve superior results.