In order to make wise stock market investments, it is necessary to understand what is meant by “value” investing and “growth” investing. These terms can be complex, but by better understanding them, you’ll have a better feel for the correct way to analyze a common stock.
A growth approach will usually emphasize enterprises that are expected to show above-average rates of growth in earnings or sales. Since growth companies tend to reinvest a greater portion of their earnings back in their businesses, for purposes such as R&D or expansion, these stocks often pay out lower dividends. Such companies often have price-to-earnings ratios higher than those of other competitors because investors are willing to pay more for a growing stream of earnings than a steady stream of earnings.
A value approach is thought to pay more attention to the intrinsic value of the assets and seeks a below-average price-to-earnings or price-to-book value ratio. While money managers and stocks often are characterized as one or the other, neither term, as commonly used, identifies the correct approach to stock investing.
The best approach is value investing that goes beyond the conventional definition. We begin with the notion that the initial price is crucial in determining the ultimate rate of return. Imagine a building that produces $100,000 of profit for its owner. It is clear that the return to the buyer who pays $800,000 is 12.5 percent, but the buyer who pays $1 million only receives a 10 percent return.
It is the same with stock. The value of a company is measured by the amount of cash that will be available to its owners over a 10-year period. Of course, at the end of the period, the company’s capacity must be the same; that is, paid-out cash is not at the expense of replacing equipment or otherwise partially liquidating the company. To the extent that the company retains its earnings, we need to know the rate of return it is earning on its cash reinvested in the business.
We have now arrived at the juncture between value and growth investing. A company is more valuable if its reinvested earnings will produce a higher return than its existing business. If reinvested earnings cannot earn at least equal to what the company is earning now, the business is worth less, and the company should consider paying dividends rather than reinvesting its earnings.
Attempts to characterize style often lead to confusion. Morningstar, for example, has an arbitrary nine-box style system for dividing common stock mutual funds. We have already seen how arbitrary growth and value distinctions are. Another defect is grouping funds in a category based on the market capitalization of the average holding. (Market capitalization equals the price of a share multiplied by the number of shares outstanding.)
The mutual fund which I manage, Marathon Value Portfolio (MVPFX), has about 20 percent of its holdings in medium capitalization companies, yet is called a mid-cap blend fund because Morningstar combines the large and small capitalization stocks to get an average.
Many funds in that category, however, are focused on the medium-capitalization sector. The other mutual fund service, Lipper, does a far better job by distinguishing between a multi-cap fund and a fund that invests strictly in medium-capitalization companies.
After we have shunned labels, we arrive at the following conclusions:
* The price paid is important because it establishes the initial return.
* The value of a company is determined by its ability to return cash to its owners.
* For a company that is not returning all its unneeded cash, a judgment is needed about the rate of return at which it can reinvest its cash. It is here that the growth and value investments distinction has to be abandoned. Marc Heilweil ([email protected]) is president and CEO of Spectrum Advisory Services Inc. The firm manages approximately $282 million in assets, including the Marathon Value Portfolio mutual fund. Reach him at (770) 393-8725.
