Olga and Hugo dive into the controversy around growth versus value stocks. Some investors are asking whether growth companies, with their current high multiples, are too expensive compared with value companies. But Olga and Hugo believe this is the wrong question. Instead, investors should consider: What drives the competitive advantages of growth companies, and how can we better understand what produces innovation?
Hugo Scott-Gall: A lot of what I’m reading suggests I should be worried about the high multiples awarded to growth companies, or even quality companies, versus value companies. But I think that’s wrong. Is growth expensive versus value? Let’s break it down into its component parts. What do we mean by growth, what do we mean by expensive, and what do we mean by value?
Olga Bitel: Right off the bat, I come back to my favorite topic: perceptions change much slower than facts. So, what is value? The father of value investing, Benjamin Graham, developed the concept in the 1930s. At the time, it made a lot of sense, because there was very little data on companies in terms of their revenues or profitability. Over time, we had more data, but our ability to compute that data was still pretty limited. So, value was really about, “Is this business viable, and how much is it worth?” The concept of value investing was really about investing versus casino gambling.
Today, the concept of value is still predicated on growth. To figure out how much your business is worth, you need to know how it’s generating profit and how fast it can grow and for how long. With the proliferation of data and computational capability, I don’t know why the concept of value investing versus growth investing still persists. If you look at the indices, whether it’s MSCI or Russell or any of the others, the constituents of the growth and value indices change regularly. In the last 20 years, we’ve seen that 75 percent of the constituents change back and forth between growth and value, which means these definitions are highly flexible. For example, look at that construction on Michigan Avenue. That backhoe loader is made by Caterpillar, which was a growth stock during China’s boom but in a recession may better represent value.
Growth is the same thing that it’s always been: innovative companies, whose competitive advantages are often underappreciated.
As best as I can see, today everything is defined as growth, but the really cheap and out-of-favor stuff is value. That’s not a robust definition. So, what’s in the value index? Banks, which have done very poorly with low interest rates, and whose business models have been disintermediated by digital proliferation and online payments. Also, energy companies, specifically oil companies, have done very poorly, so they are also in the value index.
What is growth? Growth is the same thing that it’s always been: innovative companies, whose competitive advantages are often underappreciated. It’s just that we can assess it better and think about it more holistically now, and we can assess different growth opportunities relative to each other.
Hugo: If investors are making a distinction between growth and value—though I would question why they would do that—I think you have to ask, what are you paying and what are you buying?
Now, what you are paying is the market cap. But participants in public markets often would rather use the year-one price-to-earnings ratio or price-to-book ratio. The issue I have with that is it’s incomplete. What we really care about is underestimated, underappreciated earnings power, and that gets you to the ability to grow, the cost of growth, and the competition.
I would argue, in terms of earnings power, growth companies are doing so well because they’ve demonstrated they have it.
Not only do they have good earnings growth, they also have at least one of two additional things: underappreciated earnings growth due to greater revenue-generating opportunities than forecasters understood, or the opportunity to reinvest organically generated cash at a high incremental rate of return.
The problem with so-called value companies is that the earnings haven’t materialized. As the real economy gets remade, the characteristic of really good companies is their ability to grow with minimal capital. That is key because that’s a sign of earnings power. That’s been the most important thing to understand for investing in the last decade.
If investors are making a distinction between growth and value, I think you have to ask, what are you paying and what are you buying?
Olga: Maybe what millions of investors and financial analysts are ultimately trying to do is to address the question of what kind of growth you’re buying. And it’s just that now we are more able to answer that question.
Hugo: Are we better able to answer it, or have we just had a period where we haven’t been very good at forecasting? Is that because of a misunderstanding of the underlying foundation-shaking changes in the economy?
Olga: I think we have new tools, but we were using old concepts and definitions. And, therefore, we missed it. One notion is this idea that, somehow, we’ve run out of things to innovate. In fact, innovation is only accelerating, and so our ability to think systemically about innovation as investors is supremely important.
Hugo: Completely agree. Technology is a good tool for solving scarcity and introducing abundance. I think that gives one a belief in growth, that if you solve these things, there’s a value. But forecasting errors are frequent because it’s difficult to anticipate how people will make use of innovations. I don’t think understanding 4G is enough to tell you Spotify will lead to greater music consumption, for example.
To go back to what’s in the price, I have two thoughts. First, have you really thought expansively enough? On average, you might be right, but I’m sure that in our distribution, there will be a tail where earnings power will be massively underestimated. Famously, Jeff Bezos of Amazon, in one of his rounds of fundraising, underestimated earnings three years out by a huge factor.
Second, will higher and broader growth favor parts of the economy that haven’t grown much in the last couple of years? You might see the highest rate of change in companies that we might call value, but certainly are not high growth, high quality. I sympathize with the idea that companies can have an attractive risk/reward profile because their earnings are growing in the near term, even though the growth rates they can sustain over multiple years aren’t that attractive.
I think economic growth driven by innovation is our ultimate perpetual motion machine.
Olga: Absolutely. That’s purely cyclical.
In general, asking the right questions is 70 percent of the challenge. We may not get the right answers all the time, but if we’re broadly correct, I think we will do quite well as investors.
I think economic growth driven by innovation is our ultimate perpetual motion machine. We can talk about what forces accelerate that growth or act as a headwind. Where, geographically, that growth is likely to accelerate or decelerate. Those are infinitely more useful questions in uncovering investment opportunities and, importantly, divestment opportunities, than trying to figure out if growth or value will outperform in the next quarter.
Hugo: Yeah. It seems that the difficult task of a long-only equity investor is to really understand future earnings power, and that gets you to the innovation economic-growth machine. It requires legwork, imagination, and non-linear thinking.
The simple observation that one group of companies’ multiples is higher than another has at its heart this notion of mean reversion. But the conditions that allow for innovation—resources, capital, humans—were, in the past, physical resources. Now, things like data and computing power are about beating mean reversion. The old rules probably don’t apply, and value investors are looking at seemingly attractive near-term multiples and forgetting to compress the terminal multiple, because an industry that hasn’t felt the full force of disruption in its current earnings power may have a reasonable probability of extinction.
Olga: If you look at the broad Russell 3000 index in the U.S., you can see that the multiple reverts to around 16 times next year’s earnings. But the concept of mean reversion doesn’t apply to individual investments, because if you bracket companies and stocks by different quintiles, according to their multiples, they are not the same companies each time. Growth opportunities were always there, and that’s what the market is trying to systematically seek out and reward.
Hugo: What we’ve discussed here is, what are the ingredients for growth? There is a lot of churn at the top. It’s often working backward from pain points, understanding the problems to solve, and the incumbents can get complacent. For future walks, we should talk about what the difficult questions to answer are that will enlighten the growth path.
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