Combining Growth and Value
In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value.
Warren Buffett
1992 Berkshire Hathaway Annual Letter to Shareholders
For decades, investment strategies have been placed in one of two distinct buckets: Value or Growth. This binary approach pits the allure of undiscovered gems against the excitement of tomorrow’s industry leaders and assumes that “value investing” and “growth investing” are polar opposites. However, we believe these two investment styles are not so different from one another and should be used in combination in our pursuit of excellent long-term investment outcomes.
The Traditional Divide
Today’s investment industry and mainstream media portray the value and growth investing styles as opposite ends of the investment spectrum. Traditional value investing is commonly defined as purchasing companies that trade at a low price-to-book value (P/B) ratio or price-to-earnings (P/E) ratio with little regard for business quality or long-term growth prospects. These “value stocks” often have high dividend yields as they pay out their cash earnings to owners because they lack exciting growth opportunities.
Growth investing, on the other hand, is commonly defined as purchasing companies with above-average revenue or earnings growth potential with little regard to near-term valuation ratios like the P/E multiple. The key assumption is that future growth will be strong enough to more than make up for an optimistic valuation today.
Both approaches have their strengths and weaknesses, and there are many successful investors that focus solely on one style or the other. However, we aim to incorporate the strengths of both styles into our long-term business owner approach to investing.
Growth: The Joys of Compounding
At its simplest level, a business is an entity that generates a stream of cash flows for its owners for an indefinite period of time. Because we approach investing with a long-term business owner mindset, growth in those cash flows is highly important. A business with a durable competitive advantage, an intelligent leader and a long-term growth tailwind can produce outstanding results for its owners over many years.
Growth can come in many forms, such as revenue growth, margin expansion or a reduction in shares outstanding that drives earnings-per-share growth. Companies experiencing growth, especially over long time periods, are almost always more valuable than businesses that are stagnant. This is due to the remarkable impact that compounding can have over time.
In summary, future growth – in intrinsic value per share – is a key consideration of our investment criteria. All else being equal, we would much prefer to own a sustainably growing business to one that doesn’t grow.
Value: A Margin of Safety
However, all else is not equal. As Warren Buffett has said, “Price is what you pay, value is what you get.” Growth is a crucial driver of value, but in our view, the other criterion – price – is also critical. At time of initial purchase, we will always demand a purchase price that is at a discount to our estimate of a company’s value no matter how fast the business is expected to grow.
We retain this strict value discipline because it gives us a margin of safety in case we are wrong. For instance, a business might not grow as much as expected, a competitive advantage may deteriorate unexpectedly, a CEO could make a capital allocation blunder or any other unexpected outcome might occur that results in the impairment of a company’s intrinsic value. Capitalism is an unforgiving force, and the future is extremely difficult to predict consistently. By demanding a margin of safety on our initial purchase, we are attempting to build in a level of downside protection.
Transcending the Style Boxes
The ideal scenario we strive for is to identify an advantaged business with terrific long-term growth prospects, as well as a fantastic leader, that is going through some sort of short-term uncertainty, causing the share price to fall and trade at a “value” price. This is what we spend all our time preparing for by studying great businesses, building our library of knowledge day-in and day-out and waiting patiently for opportunities to arise. Once purchased, we aim to own that growing business for decades to allow its intrinsic value to compound for many years.
Ultimately, we don’t think of growth and value as a choice of investment styles that investors must make. For us, both play an important part in successful long-term investing and, when combined, can have a powerful effect. Our value discipline helps protect on the downside, while a sustainably growing stream of cash flows allows for attractive compounding of business value. Both are important ingredients in the investment strategy we employ as we strive to help you compound your capital at attractive rates of return for years to come.
We are truly grateful for your partnership with our team at Baird Trust, and we continue to commit our best efforts to you, our clients.
Baird Trust Company (“Baird Trust”), a Kentucky state-chartered trust company, is owned by Baird Financial Corporation (“BFC”). It is affiliated with Robert W. Baird & Co. Incorporated (“Baird”), an SEC-registered broker dealer and investment advisor, and other operating businesses owned by BFC. Past performance is not a predictor of future success. All investing involves the risk of loss and any security may decline in value. This is not intended as a recommendation to buy any security and views expressed may change without notice. Baird Trust does not provide tax or legal advice. This market commentary is not meant to be advice for all investors. Please consult with your Baird Financial Advisor about your own specific financial situation.
