Value Stocks vs. Growth Stocks: Timing CountsPublished: March 25, 2004 in Knowledge@Wharton
For money manager and small investor alike, it’s practically a religious debate, with each group sure its style is best but unable to produce evidence that would put the matter to rest. The fact is, sometimes value pays off best, other times growth does. Growth investing beat value during the bull market of the 1990s, but value investing did better in the bear market that followed.
Basically, growth investors look for companies with fast-growing earnings and revenues and rising stock prices, while value investors look for bargains – stocks trading at low prices relative to earnings, or low price-to-earnings ratios. But of course, for the sophisticated investor, it’s more complicated than that. The value-investing panel looked at the strategies employed by a half-dozen value-fund managers and found a variety of approaches.
A good working definition of a value stock is one that can be bought for a price that offers “a big enough margin of safety that when you are wrong in your analysis, you don’t lose too much money,” said Kenneth Shubin Stein, cofounder managing member and chief investment officer of Spencer Capital Management. Stein, who moderated the value-investing session, added that value means “basically, doing what other people are not.”
To John D. Spears, managing director of Tweedy, Browne Company, an attractive value stock is one trading at $50 or $60 a share even though it ought to be at $100, based on the company’s fundamentals, market conditions and other factors. Among the conditions that can make a company appealing are high returns on capital and solid cash generation, he said, adding that this approach provides a type of leverage. If a stock should trade at $100 when it’s acquired for $50, conditions that drive that correct price up by $10 will give the value investor a $20 gain.
“It’s a double dip,” Spears said. “Some of our best companies are like that.” The value investor, he added, should be humble, recognizing that since many bets won’t pay off a portfolio needs to hold 50 to 200 stocks.
At Wellington Management, value stock pickers are contrarians, according to Gregory D. Pool, vice president and equity portfolio manager on the natural resources/value team. “We are focused on what can look better. We like to buy apathy and sell optimism,” he said, explaining that some stocks are cheap because investors have lost interest for no good reason.
Wellington managers look at whether a company’s problems are cyclical rather than structural, and they are likely to sell when other investors begin to think a stock is looking attractive. The trick, said Pool, is to judge when it is appropriate to bend the firm’s disciplined selling strategy.
Buying Dollar Bills for 50 Cents
David M. Knott, general partner of Knott Partners, said his firm specializes in pairing stock purchases with short sales. This doesn’t mean the plays are short-term moves. “We still own the first stock we bought and we’ve bought more of it over the years.” The firm does not use much leverage.
“To us, the best thing we will ever see is when we buy a great company at a great price,” Knott added, noting that it’s more common to buy a good company at a reasonable price. “Oftentimes it will be a great company in an industry that is not very exciting for most people.” Banks, insurers and homebuilders have been in this category at various times. Sometimes this involves a company with a problem the press has blown out of proportion or a company in an out-of-favor industry, such as any non-dotcom industry in 1999 and early 2000.
“I’m a generalist,” said Whitney Tilson, manager of the Tilson Growth Fund, which uses a value approach despite its name. “I look for dollar bills I can buy for 50 cents, like any value investor.” Typically, he will ask four questions of an investment prospect: Is the company in his area of competence? That eliminates about 9 of 10 candidates. Is the company in an attractive business? Does he like the management? Is the stock cheap?
The first three questions are fairly easy to answer, but it’s hard to find companies that satisfy those three and are cheap as well, he said, adding that he tends to buy two kinds of stocks – “unknown and unloved.”
Managers at Gotham Capital usually look for companies in special situations such as spin-offs and restructurings, according to partner John Petry. Often the firm has only six to eight holdings, some representing as much as 20% of the firm’s capital. Good candidates have strong cash flow, are positioned to compete effectively, use leverage well and have strong performance incentives for managers, he noted.
Chris Bartel, equity research analyst and manager of Fidelity Investments/ Fidelity Select Industrial Equipment Portfolio, said that since his fund is designed for investors making a narrowly defined bet, it is concentrated in a handful of positions. Nonetheless, “you have to be willing to go outside your comfort zone” to find good candidates and be willing to buy a stock “in its darkest days.”
Looking for Fraud
How do value managers identify short-sale candidates? Stein asked.
Knott responded that he looks for companies with any of a number of potentially deadly problems: a high probability of bankruptcy, a history of committing fraud or “companies that are hype jobs.” Others may simply be overvalued.
Short sellers sell borrowed shares in hopes they can be bought back cheaper to repay the lender. As with all investing, the profit is the difference between the sales price and purchase price, but short sellers reverse the order and thus profit when a share price falls.
Short sales are particularly risky because troubled stocks tend to be volatile. Short selling is an art, Knott said. It’s critical to get the timing right, and to be able to judge whether an undesirable rise in price is only temporary. “A stock doesn’t have a clock,” Spears added. “It doesn’t know you own it.”
The risks and rewards of a short position are the opposite of those of a long position – when the investor owns the stock, he pointed out. The potential profits for a long position are theoretically unlimited, since a stock’s price can go up forever. The loss is limited to the amount invested. With a short, the biggest gain is achieved when the stock becomes worthless, but the profit per share is limited to the price paid. Losses are theoretically unlimited on short sales – the higher the price rises above the short-sale price, the more it will cost to buy shares to repay the initial loan.
Even a troubled stock can rise against all logic, according to Tilson. “If something is trading at 100 times earnings, there’s no reason it can’t trade at 300 times earnings.” Knott and Tilson agreed that short sales are best with stocks that have a “catalyst” – an event very likely to drive down the price. Such events drive away the momentum investors who pile into rising stocks, driving prices up further, Tilson said.
Where are the best prospects for value investors today? Stein asked.
Many U.S. stocks remain expensive, despite the bear market, noted Spears. His company finds the best value opportunities overseas. Pool said he is prospecting among U.S. companies involved in spinoffs, such as those in telecommunications services and pharmaceuticals, and Petry said he likes power generation and aerospace companies.
Bartel pointed out that value stock picking is on a case-by-case basis and there are always opportunities regardless of what the broad market is doing. Knott found some cheap homebuilders last March, but hasn’t found many value candidates since then, when share prices started to take off again. “We probably haven’t made a big investment in two months,” he said. “We just aren’t finding much value now.”