Markets at an All Time High: Is it Time to Switch from Value to Growth?

If you've been wanting to read Ben Graham's classic, Security Analysis, for long now but always ended up postponing, this could be the time to make amends.

A mint-fresh edition of the book has just hit the stands. And it has a foreword penned by none other than Seth Klarman. Klarman is one of the most respected names in value investing. Warren Buffett is a big fan of Klarman and rates him highly.

Now, apart from being an ace investor, Klarman is also a prolific writer, a combination that's common among very successful value investors. So, whenever Klarman says something, it pays to listen.

Klarman was on air recently to talk about the latest edition of Security Analysis. I was all ears. A range of questions was thrown at him. He answered almost all of them with candour and clarity.

I particularly liked his take on growth vs value investing and why he believed investors should not obsess too much about the difference between both these styles of investing.

Here are his words...

• The way I think about the market is, not that there are growth stocks and value stocks, but rather that all stocks may hold value. But that all stocks also could potentially be overvalued.
  
  You have to have a mechanism, a rubric for figuring out the value of different kinds of assets, different kinds of businesses, and then figure out which ones are trading particularly mispriced.

So, as per Klarman, there is no growth vs value. There are only overvalued and undervalued stocks.

By the way, Klarman is not the only one who believes that the distinction between growth and value is fuzzy. Even Warren Buffett is of a similar opinion.

In fact, Buffett has even gone to the extent of saying that growth is nothing but a component in the calculation of value. It constitutes a variable whose contribution can range from negligible to enormous and whose impact can be negative as well as positive.

Ok, so there are two clear takeaways...

• There is no growth vs value. There is only overvalued vs undervalued stocks.
• Growth is a component in the calculation of value. But growth does not always make a positive contribution to value. It can also make a negative contribution and a significant one at that.

I believe examples for each of these takeaways will bring more clarity.

A year ago, IRCTC was touted as the growth stock of the railway sector. A virtual monopoly with an asset light balance sheet, it was a must have in every investor's portfolio.

IRCON, its peer on the other hand, was labelled the quintessential value stock. It was slow moving, lacked excitement. Retail investors were not going ga-ga over it.

Well, a year down the line, it's IRCON that has given much better returns that the more fancied IRCTC.

While IRCON is up a whopping 131%, IRCTC is up just 10%. A value stock knocking the daylights out of a growth stock.

Why do you think this happened? Well, my guess is valuations. A year back, IRCTC was trading at a PE multiple of a whopping 70x. IRCON on the other hand, was available at a mouthwatering PE of just 6x.

Thus, as all rail stocks began to go up, IRCTC underperformed massively whereas IRCON more than doubled.

Therefore, as Klarman mentioned, it should not be growth vs value but undervaluation vs overvaluation. The highly undervalued IRCON outperforming the highly overvalued IRCTC.

As far as the second takeaway is concerned, look no further than the FMCG sector vs the airlines sector.

Nestle India, the FMCG giant, has multiplied its market value by almost 4x over the last decade. That's a respectable CAGR of around 15%.

SpiceJet, an airline company, has remained flat on the other hand. The stock price was around Rs 27 per share a decade ago and it's at the same level right now.

Mind you, both the FMCG as well as the airline sectors have grown over the last decade. In fact, airlines may have grown faster than FMCG. Yet, Nestle has outperformed SpiceJet significantly.

The reason is found in the Warren Buffett's statement that growth does not always make a positive contribution to value. It can also make a negative contribution. And this is exactly what seems to have happened with SpiceJet.

Although the sector has grown, SpiceJet has been unable to grow its profits due to constant pressure on its profitability from fuel costs as well as interest and depreciation.

Even though its topline seems to have grown, it has continued to incur losses. Its market value has gone nowhere. A classic case of growth having a negative impact on value.

Nestle on the other hand, has managed to grow its market value by an impressive 4x on the back of both sales as well as profits growth. Thus, in this case, growth has certainly made a huge positive contribution to value.

Think of it this way. If you have a business with Rs 100 crore topline but a loss of Rs 10 crores, doubling your topline would lead to doubling of your losses unless things improve fundamentally. So growing your business could actually prove to be value destroying instead of being value accretive.

However, if you have a profit of Rs 25 crores on the same topline then doubling of topline can double your profits...and your value. Hence, growing your business will prove to be value accretive here.

Conclusion

As the markets reach a new all-time high, you shouldn't worry about switching from value to growth or vice versa. But you should move from overvalued stocks to undervalued stock.

Also, don't believe blindly in growth stories. Ensure the company has some kind of a competitive advantage that will allow growth to make a positive contribution to value. Without that you may end up in a wealth destroying stock despite its strong growth prospects.

Happy Investing.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)