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The psychology of growth versus value investing
IN his first book Security Analysis published in 1934, Benjamin Graham proposed a clear definition of investment that was distinguished from what he deemed speculation. It read: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." Graham recommended that investors spend time and effort to analyse the financial state of companies. When a company is available on the market at a price which is at a discount to its intrinsic value, a "margin of safety" exists, which makes it suitable for investment.
Thus value investing was born, and Graham has since been widely known as the "father of value investing". This style of investing was made wildly popular by Graham's disciple Warren Buffett. Mr Buffett's legendary returns from the stock market achieved through value investing is the ultimate prize that novice investors around the world seek.
Meanwhile, growth investing owed its genesis to Thomas Rowe Price, Jr who has been called "the father of growth investing" because of his work defining and promoting growth investing through his company T Rowe Price, which he founded in 1937. Growth investors invest in companies that exhibit signs of above-average growth, even if the share price appears expensive in terms of metrics such as price-to-earnings or price-to-book ratios. Also influential in shaping this investment style was Phil Fisher, whose 1958 book Common Stocks and Uncommon Profits is still today a reference for identifying growth companies.
Over the long history of the stock markets, value investing has trumped growth investing most of the time. But there have been periods when growth significantly outperformed, notably during the dotcom frenzy in the late 1990s and early 2000, and the last 10 years where we have a crop of companies that have managed to come up with innovative business models to disrupt the old ways of doing things.
Enticed by the returns of stocks like Amazon, Google, Apple, and Facebook, many are hoping either to spot the next super growth stock, or bank on the current crop continuing to deliver super normal growth.
Different psychology at work
There is a very different psychology at work for value and growth investing. Mental fortitude is required for both styles at different stages.
The more conventional value investment is in essence a contrarian strategy. A value investor has to have the courage to go against the crowd and pick up stocks that others shun if he or she deems the stock to be mispriced, in that it is trading significantly below its fair or intrinsic value. The stocks could be shunned because they haven't been doing well operationally, there was some bad news, the industry is facing severe headwind, etc.
Hence for a value investor, the most difficult part is having the conviction to trust his or her own judgement and go against the crowd to pick up bargains. Humans are social animals. We like to herd. It is against our natural instincts to go against the crowd.
To make matters worse, sometimes the market will test the value investor's conviction by driving the price down even further after the purchase. This will create doubts in the value investor's mind.
Next comes the wait. There is no knowing when the market will start to recognise the value of the stock, leading to the closing of the price-value gap. The longer the wait, the bigger the doubt grows. At this stage, in addition to patience, it is also imperative for the value investor to revisit his or her understanding of what constitutes value in a company, and to re-establish that indeed there is unrecognised value. Once that's done, it is down to having faith in the workings of the markets, that prices can't stray too far away from value for too long.
Investors who truly believe in the value investing process will generally be less affected emotionally by market movements. They know that prices move up and down because of sentiment, but the value of the company they own doesn't change overnight. The biggest comfort is that they know they have paid less for something that's worth more. And oftentimes they get paid decent dividends, which makes the wait much more bearable.
Meanwhile, the emotional trip of a growth investor is slightly different. Typically a growth company is one that has been doing well, in terms of their business which is then reflected in the share price. Seeing the stock's recent performance, it is easy for investors to extrapolate that into the future resulting in them wanting to join the ride.
So the buying part tends to be easier for growth investing. One, because the company has been doing well, and two, because a lot of other investors are also positive on the company. There is safety in numbers. Then of course the promise is tantalising. All investors harbour the dream of bagging a stock like Amazon, which returned 1,245 times since its initial public offering 22 years ago. A US$20,000 invested in the stock at its IPO in 1997 would be worth about US$25 million today!
But realistically speaking, not many investors would stay with Amazon from day one till today. Amazon registered very strong revenue growth after its listing. But it wasn't making any profits until six years later, in 2003. From its IPO till the peak of the dotcom bubble in December 1999, its share price skyrocketed to 70 times its initial level.
Let's say someone had US$30,000 to invest back in May 1997 and decided to allocate US$1,000 or about 3 per cent of his or her portfolio to Amazon. The rest of the money was allocated to a basket of stocks that yielded similar returns as the S&P 500. By December 1999, Amazon was worth US$71,000, and the rest of the portfolio US$51,000. In other words, just before we entered the new millennium, Amazon alone made up 58 per cent of this investor's portfolio.
Would he or she not be tempted to take profit then, if they hadn't already done so earlier when the stock doubled, tripled or quadrupled?
Let's assume they hung on to the stock, because of the deterrence of the huge capital gains tax that they would have to pay had they liquidated their holdings if they were US citizens. As we entered the new millennium, the dotcom stock bubble burst. Amazon, without any earnings to provide comfort to investors, plunged by a whopping 94.4 per cent from its peak in end-1999 to a low by end-September 2001.
Run or hold?
Talk about a stomach-churning ride! One surely needed a strong heart and unwavering resolve to continue to hang on. From US$71,000, the value of the position dwindled to just about US$4,000 by the third quarter of 2001. Still, that's a 300 per cent gain from just over four years ago. Would most investors not take whatever gain that's left and run?
At the bottom, Amazon was still not making profits. But perhaps some investors who were able to model the company's business trajectory could see that what it was building was worth more than its price then. In that case, Amazon could be argued to be a value buy.
After all, as Mr Buffett said, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
And value features in growth investing as well. No sane investor, even if they are growth investors, would be willing to buy a stock at any price. Valuation still needs to be done, and the share price compared to the value will determine if the stock is a buy or not a buy. The difference perhaps is in how the valuation is made - some can be more aggressive, some more conservative.
There are numerous ways to make money in the market. Ultimately investors will tend to gravitate to a style that suits their temperament and their preferences - one that doesn't take too much emotional and psychological toll on them.
- Hooi Ling is the portfolio manager of a no-management-fee Asia fund, Inclusif Value Fund (www.inclusif.com.sg)