The Third Option – Value and Growth

March 2021 - Joe Bauernfreund

Value investing versus growth investing is a decades old debate, one that has quietly raged since Benjamin Graham’s first ‘value’ stock picks in the early 20th century.

The traditional argument squares off two strategies in each corner of the ring, to fight it out over issues such as risk, valuation, investor temperament and global market forces. But is this fight still relevant? Was it ever a true contest at all?

 

In the red corner…

Depending on who you ask, ‘value investing’ is defined as seeking returns on relatively ‘low risk’ investments in stocks that are undervalued. For one reason or another, the market value of the stock does not reflect their intrinsic value. Value investing is tied in many peoples’ minds to low growth, often challenged, businesses that the myopic market has cast aside and put on sale.

By comparison, ‘growth investing’ conjures an image of savvy investors picking the next billion-dollar superstar in modern, high-tech sectors. The aim of growth investing is to pick companies that will outstrip their competition, growing at above average rates and rewarding their investors with their high performance.

Of course, as is always the case with such things, neither of these typologies quite hold. They are caricatures. This however has not stopped their proliferation across all areas of the investment world. Clients and allocators often reference such terms, whilst the press commentary is rife with the debate about “value” vs. “growth”.  Even this author’s tongue slips from time to time and asks a fellow fund manager “are you more value or growth”?

Metrics Compared for MSCI defined Value and Growth Indices

P/E P/BV Sectors (Top 50%)
Value 21.07 1.85 Financials 21.5%, Healthcare 13.8%, Industrials 11.8%
Growth 43.74 7.05 Information Technology 43.7%, Consumer Discretionary 17.4%

*Source MSCI World Growth and Value Indices at 31 December 2020

 

Goliath versus Goliath’

The conversation around growth and value investing is dominated by the narrative of competition. Performance versus valuation, risk versus safety, us against them.

A recent AIC report entitled ‘Has value had its day?’ laments the widespread “cavalier references to the rivalry between growth and value investment styles” – but fails to address a fundamental issue. Value and growth investing are not two rival camps, spouting incompatible investment theses, divided by insurmountable ideological barriers.

 

“You haven’t given me a third option”

Asked in a webinar whether Asset Value Investors are value or growth investors, CEO Joe Bauernfreund responded that “we are neither”.

He could very easily have argued that we are both. Or that the question itself no longer makes sense.

“People think of us as value investors. To an extent that is true””

“We are interested in buying companies trading at a discount to their realizable value. But we are not interested in buying companies that are cheap for a reason – zombie business or operationally challenged companies”.

“We will not invest in companies where we don’t see the long-term potential for substantial growth in value.”

“We want to buy good quality companies trading at a discount, where we will benefit not only from closing the discount gap, but from long-term growth”.

 

The Third Way

So how do you follow this third way, treading between the two camps? Is it possible to find attractive quality companies, growing at above average rates but undervalued by the market?

Obviously, if these companies were easy to find then they would not trade below their intrinsic value for long. Companies in high growth sectors are under constant scrutiny by analysts and such an opportunity would be snapped up immediately.

But these companies do exist. Often hidden beneath ownership structures that obscure the value of the stock from easy evaluation. It requires time and effort to peel away the layers to see what is underneath.

A simple screening process will overlook the hidden value behind these sometimes complex structures and most analysts will simply miss them entirely.

If you unearth a company that incorporates the characteristics of both ‘value’ and ‘growth’, it can be complicated to understand at first glance. So, let us examine this with an example.

The Golden Eggs

Kinnevik AB is a Swedish listed holding company embodies the value-growth characteristics we seek. Established in 1936 Kinnevik has evolved from iron paper and woodworking industries, to telecoms, e-commerce and early-stage investments in digitally enabled businesses.

As is often the case with holding companies, Kinnevik typically trades at a discount to its Net Asset Value (“NAV”). Reframing the “value” vs. “growth” debate as an analytical style, not a statistical factor, buying a company on a discount is value investing in its purest form – you are buying something for less than it is worth. At AVI we take advantage of situations where the discount widens, and invest at points of pessimism, earning a return once the discount narrows.

Is it possible to find attractive quality companies, growing at above average rates but undervalued by the market?

However, this is only part of the equation – the other side being growth. Kinnevik have built a strong track of value creation, with European e-commerce platform Zalando a case in point. Having invested early in 2010, Kinnevik supported Zalando’s growth, through the IPO in 2014 and the strategic evolution to become the dominant European platform, reimagining the European fashion market in the process. In February 2021 Kinnevik announced plans to distribute their shares in Zalando to shareholders – having returned 8.6x their initial investment at the time of the announcement. Shareholders in Kinnevik have rode this wave and can continue to do so directly going forward.

This combination of unusual and unloved structures, and high-quality underlying assets, typifies that growth-value approach. We want to buy assets for less than they are worth, and then watch the assets growth in value.

Finding the balance

Value-growth investing is a nuanced game, relying on your ability, patience, and diligence to find that golden opportunity. A company that is undervalued by the market, but with long term prospects that would excite any hard-core growth investor is the archetypal ‘value-growth’ stock. Ardent value investors will claim it for their own, pointing at the fundamental undervaluation. Growth investors will retort that the value is in the long-term potential to outstrip the market. We are staking a claim to both.

 

Read more AVI Insights here

 

Definitions:

P/E –The price-earnings ratio (P/E ratio) relates a company’s share price to its earnings per share.

P/BV – The price-to-book ratio compares a company’s market value to its book value. The market value of a company is its share price multiplied by the number of outstanding shares. The book value is the net assets of a company.