Values Plus Growth Investing Strategy (Part 1)

By: Hans_Wagner

Many investors seek to beat the market buy using value or growth strategies. Does an investor have to chose one approach, or can they be blended together to get the best of both? To help people to learn to invest his is the first of several articles on value and growth investing.

As defined by Investopedia , “value investing is the strategy of selecting stocks that trade for less than their intrinsic value. Value investors actively seek stocks of companies that they believe the market has undervalued. They believe the markets overreact to good and bad news, causing stock price movements that do not correspond with the company's long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated.”

So what determines value from an investor's perspective? That usually depends on the perspective of the investor. Some look at current measures such as the Price/Earnings ratio (P/E) and other measures that focus on the current financial situation. Others look to future cash flows that are discounted at some rate to arrive at a value estimate based on future financial performance. The point of this analysis is to try to find stocks cheap in comparison to what they should be worth.

Although it is often said that growth investing and value investing are diametrically opposed, a better way to view these two strategies is to consider a quote by Warren Buffett: "growth and value investing are joined at the hip." Another very famous investor, Peter Lynch, pioneered a hybrid of growth and value investing with what can be termed as Growth At a Reasonable Price (GARP) strategy.

Mr. Lynch followed a set of rules when looking for growth opportunities. Here a are a few of his rules:

• They need to have a reasonably healthy balance sheet and are generating profits.
• The business should be relatively simple that can be easily understood.
• For the most part avoid the “hot” industries, and instead find those that are in the sectors    that are out of favor.
• The PE ration should be at or near the growth rate of the company. 
• The growth rate should be accelerating.

So how does an investor, who recognizes that growth and value is a rational way to invest, get started? The first thing to understand is just how efficient are the markets. When you sell a stock, somebody else believes in the stock and buys it. Conceptually one of these investors is wrong about the stock. This is not always true, as one investor could be in for the short term and the other in for the long run and both can win. The investor selling might need the money for another investment. However, in many cases the market is being efficient and one investor is right and the other is wrong about the stock. So if you want to win most of the time, you want to structure things so you are on the right side of the trade.

Benjamin Graham was probably the first investor that fully understood this aspect of the market. That is stocks and markets can get oversold and present opportunities for investors to get into quality companies for a low price. Not only do you want to look for cheap stocks, but you want to find the ones that are out of favor, the ones that no one else is examining. They might be boring or last year's hot stock. The ones that people are ignoring yet have solid fundamentals and a special factor that can trigger renewed growth in the price of the shares. Psychologically people have shied away from these stocks so they have become oversold.

The questions an investor needs to ask is where can I find the best opportunities where I will be on the right side of the trade? This isn't just buying the cheap stocks that have a chance to move up based on statistical probability. These are the ones that meet proven value assessment criteria and that offer the best potential for growth. 

So this is the first principle for value plus growth investors. Search for quality companies that are out of favor, yet still possess good fundamentals and that offer a catalyst for growth. Basically, you want to find good bargains. As Bruce Greenwald, a Professor at Columbia says, “You also need to answer the question from the stand point of the market psychology. Why am I the only one looking at this stock? Is there something wrong with it, or does the market just not understand it?”

The search for value plus growth can use a number of criteria. But basically most approaches look for good businesses that earn more relative to the price being paid than others. Then they look for a reason the company will grow their revenues and earnings more than is currently expected.

First, let's look at how to determine if it is a good business. Several measures include Return on Invested Capital, Return on Assets (ROA) and Return on Equity (ROE). I like to use a variation on Return on Invested Capital that for this purpose I call Return on Capital. It is the ratio of pre-tax operating earnings to tangible capital employed. Pre-tax operating earnings are often called EBIT or Earnings Before Interest and Taxes. The reason interest and taxes are excluded is that companies can operate with different levels of debt. The interest charges on this debt can and does skew the comparative earnings of a company. Also companies can operate with different tax levels which can also skew the comparative earnings of a company.

Tangible capital employed is defined as the Net Working Capital + Net Fixed Assets. Working capital is the difference between the Current Assets and the Current Liabilities of the company. Net Working Capital is used because a company must fund its receivables and inventory but does not have to pay money for its payables, as these are effectively an interest-free loan, as long as they are paid off within the terms of their specific agreement. Excess cash and short term investments are also excluded, since they are not used to help run the current operations of the company. Do not get me wrong, cash is good. It is just that any cash not needed to run the business should not be part of the assessment of how well the company is performing, as it has not yet been invested in operating assets of the company. The idea is to use the actual capital the company has invested in its business.

In addition a company must fund the purchase of fixed assets necessary to conduct its business such as real estate, plant and equipment. The depreciated cost of these fixed assets is added to the net working capital requirements to derive the estimate for tangible capital employed.

This results in the following formula:

Return on Capital = EBIT/(Adjusted Net Working Capital + Net Fixed Assets).

Let's look at two examples from very different industries. The first on is Accenture (ACN) the large consulting and outsourcing firm. The other is EMC Corporation (EMC) the data storage company. Both are large companies with EMC in the technology manufacturing business and Accenture the consulting and outsourcing business, a service industry. The financial numbers are from the latest available, February 28, 2007 for Accenture and December 31, 2006 for EMC. While the sources for these numbers are the SEC filings of each company, investors can also use financial sites such as Yahoo which readily displays these line items.

Earnings Before Interest and Taxes is the sum of the latest 12 months results. All these calculations are straight forward with the decision on how much excess Cash & Short Term Investments to exclude from Total Current Assets is the only one requiring some judgment. Remember that Excess Cash and Short Term Investments are excluded, since they are not used to help run the current operations of the company. In other words, cash is being subtracted because it does not yet represent operating assets. How much is excluded is based on what leaves the company with sufficient Net Working Capital. In ACN's case this only included Short Term Investments. Excluding all the cash would have created a negative Adjusted Working Capital making the Return on Capital not meaningful. For EMC it was possible to exclude their large Short Term Investments and all their Cash. 

One of the reasons ACN has a much higher Return on Capital is that they are a service firm, while EMC is a manufacturer. EMC requires substantially more Property, Plant and Equipment than ACN. Using only this measure an investor would chose ACN over EMC. However, there are more factors to consider. This indicator is one factor to help find quality stocks.

We will address another indicator, called Earnings Yield in the next edition of Value Plus Growth.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

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