The growth stocks vs value stocks debate has raged on over many market cycles. Some expert investors, like billionaire Warren Buffett, has said there’s no such thing as growth vs value—but rather that they are adjoined at the hip.
Peter Lynch, former fund manager at Fidelity of one of the most popular funds of all time, is long known as a growth at a reasonable price (GARP) type of investor.
One of his primary valuation techniques had been to compare P/E with the growth rate, in a ratio called the PEG (or P/E to growth) ratio. Basically, Lynch is happy to pay a higher P/E ratio as long as a company’s growth can match it.
The reasoning behind this idea is what I’ve found most fascinating.
Lynch has popularized the following idea:
“Because of compounding, a 20 percent grower with a P/E of 20x is a better investment than a 10 percent grower selling at a P/E of 10x.”Empower Your Investing, by Scott A. Chapman, CFA
See, buying on low price based ratios has always made sense to me. But, the power of compounding has also always made sense to me.
So I decided to put this theory to the test, using some handy Excel calculations and some mildly reasonable assumptions. I found these revelations also fascinating, so I’d like to share them with the world.
Maybe it will help bridge the divide between the most adamant growth and value investors.
But first, some background…
Background of the Growth vs Value Debate
Value stocks, defined as low Price to earnings or assets, has seen periods of outperformance and underperformance through the decades. As has growth stocks, defined (by most) as high price to earnings or assets (assumed to be accompanied with a high growth rate).
Over the very long history of the U.S. stock market (going back to the 1920’s), value and growth have had alternating periods of outperformance against each other, usually in a time range of anywhere between 5-20 years.
Interestingly these results have occurred over a very long time period characterized by generally falling interest rates, which has a bearing on the value of cash and assets (which we won’t get into with this post).
Suffice to say, you can make the argument for the long term superiority for growth stocks (such as a study from Merrill Lynch looking at 1926-2016), or you can make a similar case for growth over value (especially since growth has generally outperformed value over the last 15+ years).
It all depends on what starting point or ending point you look at.
Bottom line—value and growth stocks go through bear and bull markets in relation to each other just as the stock market in general goes through bear and bull markets over its very long term history.
Is Growth Better Than Value Due to Compounding?
Now we’ll get to the heart of this discussion, which was admittedly eye opening to me as a long time value investor.
First, I had to see the P/E example for myself.
The question becomes: how much better is 20% growth at a 20 P/E vs 10% growth at a 10 P/E?
A few assumptions before I reveal the titillating answer:
- Most seasoned investors know that over the very long term, the average P/E for the stock market has been close to around 15- 17.
- And so one reason that value investing works is that if you buy at a P/E of 10, for example, eventually the stock should trade near the long term historical average of the stock market (say 15), and so you get stock price gains just from the P/E rising all by itself (this is also called mean reversion).
- So in my opinion, we not only have to take into consideration growing earnings, but the likelihood that a stock at a P/E of 20 will eventually settle to the long term average of around 15, and this causes downward pressure on the price (over the long term).
The calculations at this point are simple.
Taking two examples of a stock with earnings of $1,000: one is trading at a P/E of 20 ($20,000) and one at a P/E of 10 ($10,000). Now we’ll grow stock A’s earnings at 20% and stock B’s earnings at 10%. Then, after 10 years, we’ll take year 10’s earnings value for both stocks and multiply both by 15 to account for mean reversion. Which stock does better?
I was very surprised to see that the higher grower did much better than the lower grower even though the lower grower got the mean reversion boost.
That’s the power of compounding at work.
To further emphasize this point, I want to highlight another important aspect of stock prices that Peter Lynch has talked about over and over again in his conversations and writings.
From a fantastic book profiling great investors like Buffett and Lynch called Empower Your Investing was this quote by Lynch (repeated several times in different forms by the way):
“I can’t say enough about the fact that earnings are the key to success in investing in stocks. No matter what happens to the market, the earnings will determine the results. In thirty years, Johnson & Johnson’s earnings are up seventy-fold, and the stock is up seventy-fold. Bethlehem Steel earns less today than it did thirty years ago, and, guess what? The stocks sells for less than it did thirty years ago”Peter Lynch
And that’s really the crux of it.
Because a stock’s price will eventually follow its earnings, a higher grower could eventually grow into its valuation even if that valuation is rich today, because of the compounding effect of growth on its earnings.
I wanted to take this a step further because there can be many variations on this effect. For example, if the relationship between P/E and growth is now 2x (with growth still at 20% but the P/E at 40), there’s less chance of such a similar guarantee—because that’s quite a high valuation to grow into.
But I really wanted to quantify this with data so that I could get context as I look at stocks in the market in my day-to-day investing. So, I have more data to present for you that really helps conceptualize to what degree higher valuations are appropriate compared to higher growth, and at what growth rates that value is likely to be superior to growth.
Why We Need to Look at Free Cash Flow Growth (vs Earnings Growth)
With 30+ years since Peter Lynch’s investing career, we have the luxury of many more years of human brain power and ingenuity in not only the world, but also in the world of finance.
Students of finance today are lucky in that they get to learn advanced concepts like free cash flow and discounted cash flow (DCF) models in schools today—which were concepts much more in vouge even 30 years ago.
Not only is the DCF the primary method of valuation taught in top business schools, but it’s also the correct way to value a company according to the Oracle of Omaha himself, Warren Buffett.
Buffett has been quoted as saying: “In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value“. Taking a rabbit hole into John Burr Williams’ book (which I’ve done for you in this blog post already, lucky you) shows that Williams basically advocated a simple DCF formula for assessing company value.
What we also know about Free Cash Flow is that free cash flow basically leads to earnings. So companies with higher free cash flows can retain more cash to invest back into its businesses, while companies with less free cash flows need to reinvest lots of cash just to retain their earnings levels (making it harder to grow).
With these two concepts in mind, we can use P/FCF as a shorthand proxy for the DCF valuation model, and compare P/FCF to growth in the same way that Lynch compares P/E to growth for a similar comparison on the growth or value stock that you are analyzing at any given time.
Examining a Range of P/FCF and Growth Rates for the Growth vs Value Debate
I won’t go into the minutia of the DCF model in this post, but basically we can use a reverse DCF model to estimate how much growth Wall Street thinks a stock will grow based on how it is valuing it (we’ll call it “the implied growth rate”).
In other words, if a stock has an implied growth rate of 20%, then if it maintains this growth rate for the next 10 years then it is fairly valued at its price today.
That might sound a bit theoretical if you’re not familiar with these advanced topics but bear with me for this introduction.
A discount rate also changes the implied growth rate, basically in lockstep. So the higher the discount rate, the higher the growth rate must be (and thus the higher the implied growth rate is) in order to match a stock’s current valuation.
Discount rates generally move with interest rates and are associated with risk—so higher interest rates usually lead to higher discount rates in DCF models because an investor has more options for higher returns (at less risk) when interest rates are higher, so the cash flows should grow more to compensate for the additional risk to buy this investment (since less risky, higher return alternatives are available).
Now that we’ve gotten that explanation out of the way, here’s some more data:
You can see at varying levels of P/FCF, we have different assumptions on the implied growth rate of a stock. I used a 6% discount rate for this example.
With this chart, we can quickly observe any stock based on its P/FCF and get a general sense of how much it must grow to justify its current valuation.
Stock Grows at Implied Growth Rate
Now let’s do the “Peter Lynch” exercise again.
First, let’s assume that each of these example stocks do indeed grow at their implied growth rate. You’d think that each would attain the same gains for investors, since they’re simply growing at the implied growth rate for their current valuations, right?
That’s what I thought…
Turns out that Peter Lynch was on to something when he mentioned the compounding. You can see that at higher and higher growth rates, the price of the stock grows higher even after mean reversion.
We can also see that simply growing at the implied growth rate doesn’t equate to great returns (are you happy with 1-6% gains per year?). We probably need a margin of safety…
Alright, so based on this test, it appears that growth wins out over value.
But remember, this first test assumed that each stock was able to grow into its implied growth rate. 19.39% growth is really crazy growth over a 10 year time period (more on this later).
Stock Grows Above Implied Growth Rate (+3% over)
Let’s assume that each stock actually outperforms its current expectations on Wall Street. Do we see a similar conclusion?
Yes, you can see that the annual return numbers are starting to look much better. Again, the higher the growth rate the better the return even after mean reversion, so growth can do better than value if high growth can be sustained.
Stock Grows Below Implied Growth Rate (-3% under)
This one shocked me. I assumed that underperformance under expectations would mean that the “value stocks” (those with lower P/FCFs) would preform better than the high P/FCF stocks, but that’s not the case either:
Doing better or worse than implied growth rate (based on valuation) still means that the higher growth stocks do better than the lower growth stocks every single time, because of compounding.
But, this doesn’t tell the entire story on growth vs value.
Where the debate can get tricky is on how future growth is expected.
What I think the Problem is with High Growth Rates (and Valuations)
The key to each of the 3 results above is that each high valuation stock in our example had a high implied growth rate, and was able to grow close to this.
Meaning, the stock with the implied growth rate was still able to grow 16% (in the -3% case) or 21% (in the +3% case), and so was able to compound fantastically and have better results.
In the real world, there’s no law that says a business with a high implied growth rate (based on valuation) will achieve that growth rate, or even get close to it. It’s simply expectations, nothing more or less.
So we can’t crown growth over value simply because we think most growth will perform close to expectations. I just don’t think that’s realistic.
Let’s take some more pessimistic cases.
Reality Check: Reasonable Growth Rates and Values
I have a blog post upcoming where I review some of the major macroeconomic datasets that have been officially released by various government agencies over the last 25 years (1994-2019).
Some of these include averages for consumer spending (4.6% per yr), business reinvestment (4.6% per yr), corporate profits after tax (8.9% per yr) and other important variables like population growth (0.9%/yr) and (nominal) GDP (4.4%/yr).
The gut reality check we need to make as investors, especially if we’re going to lean on growth stocks instead of value stocks, is that there are limits to growth and the possibilities of growth.
Use some common sense.
Take the car insurance market, for example.
One of Warren Buffett’s best investments of all time was GEICO. It grew fabulously and capitalized on its low cost advantages (not paying any commissions to sales agents). But, what’s key in Buffett’s case, was that the company was only in a few states back in 1951.
There were much bigger auto insurers with more national reach, but the fact that GEICO didn’t have this national reach actually worked to its advantage, as they had room to grow. So as they took market share from the national competitors in this matured industry, they were able to maintain fantastically high growth rates for many years.
What about investing in a “GEICO” today?
Well, GEICO today is probably all over the U.S. now, with its national commercials in Super Bowl ads and other big TV shows. They can squabble over percentage points with other insurers, but it’s hard to imagine double digit growth from market share alone, as the insurance market is only so big.
The auto insurance market itself, being a matured industry, probably doesn’t have much growth behind it either.
Today, most people who could have cars already have cars, and so the only growth drivers would be new car drivers like 15-16 year olds, or people who buy 2nd cars.
Remember that the population growth has only averaged 0.9% a year over the last 25 years, and that consumer spending is only around 4.6% growth, so unless everybody for some reason starts buying expensive cars, it’s hard to imagine a huge growth in the auto insurance market.
Finally, you do get inflation to help push the auto insurance market higher, as higher car prices mean higher premiums– but it also means more expensive claims. So as a general rule, maybe the growth in the auto insurance market (in revenues) is close to inflation plus population growth (3-4%). Maybe GEICO could steal some national market share, and buyback some stock (if they were publicly traded) to get their FCF per share growth closer to 7-8%– but you’d want to be really sure on the possibility of those results in order to feel confident in that growth rate moving forward.
Double digit growth for a matured company in a matured industry like GEICO seems a bit ridiculous.
You can use that same logic with high growth.
Take any company with an implied growth rate of 15% or higher (P/FCF of around 37+). With an assumed growth rate like that, you’re projecting that your stock will grow (for the next 10 years) at least 3x the average growth of the U.S. economy over the last 25 years. Is that reasonable?
Maybe, but be undoubtedly sure that’s the case.
High Growth Stocks vs Low Growth Value Stocks, with Reasonable Growth Rates
I’ll close with 3 more examples, with more muted growth rates.
Let’s take implied growth rates out of the picture and give every stock in this example a more level playing field.
I’ll assume every stock in the example does much worse than the U.S. economy average (2.5% growth). Then we’ll assume every stock matches the economy (5%), then assume above average growth (10%).
To me, the scary part of these calculations is there appears to be a sort of “dead zone” with the average (5%) growth. At P/FCF of 15-25, which I’d consider to be decent valuations, the returns for investors are 0%- 5% a year if the company is only able to maintain 5% growth.
I don’t like those odds.
Also, we can see that the high P/FCF valuations perform poorly at the 2.5%-10% growth ranges, but I hope that was expected due to what we’ve seen with value vs growth stocks over the very long term.
It looks like 10% growth at a 15 P/FCF seems to be a decent target, but I wonder if that’ll be hard to find in most market conditions (I did another calculation, and 15% growth at 25 P/FCF is about 9% CAGR as well).
I’ll have to look through historical data on some averages of past earnings growth rates, and compare those to above average past earnings growth rates, and see at what frequency were a certain level of above average past earnings growth rates were able to be achieved.
Remember that there can be multiple growth drivers for a stock and its FCF, so we don’t have to be a Debbie downer on our growth estimates even if we are a value investor. Growth drivers for FCF per share can include:
- Market share growth
- Growth of the industry
But, I also think that blindly applying historical growth rates is also not a great idea. Remember the GEICO example. If the industry is matured, or maturing, watch out! If the competitive advantage is eroding, watch out!
When it comes to growth vs value, it really comes down to the growth rate, growth rate, growth rate.
I think the takeaway is this.
Spend almost all of your time on projecting what you think is a reasonable growth rate moving forward, based on expert knowledge on the industry—competitors, drivers for the market as a whole, etc. Then apply a margin of safety.
And then finally, double check your work for sanity.
Does it make sense? Would someone say, yeah that’s using common sense…
This is what I’m thinking about today for my approach moving forward, and I hope it’s been helpful for you today too.