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The Ongoing Tyranny of the Growth vs. Value Argument

Co-written by Jeffrey Bronchick + Ben Claremon

A recent article in the Wall Street Journal—from which we lifted the chart below—once again highlights the never-ending debate about the merits of growth versus value, a discussion that inevitably forces an investment manager to self-reflect. What kind of stocks am I investing in? What kind of manager am I? Will I be judged unmercifully if I am perceived to be picking outside of my “box?”

Russell G v V

Yes, there remains hundreds of billions of dollars managed via a mental process in which these issues are incredibly real and potentially career threatening, despite a lot of evidence to the contrary. There have been “rumors” that the “long equity” investing world is breaking down these boxes. This is the result of some unsatisfying results in 2008, not to mention the inherent complexity and costs of assembling a 24 manager roster in order to cover all bases; however our own experience suggests that these efforts remain at the margin.

We would note several issues:

1 — The assessment of a “growth rate,” historical or projected, can be a crucial determination of the value of a company. Thus, to somehow separate the two concepts borders on the very silly to put it kindly. To use an extreme, which deserves a higher price: a 10-year Treasury issued today with a static 2% coupon or a 10-year security with a 2% coupon that will contractually grow by 5% a year? To value and choose between the two without considering “growth” remains an exercise in silliness.

2 — Exxon is represented in at least 84 exchange traded funds or stock market indices. We would suggest that redefines cognitive dissonance if one is seriously investing along “categories.”

3 — Speaking of cognitive dissonance, how can the same client/consultant merrily put money into hedge funds whose mandate is often by definition “go anywhere” and at the same time, strictly confine their long-only equity managers to an index basket?

4 — Being a value manager does not have to be synonymous with buying financial stocks, just as buying GM every year since 1946 does not entitle one to smugly call himself a value manager. It’s no surprise that given the turmoil in financial markets and the collective distaste for financial companies that has developed, many financial stocks are what we would call “statistically cheap.” Many of them sport price earnings and price-to-book multiples that are mere fractions of those that these companies have traded at over the two decades and some even offer high dividend yields. These facts point to financials categorized as statistically “value” stocks and, not surprisingly, they make up a large portion of the value indices. Specifically, as mentioned in the article, 25% of the S&P Value index consists of financial stocks and they even represent a higher percentage of small cap value indices. If one possible outcome of the intermediate future is that banking and related stocks are going to have profitability permanently impaired, why do I “have” to be represented?

5 — While we cringe at using our own clichés, we would note that benchmarks are like potato chips—it is difficult to eat just one. As the WSJ article notes, value indices are underperforming because they are heavily weighted in financials and financials have been underperforming. We are under no illusion that we are inherently wonderful because we outperformed the Russell 2000 Value by 1000 basis last year. We chose some great stocks, but we also avoided the banking industry. If global financial stocks bounce back, we could still pick wonderful stocks and yet “underperform.” If one were going to pursue the box route, we would counsel using both a “broad” and a “style” index as each has its own bias, just as we the manager have biases.

For ourselves, we remain “index agnostic” and simply attempt to pick the best combination of business, value and people that we can find. We own gypsum and aggregates player Eagle Materials (EXP), a company whose fortunes have recently been decimated by the collapse in new housing construction and who would define growth as “a slower decline than the previous quarter.” But we think the stock offers a substantial value based on a normalized earnings and cashflow basis. In the same portfolio we own Approach Resources (AREX) whose revenue has been growing extremely fast as it is starting to drill for oil and gas on some very productive properties the company acquired years ago. Its “value” is in the ground as its price-to-earnings ratio looks very un-value-like, trading at a 54x multiple. So, is it a value stock or a growth stock?

We will close with a quote from Charlie Munger of Berkshire Hathaway (thanks to Santangel’s Review for the reminder):

The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle. It’s convenient for a bunch of pension fund consultants to get fees prattling about and a way for one adviser to distinguish himself from another. But, to me, all intelligent investing is value investing.

This report is published for information purposes only. You should not consider the information a recommendation to buy or sell any particular security, and this should not be considered as investment advice of any kind. The report is based on data obtained from sources believed to be reliable, but is not guaranteed as being accurate and does not purport to be a complete summary of the data. Partners, employees, or their family members may have a position in securities mentioned herein.

Past performance is not a guarantee or indicator of future results. The opinions expressed herein are those of Cove Street Capital and are subject to change without notice. Consider the investment objectives, risks, and expenses before investing. These securities may not be in an account’s portfolio by the time this report has been received, or may have been repurchased for an account’s portfolio. These securities do not represent an entire account’s portfolio and may represent only a small percentage. You should not assume that any of the securities discussed in this report are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in this report. Recommendations made for the past year are available upon request.

CSC is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. Additional information about CSC can be found in our Form ADV Part 2a.

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