Last week I was watching a golf tournament on television, and when a highly consistent golfer stepped up to the tee box, the announcer broke off into a sidebar to describe the golfer. This golfer's consistency over the past year had propelled him to place higher in tournaments, and as any PGA Tour fan knows, a few strokes equal serious money. The announcer referred to this golfer as a "growth stock," because his "fundamentals" -- driving accuracy, greens in regulation, scrambling percentage, etc. -- were "very impressive."
That announcer gave a clear description of why growth is the value investor's best-kept secret. After all, growth is the ultimate value-creating catalyst. When I analyze a stock and examine the cash flows, the first question I ask is, how much cash will this business generate in the future? What I am looking for are simple reasons why future cash flow will grow over time. Warren Buffett put billions of dollars into names such as Coca-Cola (KO), Wells Fargo (WFC) and IBM (IBM), precisely because he is predicting that five years from now, all these companies will have generated growth in profits and cash flows.
Where many so-called value investors go wrong is in thinking that they must pay the same multiple for all types of growth. Growth is not easy to attain, and not all businesses possess the same qualities that enable one to grow faster than another. A high-quality company that has tremendous growth potential should not be evaluated the same way as a similar business that has less desirable characteristics. For example, Yum! Brands (YUM) trades at 15x earnings while Chipotle Mexican Grill (CMG) is at 25x earnings, but that doesn't necessarily make Yum! a better value. Five years ago, Chipotle was probably trading for 25x to 30x earnings, and Yum! was fetching perhaps half that multiple, and a buyer of Chipotle is up nearly 200% today while Yum! shares are up 85%. The reason? Chipotle's fundamentals kept getting better and better, resulting in phenomenal growth.
A value approach tries to exploit temporary opportunities, akin to signing a great athlete during a period of weakness. (Imagine if you could have bought a share in Tiger Woods' golf earnings back in 2009 and 2010 when his performance was subpar.) The ability to invest against the crowd is the distinction that differentiates the intelligent investor from the rest of the pack. It's why I was happily picking up shares of Chipotle at $270, more at $250 and still more when the stock fell lower. If you want to call that "value investing," so be it. I simply call it intelligent investing. After all, what is investing if it's not the attempt to attain maximum value for every dollar invested?
Of course, growth cannot be justified at every price; investing is a relative exercise. Why invest in Amazon (AMZN) at a forward price-to-earnings ratio of 74 when you can get Google (GOOG) at 25x earnings? Or why invest in either one for that matter? Your answer should be backed by a rational and independent assessment of the value you are getting for the risk being assumed, and not by the emotional excitement of watching a stock price go up. These are businesses, after all.
Any value-priced stock is that way by definition because the future growth potential is being currently underpriced. Otherwise, what you are buying is not value at all but rather a cheap business with deteriorating fundamentals, in which case the business will continue to get and cheaper and cheaper -- the so called "value trap."