Growth vs. Value Investing

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Photo by Wayne Robinson on Unsplash

Let’s say you have $1,000 to invest, and you’ve decided you want to make a bet on one company. Two retailers have caught your attention. Company A is an established market leader with 30 years of success under its belt, and it continues to earn strong revenues. Not surprisingly, it’s trading at a premium relative to its competitors because investors want to own a piece of its success.

Company B has been in the business almost as long. Until two years ago, it was among Company A’s strongest competitors. But then an aggressive expansion plan failed and the stock price took a hit. Company B’s share price has been trading at a discount relative to its competitors ever since. Management is telling investors they have a new strategy, but analysts are quick to point out how difficult it can be to grow a retail chain.

Which investment looks better to you? Obviously I haven’t given you enough information to do a proper analysis, but the two scenarios do illustrate the difference between what’s described as a growth stock (company A) and a value stock (company B).

A growth stock is a company that is growing quickly and/or consistently. It’s been doing well. It is expected to continue to do well. And its share price is expected to rise as a result of that success. That last point is important, because not all successful companies see their share price rise steadily.

Remember that the price of a company’s stock is not just a result of what the firm has done to date; it reflects what investors believe the company will earn in the future. So the challenge for growth investors is to estimate future rates of growth, understanding that past performance is not indicative. In fact, an investment is a bet that the company will not just continue to grow, but grow more than investors expect it to.

A value stock is one that is thought to be underpriced relative to its actual potential value. In our scenario, company B has been oversold as a result of the failed expansion two years ago. It has a bad reputation among investors relative to other companies in its industry right now, and so they’re being overly pessimistic about the company’s ability to produce earnings in the future.

Value investors seek companies trading at a 33% or better discount relative to what they believe the stock is worth. In other words, they’re cheap. The trick of course is not only to find these investments, but to identify those cheap stocks that are going to rise in price as other investors come to realize there is greater value there.

All of this means research. When done properly, that means poring over the company’s financial statements, reviewing its management team, looking at its competitive position and that of other companies in its industry. It means looking at the state of the industry itself and of the region or regions in which the company does business.

Benjamin Graham wrote the book on security analysis. Literally. At least he co-wrote it, with David Dodd. Security Analysis, first published in 1934 – along with The Intelligent Investor, originally published in 1949 – helped earn Graham the nickname Dean of Wall Street. Warren Buffett, whom Graham famously mentored, called The Intelligent Investor “the best book about investing ever written.”

The books contributed significantly to Graham’s reputation as the father of value investing, an approach he developed with Dodd in the years leading up to the release of Security Analysis. He contributed a great deal more though, as Benjamin Graham and the Power of Growth Stocks argues. Published in 2011, author Frederick Martin makes an argument that he himself recognizes is “almost heretical.” While the man never fully endorsed growth investing – at least not at the expense of his value philosophy – Graham did come to see merit on the growth side. In making his argument, Martin challenges the reader to rethink the traditional growth versus value debate.

It’s a technical, yet practical book. Perhaps its greatest contribution is that it republishes a lost chapter from the 1962 edition of Security Analysis that Graham wrote called Newer Methods for Valuing Growth Stocks. The book as a whole has been well received though, in part because the writing is understandable and engaging.

It’s also a useful reminder of the importance of good old fashioned research.

Kevin Press

What Happened to Global Stocks?

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I was in to see an old friend from the wealth management business yesterday. Historically, global equities have been an important part of his firm’s investment focus. But the sector’s consistent poor performance is having exactly the effect you would expect.

“I’ve got this big leaky boat,” he said to me. That can only mean one thing in the money management business: clients are withdrawing their money and taking it elsewhere. Redemptions.

“We’re busy building a new boat inside the leaky boat.” That means his firm is developing new investment strategies to attract investors burned by global stocks.

What happened? The numbers below from The Wall Street Journal Market Data Center highlight how broad-based the downturn was in 2018. Keep in mind these are year-to-date numbers. Long-term investors (which includes anyone saving for retirement), should never overreact to one-year returns.

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Still, it’s important to understand what’s going on. A lot of this negativity came up in the fourth quarter of last year. Does all this red ink signal an incoming global recession?

Opinions are split. Some believe this correction has brought stock prices down to a more reasonable level. In fact, we have seen signs of a turnaround since the holidays. It stands to reason that stock valuations would come down as central banks push interest rates up.

Others are worried about weakening manufacturing numbers and the nearly inverted yield curve. That’s a measure of the difference between the U.S. 10-year and 1-year Treasury Notes.

Typically, investors demand a higher yield on 10-year notes because they have to wait longer to cash out. When investors lose confidence in the short-term economy, that gets turned upside down. They have less confidence in short-term bonds so they demand a higher yield. We watch the U.S. Treasury Notes because recessions in that country have such a consistent impact on the global economy (particularly ours here in Canada).

In a note to investors yesterday, RBC Wealth Management’s Jim Allworth wrote: “We would point out that the yield curve has not yet inverted … and it is not a forgone conclusion that it will in the near future.”

The bank predicts that the U.S. will “go on growing into and perhaps through 2020.”

Yesterday’s edition of Scotiabank’s Global Outlook struck a similar tone. “Our forecast currently calls for global growth to slow from 3.7% in 2018 to 3.5% in 2019. However, the evolution of equity markets through the fall, along with movements in the yield curve suggest a much greater markdown in growth is anticipated, including possibly a recession in some countries. … Our own recession probability model for Canada, which considers a range of economic and financial variables, suggests the risk of a recession remains very low.”

The report goes on to note that there would have to be some kind of “trigger,” such as a worsening of the U.S.-China trade relationship to make recession likely.

So while stock markets are flashing warning signs, there is no consensus that a recession is around the corner. And again, one-year returns should never drive dramatic changes in a diversified investment portfolio designed to achieve long-term goals.

Just the same, keep an eye out. This is a good environment to be managing your expenses carefully and giving some thought to an emergency savings fund.

Kevin Press

Welcome to Today’s Economy

image 2019-01-09 at 6.18 pmHere’s a promise.

I’m going to do my best to help Canadians understand what’s happening in the economy – at home and around the world. I’m not here to sell you anything. I have no agenda beyond wanting to help readers understand the world just a little bit better so that they can take care of the ones they love.

A bit about me. I’ve been writing about economics, household finances and retirement planning since the mid-1990s. I was a journalist initially, and then joined one of the country’s top insurance companies as a marketing/communications leader. Both experiences taught me the value of learning and the feeling of confidence that comes from having even a rudimentary understanding of how money works.

You’re going to see a few key themes covered in this space:

  • Expect a recession sometime soon. This year marks the 10th consecutive year of economic growth in Canada. Yes, we’ve been mired in an extended period of slow growth since the financial crisis. Just the same, we’ve seen positive numbers every year since 2009. That’s not normal. The C.D. Howe Institute reports that economic expansions have averaged about half a dozen years each since The Great Depression.
  • Interest rates matter more than ever. Low rates began to emerge as an issue for long-term investors in the 1990s. But that was nothing compared to the super-low rates implemented by central banks around the world to spur growth after the financial crisis. The Bank of Canada announced today that it will maintain its target for the overnight rate at 1.75%. Like other central banks, they’ve been working to inch that rate up. (Canada’s key rate hit a low of 0.5% in 2009.) But they have to tread carefully. Rising rates slow economic growth, so of course the risk is that they will tip the economy into recession. But if/when a recession does occur, central banks need to have room to lower rates in order to help the economy recover. You can’t do a lot of cutting when your starting point is less than 2%.
  • Navigating all this means understanding risk. That goes beyond traditional investment risk. Canadians are living longer than ever. That means longevity risk, which is to say that you might outlive your savings. In a connected world where government decisions often have global implications, political risk is significant. Canadians who invest in the U.S. market are well aware of currency risk. There is much to consider.
  • All of this is affecting how Canadians plan for the future. That’s especially true for long-term savings goals like retirement. Don’t be surprised if you’re still working at 70. And don’t be put off by that. It may be the best thing for you.
  • More than ever, it’s up to you and me. Employers have been stepping back from the old-school, paternalistic approach they’ve historically taken with retirement, life and health insurance benefits. Much has been written about the move from defined benefit to defined contribution pensions for example, which puts the onus on individuals to make investment decisions. The discontinuation of retiree benefits is another big story. It’s not clear how this will play out as baby boomers continue to enter retirement. Few expect governments to fill the gap, but it’s too early to make bold predictions on that. Obviously though, we have to be prepared to take care of ourselves to an extent that our parents weren’t required to.

If you’d like to see something covered, please shoot me a note. And if you know someone who will value Today’s Economy, please share.

Kevin Press