Letters

Growth is Value – February 2019

Growth is Value

Somar firmly disagrees with the conventional distinction between “growth” and “value” styles of investing. They are not mutually exclusive. In fact, growth is an ingredient for value creation. We believe this misperception opens opportunities for long term investors who have the skill, discipline and staying power to invest in mispriced growth opportunities.

Analysts conventionally call “value stocks” to securities that have low multiples based on published historical financials and therefore appear to offer a good value to buyers. Conversely, they call “growth stocks” to securities of companies that appear to be growing sales and / or profits at a fast pace and may be trading at higher than average multiples of historical financials.

In our opinion, most investors and analysts mistakenly confuse “value investing” with investing only in “value stocks”. We have a different perspective.

Value investing consists of buying securities for significantly less than their inherent value thereby investing with a “margin of safety”. Buying solid average businesses trading at below average valuation is a clear and straightforward way of achieving this. So much so that early practitioners of “value investing” focused almost exclusively on this path.

Another path is buying superior businesses, early in their development cycle, for much less than their inherent value. Given the early stage of these businesses’ development, they will likely trade at above market valuations when compared to their historically reported financials. Most will be classified as “growth stocks”. Regardless, a lot of them can be bought at significant discounts to their inherent future value creation capability, providing significant value and high returns to long-term investors.

Let’s illustrate this point with two hypothetical examples.

Company V is a mature company with no real growth, stable margins and distributing 100% of its profits to its shareholders through dividends. Its stock is trading at 10 times its just reported earnings. Considering this is materially less than the typical mid-teens multiple of earnings that the overall S&P 500 index tends to trade at, it is considered a good value stock.

Table 1 shows a value investor can expect to earn an average return of 10% by investing in the stock over a 10-year period, assuming he is able to sell his stock at the same 10 times earnings multiple in year 10.

Table 1
Source: Somar
Assumptions: Mature company with no need to further invest in working capital and whose capital expenditure [capex] matches its annual depreciation expense. 

 

Company G is a fast-growing company early in its development stage. It is expected to grow its sales at an average compound annual growth rate [CAGR] of 22%. Its margin is expected to expand gradually to 20% as it benefits from economies of scale and reduces its investments in growth. Given its fast growth, company G needs to invest about 2% of its incremental sales into working capital. In addition, its annual capex exceeds its annual depreciation by 4% of sales every year to fund its growth.

Given its strong growth prospects, company G’s stock trades at a higher multiple of its earnings (200x) than company V’s stock and the S&P market. Company G’s stock also trades at a multiple of 4x its trailing sales vs. 1x trailing sales for company V’s stock.

Despite its higher multiple on historic financials, company G’s stock proves to be an even better value than that of company V. Table 2 shows, an investor in company G’s stock would achieve a 19% rate of return if he held the stock for 10 years and sold at a depressed 10x trailing earnings multiple at the end of year 10 (exiting his investment at the same multiple as that of company V – please see Table 1).

Table 2
Source: Somar
Assumptions: Growing company whose profit margin gradually increases to 20%. Needs to invest in working capital and capex to materialize its growth opportunities.

Company G’s growth brings its multiple overtime well below that of company V (see Table 3). Therefore, growth is a very important consideration in determining the value of a company. What looked like an extremely expensive 200x earnings multiple at year 0 for company G, quickly became a mouth watering 7.8x trailing earnings multiple by year 5 and a “steal” multiple of 2.7x by year 10.

Table 3
Source: Somar

This is not always the case though. The math worked that way in our example but if we change the numbers, our conclusion could flip to make company V’s stock the better value. The important point here is that just by looking at multiples of historical value you can’t know which investments provide the most attractive returns.

That said, Somar believes there are currently more opportunities to find value in growth stocks than in low multiple stocks. This is due to two reasons:

  • There are many investors that specialize in finding low multiple stocks. This “deep value” strategy was pioneered by Ben Graham in the early part of the 20th century. Its strong success spawned a lot of disciples and followers which increased the competition for these opportunities, eliminating much of the low-hanging fruit of the early days
  • The advent of the internet and computers made this strategy easier to implement and made it much easier and faster to identify extremely low multiples on historical financials. Stock’s trading multiples on reported figures are widely disseminated through Bloomberg, Google, Yahoo, Reuters and many other sources. Most of these tools also provide screening and filtering tools to facilitate the identification of stocks trading according to these low multiple criteria. Algorithms can be developed for computers to buy and sell based on these metrics. Paraphrasing Charlie Munger, this lake has a lot of fishermen on it and there are limited fish left to catch.

Conversely, an analysis like the one we made on Table 2 for company G is not readily available for download. It requires business judgement and is also prone to mistakes. Most sell-side research analysts publish financial estimates for the companies they cover, but few venture modelling more than 3 years ahead. In addition, these estimates frequently prove to be materially off the mark. Therefore, to do this type of analysis right you need more than strong math and finance skills. You need a wide array of business skills. Here is a non-exhaustive list of analysis needed:

  • Quantify industry growth prospects
  • Evaluate the players’ offers through the eyes of the consumer: what impact is that going to have on market share?
  • Understand operational constraints and their impact on business model: fixed costs vs. variable costs; capital intensity
  • Calculate margin opportunity and potential competitive response to margin expansion
  • Evaluate management’s team ability and motivation to execute
  • Assess the key assumptions for the success of the investment and build proprietary financial model to evaluate several scenarios
  • Identify risks and conduct primary research to probe whether negative developments are likely to materialize

Somar was built to maximize our capabilities in these types of analyses. Some of our assets that have proven valuable in analyzing investments have included:

  • Professional background in operational roles
  • Unique perspective on the geographic diffusion of innovation and transfer of successful business models having lived and worked both in the United States and in several countries in Europe
  • Consistent process applied across time, geographies and industries with the same person(Portfolio Manager) defining and vetting the major operational assumptions and scenarios
  • Focus on vetting our assumptions through primary due diligence
  • Understanding of how VCs, entrepreneurs and other innovators look at the industry and its opportunities for disruption

The lack of hard data on which to base future year projections creates attractive investment opportunities, but also increases the risk and volatility of the investment. Not all investors share the same level of enthusiasm over the business prospects and therefore in times of uncertainty, the stock price of higher multiple growth stocks can fluctuate more widely than that of lower multiple growth stocks. While this presents a risk to investors with lower conviction who may be tempted or even forced to sell on the low, it presents opportunities to the investors who have done deep due diligence work supported by direct observation and therefore have higher conviction in their thesis. We have built Somar to take advantage of opportunities like this.

 

 

 

 

Disclaimer: This website is for general information purposes only and is not intended to be, nor should it be construed as investment advice, nor a solicitation or offer to buy or sell any securities, related financial instruments, or  interests in the Somar Master Fund, LP (the “Fund”) or its feeder funds. The information contained herein is not complete, and does not contain certain material information such as disclosures and risk factors about the Fund or its feeder funds. Opinions expressed are current opinions as of the date of this material only and are subject to change without notice. Hedge funds: (1) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; (2) can be highly illiquid; (3) are not required to provide periodic pricing or valuation information to investors; (4) may involve complex tax structures and delays in distributing important tax information; (5) are not subject to the same regulatory requirements as mutual funds; and (6) often charge high fees.

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