Common Mistakes of Value and Growth Investors
Last week we distilled down the difference between "value" and "growth" investors. Now let's talk about the common mistakes each make so we can all avoid repeating them in our own investment journeys.
Where Value Investments Go Wrong
Failed value investments are usually wrong because investors under-estimate the decline in the business’ prospects and/or overestimate the value of the assets on a company’s books. Many value investments look unbelievably cheap. For example, the stock may trade for 50% of the assets on the books. In this case you could theoretically shut down the company, liquidate the assets, pay off the liabilities and return the left over cash to the investors…with a material profit!
That is rarely how it actually works though. There is an old saying, “we don’t know how much the assets are worth but we are confident all of the liabilities are real”. The assets often have to be discounted substantially to be sold (particularly if the buyers know you are in liquidation) and yet you never seem to be able to get any discount on your debt. We have been hit by this in the past and luckily we learned it very early. In liquidation scenarios we now mark down receivables to 75%, inventories to 50% and prepaids / fixed assets to 25%, while keeping liabilities at 100%.
The good news is that value investments on average tend to work out just fine if you buy at a price that provides a lot of leeway for things to go wrong…because they often do. The key is the price you pay. There is no such thing as a bad asset, only a bad price.
Where Growth Investments Go Wrong
Failed growth investments are usually wrong because investors over-estimate the business’ prospects and therefore over-pay for what may prove out to be a very good business but maybe not as good as they expected. Growth investments tend to be more fun and are in many ways much more seductive than a value investment. Looking at a balance sheet and seeing a lot of cash that could be yours can be fun. Looking at Facebook’s ridiculous growth in revenues, user counts, etc. and imaging all the things that Zuckerberg and Co. are going to pull off is even more fun.
Where investors make mistakes with growth type investments is they let their dreams get ahead of reality. A lot of this is simply emotional. A company has grown and grown and grown, the stock has gone up and up and up. That is a lot of fun and no one wants that to end. However in order for that to continue happening, the business has to keep that growth going on an even larger base. In many ways a growth investment is a harder call to make because your margin for error is much smaller. If you are predicting a company will grow 30% for the next 5 years and it grows 20% (which is still great) there is a solid chance you will lose a lot of money because your valuation was wrong.
All of that being said, if you get the growth investments right, you are going to make A LOT of money…you just have to be patient enough to buy the growth investments at a price that gives you some leeway when the growth starts to slow.
What We Prefer
As mentioned in a previous note, growth is an integral part of value. The best of both worlds is to find an incredibly fast growing company trading at a very cheap price. However, those opportunities are rarely available. Therefore, we tend to lean more towards the value end of the spectrum as there are less variables that rely on an unknowable future. The future rarely ends up reflecting what you think it will, making it very hard to invest based on that. But if you can find an investment that is cheap based on current metrics while having substantial growth opportunities it is the best. It would be like finding a rental property that throws off substantial cash flow while also being in an up-and-coming neighborhood that will also increase the value of the home. Hard to beat that.
Until next time...
All the best,
Your Fortis Capital Management Team