In My Opinion Value, Growth, and Buffett

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By ctm
April 24, 2002

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Last week in Lincoln, Nebraska, Warren Buffett told a group of school kids that when it comes to investing he's "a no-risk guy -- always have been."

He said this in the familiar context of saying that he's more comfortable with Fruit of the Loom than with figuring out what the Internet will look like in 15 years. "We'll be wearing underwear in 15 years, Internet or not."

Now this doesn't mean that an investment in Fruit of the Loom is necessarily no risk. Nor does it mean that an investment in eBay is necessarily risky. I think what it gets to is a distinction that Buffett himself says is meaningless, but that his actions over the years suggest is not entirely meaningless. That's the distinction between growth and value.

In declaring the distinction meaningless, Buffett has pointed out that the only way to value a business is to look at the cash you'll be able to take out of the business over its remaining life. That the cash is growing or not growing is not relevant. You simply look at how much cash you can take out and when. You discount that cash flow back to the present at some appropriate rate and you have a value for that business. It doesn't matter whether the business is growing or contracting. The business selling at the largest discount to your assessed value is the one to buy. Therefore, all investing is value investing and to make a distinction between value and growth is meaningless.

As a younger man Buffett tended to buy businesses of lower quality, but in the last several decades Buffett has gravitated toward the better businesses, the ones with the brighter futures rather than the dim ones. As Charlie Munger has said, it's no fun owning something that you hope liquidates before it goes out of business. So, part of the transformation is just plain fun, but these better businesses do have two advantages over the stagnant or declining businesses. They allow for the deferral of tax consequences as you wait for the cash to be realized and paid out and they don't require new ideas all the time since the cash isn't being paid out until later. But the fundamental idea remains unchanged. You estimate how much cash you'll receive and when. Then you discount that cash flow to today.

Yet with few exceptions (Executive Jet), Buffett is a "what have you done for me" sort of investor. He says right in the annual report every year that projections of future earnings are of no interest to him. A prospective Berkshire company must have demonstrated earning power. I think that this comes back to risk. All companies have some risk of not turning out as you'd expected them to when you bought them. Buffett is not immune from this type of risk. But if you're paying a price that reflects much better future performance, or large cash flows in the future relative to the past, you're taking a larger risk than if you pay a price that reflects what the company has already shown itself to be capable of doing.

Of course the circumstances that led to past performance could change so you can't just go blindly by the past. But when you pay a price that reflects a much brighter future, you're assuming that new customers will materialize, that sales increases will happen, that the company will be able to acquire new and adequate property and equipment, that additional quality labor will be available at an affordable price, that the company will know how to adequately deploy ever-larger amounts of capital, and so forth. These projections into the future entail greater risks than looking at some business that has been operating more or less unchanged for generations and trying to assess whether or not it can continue.

So I think this is at the heart of the value versus growth debate. Theoretically, there is no difference between the two. But, practically, if your discounted cash flows reflect a future much grander than the past, that carries with it greater risk. Buffett has tended to stay clear of those sorts of investments because, as he says, he is and always has been a no-risk guy.

[What's your opinion? Are value and growth the same? Join us on the Berkshire Hathaway discussion board and enjoy the debate.]

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