I'm a value guy -- I have a dog-eared copy of Graham and Dodd's Security Analysis in my office, a significant chunk of my net worth is in Berkshire Hathaway stock, and when I pick individual stocks, I go after those that are trading below intrinsic value, like those suggested by Philip Durell in his Motley Fool Inside Value newsletter.
But for a long time now, I've had a feeling that maybe I'm missing something by not investing more in growth stocks, even ones that are fully valued. The recent dueling Fools exchange on the issue of value versus growth further got me thinking, so I sat down with pen and paper (figuratively speaking, that is -- I actually fired up Excel on my laptop) and did a few back-of-envelope calculations to test my intuition by calculating potential returns from a growth-based approach versus a value-based approach. I started with basic, theoretical assumptions, which I then adjusted step-by-step.
Theoretical fundamentals
I started with two hypothetical stocks, one a growth stock (call it New Tech Co.), the other a no-growth stock (call it Boring Industrial Co.). For the sake of simplicity, I started by assuming that both stocks had cash flows of $100 in the first year. I assumed that the cash flows from New Tech grew at 8% per year and the cash flows of Boring Industrial remained flat at $100 forever.
Simple math tells you that the intrinsic value of a stock like Boring Industrial, with cash flows of $100 into perpetuity is $1,000 (using a 10% discount rate), or 10 times the underlying cash flows. That intrinsic value never changes.
The growth stock, on the other hand, has intrinsic value of $5,000, or 50 times the current cash flow. The intrinsic value grows by 8% per year (in year two, cash flows are $108, which implies an intrinsic value of $5,400, etc.).
So, in a world where all stocks are accurately valued and cash flows grow into perpetuity, one is clearly better off investing in a growth stock than in a no-growth stock. If I had $10,000 to invest in the first year, I could purchase 10 shares of Boring Industrial or two shares of New Tech. After 10 years, my 10 shares in Boring Industrial would still be worth $10,000, while my shares of New Tech would be worth $21,589.
Injecting some reality into the assumptions
Sadly for that scenario, we obviously don't live in a world where stocks are always priced at intrinsic value and where profits grow to infinity. So I adjusted my assumptions. I assumed that New Tech's cash flows grew rapidly (20% per year) for 10 years and then profits stayed flat for the next 40 years. Boring Industrial had flat profits for 50 years.
In this scenario, Boring Industrial's intrinsic value was still about $1,000 ($991, to be exact). New Tech's intrinsic value was now $3,333, or about 33 times current cash flow. The high multiple makes sense given that with a 20% annual growth rate for 10 years, cash flows would increase from $100 per year to over $500 per year after 10 years.
So with my $10,000 to invest in the first year, I could now buy 10 shares of Boring Industrial or three shares of New Tech. After 10 years, the intrinsic value of Boring Industrial would be essentially unchanged. On the other hand, the intrinsic value of New Tech would now be $5,046 per share and my $10,000 would be worth $15,100 -- a 51% return on my investment. So again, growth beats no-growth.
But what if I could buy Boring Industrial at a significant discount to its intrinsic value? Let's say that the stock was trading for $500 instead of $1,000. I could buy 20 shares of stock, which would then be worth $20,000 after 10 years, assuming the stock price returned to reflect intrinsic value over time. I would have doubled my original investment (a 100% return) and easily beaten the return from New Tech.
So the next logical question is then: At what annual growth rate (for the next 10 years) does New Tech allow me to double my original investment and match the returns from buying Boring Industrial at a 50% discount to its intrinsic value? The answer is about 70% per year -- that means that cash flows would have to grow from $100 to $11,245, or increase over 100-fold over 10 years. Anything less would result in a lower return on investment than in Boring Industrial.
Implications for individual investors
Which is easier to find: a fully valued growth stock that is going to increase profits 100-fold over the next 10 years, or a company that is trading at a 50% discount to its intrinsic value? For me the answer is clear, and supports what I intuitively already knew -- I would much rather spend my time and energy trying to find undervalued, boring companies than to try to find the next Microsoft, for several reasons.
First, as the simple calculations above demonstrate, in order for growth stocks to match the returns from undervalued stocks, the threshold for growth is very high. I may be able to identify a company that can grow 10% or even 20% per year and that is fully valued, but finding one that is going to grow 70% per year is much, much harder to do.
Second, there is significantly more uncertainty in predicting cash flows in high growth companies (e.g., how to estimate Google's (NASDAQ:GOOG) cash flow five years from now?) than there is for stable, no-growth or slow-growth companies.
Third, I know that the market is mercurial and volatile, because companies, stocks, and sectors all fall in and out of fashion. I know that over a long enough period, most stocks will at some point be priced at a significant discount to their intrinsic value. With patience and discipline to wait for those opportunities (Buffett's famous "fat pitches"), I know that opportunities to buy stocks at a discount to their intrinsic value will present themselves.
Obviously, the best possible investment is a combination -- buying a growth stock at a discount to intrinsic value. But if forced to pick between the two, there's no doubt that for me, value beats growth hands down. And I manage my own stock portfolio in a way that is consistent with that conclusion -- I recently sold shares in Whole Foods (NASDAQ:WFMI), a great growth company whose shares I think are fully valued.
While finding stocks trading below intrinsic value in today's market is tough, there may be opportunities in beaten-down sectors like pharmaceuticals, where stocks like Merck (NYSE:MRK) and Pfizer (NYSE:PFE) are trading at historically low valuations. The Motley Fool Inside Valuenewsletter is also filled with ideas for value investors.
Until someone convinces me otherwise, I'm going to continue to spend my time looking for opportunities to buy boring stocks for cents on the dollar, rather than chasing the next great growth stock.
Fool contributor Salim Haji lives in Denver and owns shares of Merck and Berkshire Hathaway. He does not own shares in any other companies mentioned.
