Buffett’s Mixology
by Michael Peltz October 2001, Worth Magazine
The greatest investor of all time offers his recipe for the perfect stock: blend one part value with an equal part growth.
I don't know about you, but I pay a lot of attention when the world's second-richest man has something to say. I'm referring, of course, to Berkshire Hathaway chairman and CEO Warren Buffett. He may not have caught up with the invention of the transistor (Buffett famously refuses to invest in technology because it's too complicated), but his latest annual letter to shareholders contained an especially timely comment on the biggest debate in investing: "Market commentators and investment managers who glibly refer to 'growth' and 'value' styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component — usually a plus, sometimes a minus — in the value equation."
This is a critical concept that often gets lost in all the shouting between the proponents of the value and growth styles. Value investing — to offer a brief definition — is about identifying out-of-favor or underappreciated companies whose assets are arguably worth more than the stock price reflects. Growth investing, meanwhile, is about identifying rapidly expanding companies that stand to earn much larger profits in the future than they do now. The difference in emphasis means, among other things, that value managers tend to focus on cyclical industries such as energy and basic materials, whereas growth managers tend to load up on companies in burgeoning sectors such as health care and technology.
The growth and value approaches typically exchange popularity. From 1993 through the first quarter of 2000, growth stocks outperformed value stocks by 83 percent, according to Ben Inker, director of asset allocation at Grantham, Mayo, Van Otterloo, a quaint shop in Boston that manages $22 billion for institutional investors. During the past year, however, value has outperformed growth by 64 percent. "We're close to a time when value and growth are trading normally to each other," Inker says. One caveat: Trends often overshoot the mark, so value may continue to outperform growth for another year or two before the pendulum starts to swing back.
Investors can avoid being whipsawed by blending the two approaches. As Buffett correctly points out, they actually complement each other.
Guy Elliffe makes a living doing just that. He runs the aptly named Jurika & Voyles Value+Growth Fund. Like many investment managers, he analyzes a company's prospects using what's known as a discounted cash flow model. The discipline forces him to consider a company's projected-earnings growth rate to determine the present value of its ability to generate cash. Given the current economic uncertainty, Elliffe says, the best values come from companies with the most predictable growth, not necessarily the largest growth.
Elliffe likes First Data Corp., a financial services firm that provides credit card processing and payment services. At a recent price of $67, the company traded at the equivalent of 27 times this year's expected earnings. Although that's roughly in line with the current price-to-earnings ratio of the Standard & Poor's 500 Index, Elliffe thinks First Data stands a good chance of achieving 15 percent annual earnings growth during the next five years. "Ten to 12 percent earnings growth over the next five years is wonderful performance," Elliffe says. "We don't expect more than 10 percent of the companies in the S&P 500 to be able to do that. If we can find companies trading at 15 to 30 times earnings that can grow earnings 10 to 12 percent, that's pretty good." Hormel Foods, McGraw-Hill, and Nationwide Financial Services are stocks that meet Elliffe's criteria.
A truly integrated value-growth approach can yield some unexpected names at some very unexpected times. The quants at Grantham Mayo have developed a computer model that factors in the likely sustainability of profit growth along with a forecast of future cash flow. Late last year, this intrinsic value model showed that Microsoft — one of the all-time greatest growth companies — was among the cheapest 10 percent of all large-cap stocks based on the current value of its future cash flow. Grantham Mayo bought Microsoft in the mid-$40s for its large-cap value fund, despite the possibility of a potential breakup of the software giant.
Today that investment looks prescient, as some of the turbulence around Microsoft has died down and growth managers such as Janus have flocked back to its shares. The price is now in the $60s. With expected annual earnings growth of 15 percent during the next five years, Microsoft is still an attractive holding, says Grantham Mayo's Inker, although it would have to fall into the mid-$50s before his firm would consider adding to its position. Other inexpensive high-quality growth stocks recently picked out by Grantham Mayo's computer model: Altera, BMC Software, Boston Scientific, Oracle, and Safeway. All are expected to deliver 15 to 25 percent earnings growth during the next five years.
True value-growth investors need to be willing to look at any company in any industry. Just ask Warren Buffett, who is not quite the Luddite that he wants us to believe. In the second quarter, his holding company Berkshire Hathaway bought 2.25 million shares of Honeywell, which makes everything from high-density circuits to air traffic control systems. Analysts forecast that Honeywell's earnings will grow 15 percent a year for the next five years, but at a recent price of $37 its stock is trading at just 17 times this year's consensus earnings forecast of $2.20 a share. Not even a technophobe can pass up a bargain like that. |
