How I combined the best of value and growth investing
If you've followed my work for long, you likely know that I've changed my investing approach over the years from the old-school value style...
It's a hybrid approach incorporating the best of both value and growth investing – what I've been calling "make money" investing.
So today, I'll follow up on yesterday's e-mail – in which I shared the highlights of my presentation on the principles of successful investing.
Now, I'll share the highlights of another presentation I put together a few years ago on how I changed my approach from traditional value investing to this hybrid "make money" investing style.
For nearly the entire period I managed multiple hedge funds, from 1999 through 2017, I applied the classic principles of value investing. In practice, it meant that I focused on buying cheap stocks.
As a value investor, I mostly owned stocks that were trading at low multiples of sales, earnings, and/or book value. In most cases, the stocks were cheap because the companies were performing poorly.
I cared about businesses' quality and future growth prospects, but this was secondary to whether their stocks were cheap.
As such, I made what I call the four mistakes of value investors:
- Investing in low-quality businesses whose stocks were value traps because the businesses' fundamentals continued to decline.
- Failing to buy high-quality businesses whose stocks were fabulous long-term compounders.
- Selling the stocks of great companies way too soon because they had risen and didn't appear as cheap.
- Failing to understand/appreciate powerful new technologies/trends.
However, I estimate that 75% of what matters in terms of a stock's performance over time is how the company performs, versus only 25% being its valuation at the time of purchase.
For my entire career, I had this backwards. I looked among cheap stocks and tried to find good businesses, when I should have looked among good businesses to find reasonably priced stocks.
Focusing primarily on a stock's current valuation rather than the long-term prospects of the underlying business was a terrible mistake that previously cost me and my investors dearly.
However, this doesn't mean that you should run out and simply buy the stocks of the greatest companies... because then you're likely to make the four most common mistakes of growth investors:
- They overestimate future growth, forgetting the powerful force of reversion to the mean – driven by technology changes, new competitors, size acting as an anchor to growth, etc. (Trees don't grow to the sky!)
- They pay too high a price for a stock, such that even if the business performs well, the stock doesn't.
- They fall in love with great companies and fail to sell when they should.
- They get sucked into "story stocks."
I now combine the best aspects of both value and growth investing to maximize my returns as a "make money" investor.
There are a number of key principles involved here...
First, it's critical to understand that the vast majority of stocks follow the earnings trajectory of the underlying companies over long periods of time (five or more years).
Next, I'll share charts from my presentation that show some great companies whose stocks rarely if ever appeared cheap, yet were some of the greatest compounders of all time. (Note that these charts end in 2018, when I first put together this presentation... but the stock and earnings trends – and underlying lesson – haven't changed):
Of course, it's possible to pay such a high price that even a long period of earnings growth results in a flat or declining stock price, but such cases are rare.
One that comes to mind is the most popular stock early in my career, Cisco Systems (CSCO), which was the Nvidia (NVDA) of its day – a company that could do no wrong, for which no price was too high to pay. It briefly had the highest market cap in the world.
As you can see in this next slide from my presentation, after peaking at the height of the Internet bubble in early 2000, when it traded at more than 150 times earnings, the stock fell by 85% when the bubble burst:
Nearly a quarter century later, despite big earnings growth, Cisco still has yet to surpass its bubble highs.
To summarize, to be a "make money" investor, you need to apply both the growth and value investing toolkits to identify great companies that are going to grow and grow and grow – and be willing to pay what looks like a high price for their stocks, but be careful not to overpay.
Three examples of such stocks today are my three favorite tech giants, whose stocks I've been consistently bullish on for the past five years: Alphabet (GOOGL), Amazon (AMZN), and Meta Platforms (META).
In Monday's e-mail, I'll talk about another important skill successful investors need: the ability to identify and avoid value traps. Stay tuned next week!
Whitney
P.S. I welcome your feedback – send me an e-mail by clicking here.