Value and Growth

(Continuing on the wonderful compilation of Warren Buffett's sayings done by Bud Labitan called "The Warren Buffett Business Factors" but unfortunately the link I had recorded is broken.)

"We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one

(a) that we can understand;

(b) with favorable long-term prospects;

(c) operated by honest and competent people; and

(d) available at a very attractive price."

We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute "an attractive price" for "a very attractive price."

But how, you will ask, does one decide what's "attractive"? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition:

"value" and "growth."

Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).

Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield.

Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.

Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.

Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.

At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.

Now, we believe that it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. When buying companies or common stocks, we look for first-class businesses accompanied by first-class managements. We know that time is the friend of the wonderful business, the enemy of the mediocre.

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Growth is always a component in the calculation of value.
Growth is always a component in the calculation of value.
Growth is always a component in the calculation of value.
Growth is always a component in the calculation of value.
Growth is always a component in the calculation of value.
Growth is always a component in the calculation of value.

There. I have said it six times and I will continue saying it once again.... :)

Growth is always a component in the calculation of value.

However, do remember that business growth, per se, tells us little about value.

Do not be tempted just because of this growth story!
A lousy company can always grow!!

Remember the issue of the engineering of earnings growth? One can always use borrowings to boost up their unstable business to dizzy heights.... and commonsense tells us that this kind of business just will not last!

These are the type of business that are doomed for failure sooner or later. So be warned again. Do not be tempted by such growth story.

Isn't it more important for us to ask if there value in the growth story? Is there a creation of weath in the growth story?

For example, a good logical question to ask is simply Where is Ze Moola!

Meaning to say, sometimes we can have a fantastic company growing about say 30% growth in earnings per year. However, when we examine the company's balance sheet, we have it diffficult to find the value being created despite all the fantastic growth. The cash in the piggy bank does not even grow but depletes and the company borrowings keeps on increasing, in fact it increases more than what the company earns. or all the earnings growth announced by the company.

Too complicated?

For example, say this company says it makes x amount of millions in profit per year. But the company's cash flow only shows maybe 40% of that x amount in millions. And the loans increase by say 5 times x amount of millions. So despite the growth, there is not much value being created in the company's balance sheet. The most important asset, the piggy bank, does not grow in proportion to what the company is growing.

Still too complicated?

In local layman terms, "Aisehman! Company say make sibeh geng profit wor! Last year 20 million. This year it say it more geng wor! 28 million wor. But how come I see piggy bank duit become less and less? err.. mana tu duit pegi tok? Piggy bank decresed by some 8 million! Err... wonder got bruff-bruff people one onot?"

And in such instances, most of the time, we really do not understand what is happening! And since we do not understand what is happening, then perhaps it is much better to forgo the opportunity in this so-called growth stock and wait for a better opportunity in another stock, one that we know precisely how and what is happening in the business of the stock.

And oh... do you reckon that it is a crime to miss such growth opportunity as described earlier?

Or is it even a bigger crime to be made a fool out of our hard earned moola when we invest and incur huge staggering losses in investments we simply cannot comprehend?