Analyses and investment views

How we understand value investing

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We always claim to be value investors. If I look at the Vltava Fund portfolio, however, I see that it overwhelmingly consists of growth stocks. Does this mean that we have changed our approach? So, what is going on here?

Value and growth investing are often set off against one another, and wholly different characteristics are ascribed to investors devoted to one of these or the other.

While value investors are commonly believed to be boringly conservative, unimaginative, and furthermore stubbornly demanding of cheap stocks, almost visionary powers may be attributed to growth investors, along with courage to take on risk and veritable largesse in what they are willing to pay for stocks. People like these narratives, but the reality is much more complicated.

First of all, there is no clear definition of what is a value versus a growth stock and therefore of what constitutes value and growth investing. Very often, we find the same stock in both value and growth indices. The boundary between growth and value stocks is very nebulous. Moreover, future growth is always a component of today’s value, and so these two things are impossible to separate from each other.

So, if an investor wants to apply one of these two fundamental notions to his or her own investment approach, it is impossible to rely on any universally valid definitions. One needs to establish his or her own definitions.

In our opinion, there exists only one logical way of investing, and that is when what we are paying (the price) is lower than what we are getting in return (the value). This mindset is universally valid and applicable also to all types of investments for which it is possible to estimate their value. In addition to stocks, it is applicable to bonds, land, real estate, private equity. That is to say, to those investments that bring their owners cash flows while holding them. For the same reason, this mindset is not applicable, on the other hand, to gold, commodities generally, cryptocurrencies, art, stamps, vintage cars, and the like.

In our eyes, value investing is investing such that the investor endeavours first to estimate the value of individual investments and then limits his or her investments to those the prices of which are substantially lower than are their values.

In this definition, to speak of the type of stock is wholly beside the point. The sole requirement is that its value should be estimated with a certain degree of reliability and probability.

Financial theory says that the value of any asset is equal to the sum of its future cash flows discounted back to the present. That means the entire value of an investment depends upon future development. The past is irrelevant in this case. We are interested only in the amounts and timing of future cash flows.

If we completely set aside the question regarding the extent to which we are capable to predict this development, it is clear that the faster the cash flows will grow in future, the higher is an investment’s present value. This brings us back to what I mentioned at the beginning. The net present value of an investment and the future growth cannot be separated. These are two communicating vessels.

All other things being equal, a better investment is the one whose cash flows grow more quickly. Therefore, I see no contradiction in the fact that we consider ourselves to be value investors but have most of our portfolio in so-called growth stocks. What remains is the question what a growth stock really is.

We live today in a time of what I call non-profit prosperity. Many companies are in a mad rush to grow sales and present this very growth as a sure sign of success and prosperity, despite the fact that this is accompanied by nearly hopeless loss-making. It is interesting that many investors still buy into these fantasies and are ready to keep these companies afloat with their own money.

We do not regard such companies as growth companies. Our definition of a growth company is one whose value grows at a rate of at least 10% annually.

Not sales or some kind of adjusted EBITDA, but the actual value needs to grow at a double-digit rate. This is very important, because not every kind of growth creates value. The striving for growth often can be accompanied by destruction of value. On the other hand, it also can occur that value grows even without any dramatic growth in sales. We can find many examples of both on the markets.

We love growth stocks and strive actively to search them out. At the same time, though, we are cognisant of our limited ability to foresee the long-term future.

So, we like best such stocks for which long-term growth in value can be expected with a reasonable degree of probability and, at the same time, whose prices are not too high. Sometimes, we even succeed to find stocks wherein we pay nothing at all for the future growth.

If, for example, we buy a stock with P/E multiple of 5 and expect high double-digit growth in value, we need not rely on the successfulness of our own assumptions, because it is possible to show that the whole future growth is given to us as a free bonus. Such stocks are rare, but it is possible to find them. There is no contradiction, then, in the fact that value investors have nearly an entire portfolio made up of growth stocks. Invest with care!

Daniel Gladiš, October 2019


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