Labels and the Importance of Earnings
In a reversal of a long, consistent trend, we just experienced a year where “value” stocks outperformed “growth.” In 2022 the Russell 1000 Pure Value index lost 8% while the Russell 1000 Pure Growth Index fell 38%.
Though they are widely used, I’ve never been fully comfortable with these classifications. To be fair, the labels serve a purpose, as people generally understand what they mean. “Value” typically implies something along the lines of a company with a low price-to-earnings ratio or a low price-to-book value. Growth, I think, is self-explanatory. While conceding these can be useful labels, they ignore important nuance and can be misleading.
As investors with a growth bias, we bristle a bit at the idea that this somehow excludes us from engaging in “value” investing. In fact, we look for the synthesis of both. While growth is a key criterion of the companies in which we invest, our job in picking stocks is to find companies where the share price is below a company’s true underlying worth —to find value. As a famous “value” investor from Omaha has said, “price is what you pay, value is what you get.” The value you receive upon the purchase of a stock is not determined solely by something like a low price-to-earnings ratio, nor is it determined solely by growth. Many things can drive value, and growth can often be an important factor. A key determinant of value is the timing and amount of free cash flow a business generates on a per share basis, for which most people use reported earnings as an approximation. Compare the projected free cash flow per share over time to the cost of the shares and you are well on your way to determining if there is value to be had.
Not only in reality are the lines blurred between “value” and “growth,” but, within each category there exists a wide array of companies that can sometimes feel totally unrelated. For example, under the “value” classification, a slower growing but profitable company like Kraft Heinz is very different from a company that produces no earnings but trades at a discount to its tangible book value. Yet both would generally be considered “value” companies. Similarly, the “growth” camp includes both companies with a long track record of growing earnings and speculative growth companies where profitability, if it ever materializes, remains far in the future. This is an important distinction.
Many companies in the speculative growth camp capture investors’ imagination, with narrative and not results. In past Viewpoints we’ve discussed bubbles and how companies ultimately need to reach profitability. When interest rates were essentially zero and capital was widely available, the market did not pressure high growth companies to be profitable, instead encouraging the buildout of scale in an attempt to become “the Amazon of” whatever industry they operated within. Without reported earnings to help keep expectations tethered to reality, several of these companies achieved valuations that were extremely difficult to understand. Jokes even circulated in the investment community that for a speculative growth company it was detrimental to even post earnings, as then there would be a P/E ratio to scrutinize. “Can’t have a high P/E if you have no ‘E’!”. That our stocks, backed by profitable companies, lived under the same “growth” classification as some of the more egregious examples of speculative growth was somewhat uncomfortable. Some “growth” investors require earnings, others scoff at them (at least in the short term).
Buying stock results in an ownership stake in a business, and if there are never any earnings what is that ownership stake worth? As interest rates lifted from zero, unprofitable companies came under significantly more scrutiny, and many saw enthusiasm for their shares crater. While all growth companies suffered in 2022 (which makes mathematical sense as future earnings were discounted back at a higher rate) unprofitable companies were even more severely punished.
This obviously does not mean unprofitable growth stocks cannot mature into wildly successful investments— Amazon is the obvious example. However, making the transition to profitability is no easy task. Just like the labels “value” and “growth” are overly broad, so is “speculative growth.” Some of these companies will find a way to profitability, while others never will.
J.P. Morgan recently published an interesting study of tech companies during the 2000-2002 dot-com crash, with cohorts separated by their initial and subsequent profitability. The period the study covered was from 2000-2004 and it showed while companies that were unprofitable in 2000 sold off the most aggressively between 2000 and 2002, formerly unprofitable companies that turned the corner and achieved profitability by 2004 (about 50% of the initial “unprofitable” group) rallied the strongest and modestly outperformed even those companies that were profitable in both 2000 and 2004. Shares of companies that were initially unprofitable and remained so badly lagged the performance of the other two cohorts.
This study underscores that in times of market turbulence, the luster comes off story stocks as investors prioritize profitability –not a surprising result, but the runup to the dot-com crash is yet another reminder that occasionally the market meaningfully downgrades profitability as a priority. Even so, at some point earnings matter and focus always returns to this metric. We will maintain our focus on investing in growing, profitable companies, while striving to invest at a meaningful discount to what those companies are truly worth. In our view, this tried-and-true approach encapsulates both growth and value, regardless of how the market would broadly label it.
James M. Skubik, CFA