Interestingly, none of the equity strategies we invest in at BBH, either managed proprietarily or with an outside partner, uses a growth or value index to benchmark performance. This is not a surprise, given that BBH and our partners are not believers in the value vs. growth investing framework.
The False Distinction
As mentioned, we believe characterizing stocks and funds as either value or growth does not add meaningful insight into a manager’s risk or return profile, as it seeks to draw precise boundaries where none exist. At the most basic level, because all stocks can trade at bargain prices relative to their intrinsic value, applying the term “value” only to stocks that are cheap on the basis of historical accounting earnings (which can be manipulated in a variety of ways) or current balance sheets is not appropriate. Instead, in our opinion, all good investing is (or should be) value-oriented investing. That is, all businesses, whether fast- or slow-growing, cyclical or highly predictable, should be purchased with reference to the gap between current market price and a conservatively calculated estimate of the business’s intrinsic value.4 Thus, when we say we are value investors, we are not implying we only invest in “value” stocks as defined by the index manufacturers. Instead, we are stating that we seek to buy assets at less than they are intrinsically worth. In our opinion, anyone seeking to buy something for more than its worth in anticipation of profiting from non-fundamental market sentiment is a speculator, not an investor. These market participants can be found in the momentum and short-term trading tribes.
Because a company’s intrinsic worth is determined by discounting its future cash flow stream, a discount to intrinsic value framework (carried out by calculating either the NPV5 or IRR6) is the only way to assess whether there is currently any value available in a potential investment. Capturing this value by buying at a discount to intrinsic value (e.g., purchasing a 60-cent dollar) is a universal goal – but how and where that value comes from can vary from manager to manager and stock to stock. For example, an undervalued “growth” company is often available at a discount because the market underestimates the duration or magnitude of future cash flow growth and returns on capital, whereas an undervalued “value” company may be discounted because the market overestimates the duration or magnitude of various secular or cyclical headwinds, governance issues or other temporary challenges that are resulting in lower-than-average growth and returns on capital. It is crucial to note that “intrinsic value” investing applies equally in either case. In both, the investor is seeking to accurately project the future trajectory and duration of the cash flow stream and how that stream is valued relative to its current price. This is one of the primary reasons the value vs. growth framework fails in our mind – it is an all-quantitative, backward-looking metric that only begins to scratch the surface of the relevant factors that might help meaningfully categorize investments.
Anecdotally speaking, many of our managers that ascribe to a value-oriented investment philosophy have successfully found value in companies that would screen as “growth.” Alphabet (Google), for example, has been held by our large-cap equity strategy Core Select for some time; while the company is included in “growth” indices, our equity team has found enduring value (as described by a gap between the stock price and intrinsic value) in this holding for many years.
The key factors in determining value go far beyond numbers. As Edward Chancellor says in Capital Returns, “Traditional valuation measures say nothing about the specific context of an investment – for instance, a company’s business model, its industry structure, and management’s ability to allocate capital – which determines future cash flows.”
The BBH Lens: Quality vs. Discount to Intrinsic Value
If not value vs. growth, then what?
At BBH, we believe a better taxonomy is one that distinguishes investments based on quality and discount to intrinsic value. While one cannot always precisely define quality, as it is often more art than science, a high-quality company often hits on one or more of the following key themes:
- Being a dominant competitor in its industry that is becoming more relevant over time
- Earning strong returns on the capital employed in the business with a long runway for reinvestment
- Possessing a competitive advantage that allows it to consistently reinvest capital at high rates of return (a moat)
- Having a solid management team with strong capital allocation skills
- Possessing loyal customers where the business has a degree of pricing power
A company with a combination of these characteristics should be able to grow its intrinsic value over time in a more predictable manner (that is, with a narrower range of outcomes) relative to the average company. It is vital to stress the importance of this expected intrinsic value growth trajectory, as it represents the largest mitigant to any potential capital loss. The continuous compounding of business value usually offsets, over time, a potential mistake made on the initial valuation of a business (assuming the mistake was not massive).
Quality is only half of the equation, however, as even high-quality investments become risky when overvalued. An investor who buys a high-quality business at a price that is greater than its intrinsic value could lose money in the event that the stock price falls back toward its intrinsic value. Because there is always uncertainty about a business’s future prospects – and thus its intrinsic worth – buying at a discount to intrinsic value is the hallmark of value investing: It allows an investor a margin of safety that lowers the chance of permanent capital impairment. As Howard Marks said in a 1994 memo, “There is no security that is so good it can’t be overpriced, or so bad it can’t be underpriced.” Even in the extreme example of a bankrupt company liquidating itself, that too can still be a good investment if it is trading substantially below its intrinsic value, which in that case would be its liquidation value. Within our quality/discount to intrinsic value framework, “deep value”7 investing is simply a reflection of an investor’s tolerance for lower-quality, less predictable businesses and a larger appetite to generate returns through the upward movement of price to value rather than an upward movement of value (or quality) over time.
When evaluating a manager, BBH focuses on understanding his or her views on business quality and intrinsic value framework – in other words, how he or she defines “quality” and how much valuation factors in to the investment process. Evaluating the combination of these two items allows us to get a sense for the risk/reward profile of the strategy. In addition, with consistent application of a discount to intrinsic value framework across our strategies, coupled with a good understanding of the levels of conservativism used in our managers’ projection assumptions (terminal growth rates, cost of capital, time horizon, terminal multiples, etc.), we can compare the opportunity sets across all of our strategies in a more insightful bottom-up process.
Ultimately, this allows us to form an understanding of how the quality vs. value lens influences a manager’s portfolio construction process, which in turn affects our own portfolio construction decisions. For example, if we were to compare a portfolio that is estimating an aggregate 25% discount to intrinsic value composed of predictable companies with high returns on capital to a portfolio that is estimating the same aggregate discount to intrinsic value but made up of cyclical companies with lower returns on capital, we would most likely allocate more capital to the first relative to the second, all else equal. Obviously, there are other considerations, but this framework does play a large role in how we assess opportunity sets.
As value-oriented investors ourselves, we believe investors can generate solid risk-adjusted returns from a combination of growth and intrinsic value convergence (or the narrowing of the discount between share price and intrinsic value per share); thus, we pay little attention to the generic value and growth labels applied to many managers.
Chancellor summarizes the value vs. growth debate well: “The ‘value/growth’ dichotomy is false – at least, to a true value investor, whose aim is not to buy stocks which are ‘cheap’ on accounting measures (P/E, price-to-book, etc.) and to avoid those which are expensive on the same basis, but rather to look for investments trading at low prices relative to the investor’s estimate of their intrinsic value.” We could not agree more.