The book Capital Returns, written by Edward Chancellor, provides a great collection of essays from Marathon Asset Management’s Global Investment Review – some of which were written by the elusive investing legend Nicholas Sleep. One of the essays titled Warning Labels discusses why one person’s growth stock is another’s value stock. Here’s an excerpt from the book:
Marathon has often been pigeon-holed as a value manager, a description that we resist because it oversimplifies and misrepresents our investment approach. The traditional definition of a value manager is one who invests solely in companies with low valuations as measured by price-to-book, PE, price-to-sales or price-to-cash flow.
The value approach is associated with Benjamin Graham, who sought unloved stocks with low stock price multiples which could deliver more than was generally expected – what was termed “cigar-butt” investing in the sense that the object had been discarded as worthless but nevertheless could provide one last puff. A growth manager is one who invests at the other end of the spectrum in companies with high stock price multiples.
Companies in the Marathon portfolio have tended to have below average multiples, but this is not because we have been engaged in seeking “cigarbutts.” In fact, the stocks in our European portfolios have relatively strong earnings growth. Part of the reason for this apparent contradiction is that we have found that smaller companies with above average growth prospects are often cheap.
While smaller companies have, in the recent past, tended to have low valuations, large-cap stocks have attracted unjustifiably high valuations.
The growth of very large fund managers is largely to blame. In Europe, the MSCI Europe Index consists of 540 stocks of which only 88 have a market capitalization above $10bn. Liquidity reasons (that is, the amount of time it takes to trade in and out of a stock) preclude fund managers with vast assets under management from investing in stocks with market valuations below this threshold. The trouble is that the largest cap stocks are concentrated in certain sectors and underrepresented in others.
Since three-quarters of industrial stocks have a market cap of less than $10bn, industrials are essentially “screened out” by the large-cap managers. By contrast, 85 per cent of the healthcare stocks have market caps above $10bn. As a result, pharma stocks attract disproportionate attention from institutional investors.
The issue with style labelling is somewhat deeper, however. Similar to the recent obsessions with tracking error, indexation and understanding the “new economy,” it risks grossly distorting the investment process and requires/encourages managers to use inappropriate tools and measurement systems to construct portfolios. Many great investors will interpret value according to their perceptions of value.
The renowned “value” investor Bill Miller of Legg Mason has championed Amazon.com and AOL, while Warren Buffett, that great disciple of Ben Graham, has preferred growth franchises such as Coke and Disney. The latter, however, believes (or at least did believe) that these high-quality businesses were cheap (i.e., good value relative to the present value of their expected future returns) and still regarded himself as buying value.
The fact is that one person’s growth stock is another’s value stock.
Recently, the investment data company Lipper has reported that Citigroup, AIG and IBM are among the top 15 mutual fund holdings in both the large company “value” and “growth” categories. This brings us to our next point, which perhaps best explains why Marathon should never be labelled as a pure value investor.
Our capital cycle process examines the effects of the creative and destructive forces of capitalism over time. A growth stock usually becomes a value stock after excess capital, lured in by large current profitability, brings about a decline in returns. When this becomes extreme, as was the case during the technology bubble, the resultant bust can turn growth stocks into value stocks almost overnight.
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