In the 2000 Berkshire shareholder letter, which I reviewed recently, Warren Buffett (Trades, Portfolio) said investors who glibly refer to growth and value styles as contrasting approaches to investment are “displaying their ignorance, not their sophistication.”
This discussion reviews several instances where Buffett has discussed issues relating to growth and value to better understand his thoughts on the subject.
At full price
In the 1985 shareholder letter, Buffett wrote of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) holding Cap Cities acquiring American Broadcasting Companies. The guru noted this was “a major undertaking whose economics are likely to be unexciting over the next few years. This bothers us not an iota; we can be very patient.”
He continued:
"Our Cap Cities purchase was made at a full price, reflecting the very considerable enthusiasm for both media stocks and media properties that has developed in recent years… However, our Cap Cities investment allies us with an exceptional combination of properties and people - and we like the opportunity to participate in size."
Note the references to patience and “at full price”. This means there was no discount, yet Buffett wanted to participate over the long term and invest in an attractive combination of assets and managers. Since Buffett does not believe in diversification, but rather, convicition, he made a sizeable investment.
So the Cap Cities investment was not a question of value or growth, but of conviction.
Searching for bargains was an expensive lesson
In the 1987 shareholder letter, Buffett elaborated: “Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.”
He goes on to joke that earlier in his career he had searched for "bargains" and had the misfortune to find some, referencing a few investments that turned sour, such as Berkshire’s continued holding of its New England textile manufacturing business.
In making both control purchases and stock purchases, Buffett said Berkshire tries to buy not only good businesses, but ones run by high-grade, talented and likeable managers. That’s because, for Berkshire, as a holding company, Buffett needed to find managers in controlled companies who are happy to let him allocate capital, which he notes is “a critical job that they [managers] may have never tackled and that is not easily mastered.” In non-controlled companies, Buffett cannot make the capital allocation decisions, so high-grade and talented managers become a very important factor.
He wrote:
"After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business."
Your friend Mr. Market
One benefit of investing in public companies, however, is that occasionally the stock market offers investors the chance to buy non-controlling pieces of extraordinary businesses at truly ridiculous prices - dramatically below those commanded in negotiated transactions that transfer control. Buffett provided his investments in Washington Post and GEICO as two examples of this. He said, “In cases such as these, Mr. Market has proven to be a mighty good friend.“ This clearly is the holy grail: a great business at a great price. The famed investor Jim Rogers might call this situation like picking up money off the floor.
The point is value, as it is very often perceived, is not just about the discount, but about the low risk inherent in the great business that is getting picked up. Very often, “discounted” opportunities have embedded high risk, and the high return seemingly on offer is just compensation for the high risk being assumed. An “extraordinary business” really means one having a clear visibility to profits and low risk around that.
What does attractive mean?
In the 1992 shareholder letter, Buffett wrote Berkshire wants businesses 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 an attractive price."
He then asked:
"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."
According to Buffett, the two approaches are joined at the hip, noting: “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.”
The very term "value investing" is redundant
Buffett then goes on to state if an investor is not seeking value at least sufficient to justify the amount paidm then he is speculating, which in Berkshire’s view is not “financially fattening”.
The term “value investing” 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. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio and a low dividend yield would typically be screened out by value investors. Buffett disputes these notions as what is truly important is to buy something for what it is worth and to truly operate on the principle of obtaining value in one’s investments. Growth for growth’s sake is also pointless. Just look at the history of WeWork for a good example, where low or negative returns constantly requiring incremental funds hurt the investors.
So growth benefits investors only when the company can invest at incremental returns, which are enticing. That’s the say, when each dollar used to finance the growth creates over a dollar of long-term market value.
The equation for value
Buffett wrote:
"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought."
To avoid going wrong in estimating future cash flows, Buffett sticks to businesses he believes he can understand. He said, “An investor needs to do very few things right as long as he or she avoids big mistakes.”
This is why Buffett insists on a margin of safety in his purchase prices. The investor wrote:
"We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success."
