Revisiting Growth and Value Styles

The investing community has generally considered two investing "styles" of equity investments - growth and value.  These two styles purport to represent the types of stocks certain investors seek for their portfolios.  Value investors have been characterized as seeking low P/E, low M/B, and high dividend paying stocks. Growth investors, in contrast, are thought to target high P/E, high M/B, and low or no dividends.  A third style, "growth at a reasonable price," is also cited as an investment philosophy – one pursuing growth stocks but only at an appropriate price.  (This characterization implies that general growth investors care nothing about the price paid for their investments, something very peculiar indeed.)

The style labels of value and growth have troubled me.  I considered the terms growth stock and growth investor to be uninformative.  This is because, I thought, all rational investors are looking for one thing: a stock whose price is below its intrinsic value.  Notice  the word "value" contained within my preceding description, while the word "growth" is missing.  This simple thought led me to conclude that all successful investors were really value investors, some of which may mistakenly refer to their approach as a growth style.  Prominent investors (Warren Buffett comes to mind) have made eloquent observations suggesting growth is simply a component to the basic investment analysis process.  I agreed with this type of assessment.

Fairly recently I have become quite interested in the Austrian school of economics.  One basic tenet of the Austrian school is that the trends and results of complex systems such as our economy "emerge" and are not part of a linear process of cause and effect that can be easily be identified or forecasted in advance.  This belief in "emergence" is largely an accepted principle of complex adaptive systems, a term that describes our economy, among other things. Other complex adaptive systems include the stock market and natural ecosystems.  Complex adaptive systems form when an participants in an environment exhibit interdependencies, i.e. when each individual’s actions depend on the actions of others.  Often times, emerging results in complex adaptive systems can be observed in the form of power laws. A famous power law is the "80/20" principle, where 20% of the units can explain 80% of an effect.  More on power laws can be found here.

How do the idea of emergence and complex adaptive systems relate to my thoughts on growth investing?  Based on what I’ve learned from complexity, I’m more and more convinced that growth investors must analyze the likely emergent results produced by the system, as opposed targeting individual company for analysis.  Said differently, a growth investor must analyze the relevant ecosystem first to identify an emerging winner, whereas a value investor can select individual companies to evaluate. One could label this as a simple top down vs. bottom up difference, but I would disagree.  In the growth style, the analysis is done only at the top, or system level.  There is no “down” necessary for a “top down” analysis.

Importantly, the tools used for analysis are likely different between growth and value investors.  As mentioned above, complex systems often do not exhibit linearity.  There is no clear cause and effect when the environment becomes nonlinear.  These systems do demonstrate predictable patterns, however, such as power law distributions.  Successful growth investing may depend less on fundamental analysis behind a convincing investment thesis than timely recognition of an emergence pattern.  Value investors, on the other hand, stay more in a linear environment.  Microeconomic principles can be applied when cause and effect is clear.  Fundamental analysis and industry dynamics are easier to apply in this environment.  A rigorous investment thesis is more likely to succeed for value investors.