Thursday, December 21, 2006

Hips don't Lie

Dear Sir,

This is with reference to the ‘Hips Don’t Lie’ lecture. There are a few doubts I have about this…

Firstly, this is what I understand about the two approaches (please correct me where I’m wrong):

An investment is ‘good’ if the present value of future cash-flows is greater than the price paid for it (the basic economic concept). Since future cash-flows have to be estimated, there is a risk that we may overestimate these cash-flows. To deal with this risk, we keep a margin of safety in the price that we are willing to pay for an investment. These points are common for both ‘value’ and ‘growth’ approaches.

Now, on the one hand, in the value approach, we keep a margin of safety by mainly relying on the current economic value of the firm’s assets and not so much on its future growth. We mainly try to value the existing assets of the firm and see if we can get an ‘interest’ in them at a cheap price. Graham’s 10 rules of return and risk largely point in this direction.

On the other hand, in the growth approach, we keep a margin of safety by mainly relying on the future growth prospects of the firm and not so much on current economic value of its assets. We try to estimate the future cash-flows of the firm based on our strong expectations of growth and see if we can get an ‘interest’ in these cash-flows at a cheap price.

The ‘value’ approach relies on cash-flow value of assets while the ‘growth’ approach relies on the cash-flow value of growth. Therefore, in using Graham’s approach, the nature or quality of a company’s business is not of critical importance but the quality of its assets is. On the other hand, using Fisher’s approach, the nature and quality of the business (including the management) is of prime importance and not the quality of its assets.

Now my question: when you say that the two approaches are ‘joined at the hip’, do you mean that they CAN be integrated into a better investment philosophy or they SHOULD be integrated to have any sort of philosophy at all?

To my mind, the two approaches are separate and can be effectively used separately. Even if someone is able to integrate them, at some point of time, there would have to be tradeoffs between the two approaches. When I say this, I’m thinking similar to Michael Porter’s model of basic strategic orientation of firms: Low Cost OR Differentiation. A firm cannot be both: a low-cost operator as well as a differentiator, at the same time. It has to make a trade-off and focus on one approach as a provider of ‘sustainable competitive advantage’ this is because the two approaches are mutually exclusive. This does not mean that a low cost operator should completely ignore differentiation and vice-versa. What it only means that in the end, a firm can focus on only one approach from which to derive its competitive advantage.

Similarly, can an investor, psychologically and intellectually, handle the diverse demands of the ‘growth’ approach and the ‘value’ approach? Will he not have to eventually make trade-offs, in his investment philosophy, towards one approach, at the expense of the other? The expertise required to pick a good value stock and a good growth stock are probably very different. Should one try to achieve both? It is certainly desirable to be able to do both.

But is it feasible?

Sincerely yours,



Dear K.K,

I think it is feasible to have your cake and eat it too :-)

You made some excellent points.

Graham's approach - often called the value approach was based on “protection” instead of “prediction”. He was never a believer in forecasting financial statements beyond a year or two. Rather, he focused on getting something that was cheap today based either on asset valuation, or on earning power valuation, WITHOUT making optimistic growth projections about that future earning power.

The key thing to remember is that Graham never really valued a business or a stock. Rather he insisted on a large margin of safety i.e. proof that the price was he was paying was much less than the value that he was receiving, whatever that value may be. Moreover, his extreme diversification took care of mistakes of commission.

In the modern context, many Grahamites, including me, have evolved Graham's approach to incorporate growth expectations in our investment process. Basically, we are so spoilt by Graham that we like getting free lunches and having our cakes and eating them too :-)

Seriously, we DON'T pay for growth. We are aware that some businesses have a great growth potential but we don't want to PAY for that growth. So we like to buy growth stocks at prices which imply low or negative earnings growth.

Read the following very interesting document which will hopefully resolve your questions. If not, please revert.



Dear Sir,

The speech you sent does indeed explain the ‘have your cake and eat it too’ approach. In essence what you and Mr. Nygren are saying is: take Graham’s value approach and apply another ‘filter’ of growth to these value stocks. The ones which emerge out of this double selection criterion are good stocks for investment.

So the approach is essentially value investing with an additional safety buffer called growth. You are not looking for high-growth stocks and buying them almost regardless of the price because the high internal rate of return will make up for a steep valuation today, given sufficient time.

So, I’m probably beginning to understand the idea behind value and growth approaches being ‘joined at the hip’.