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Monday, August 10, 2015

Death of (Plain Vanilla) Value - Long Live GARP

Warren Buffett made news this morning, not just for making the largest acquisition of his career, but for making it at a relatively lofty 22x earnings multiple.

Reuters reports:

Warren Buffett is paying a hefty price for the biggest acquisition of his career, now that his Berkshire Hathaway Inc has agreed to buy Precision Castparts Corp in a merger valuing the maker of aerospace and other parts at $32.3 billion. 
As for that valuation...
Buffett, known for buying undervalued and often unloved companies, acknowledged the high price. "In terms of price-earnings multiple going in, this is right there at the top," he told CNBC television. 

The Death of the (Plain Vanilla) Value Premium

Which brings me back to a chart from my March post outlining The Disappearing Value Premium since the seminal Fama French white paper.

More recent data outlining the relative performance of value vs. growth is even more striking, as growth has outperformed value across market caps (small through large) materially over five and ten years.

How Can Something Be Hated, Yet Receive the Bulk of Flows?

Value traditionally outperformed growth in large part because it was composed of the most hated, beaten down stocks. But over the last 15+ years flows have increasingly piled into "value stocks". How can something be hated, yet receive the bulk of flows? To put some numbers to this, $200 billion more has gone to large value vs. large growth in the last ten years alone. 

Growth at a Reasonable Price Matters

As Investopedia outlines, GARP is:
An equity investment strategy that seeks to combine tenets of both growth investing and value investing to find individual stocks. GARP investors look for companies that are showing consistent earnings growth above broad market levels (a tenet of growth investing) while excluding companies that have very high valuations (value investing). 
In other words, while value is by definition "cheaper" if you simply look at price multiples (such as price to book or price to earnings), it isn't necessarily cheaper once accounting for the underlying fundamentals of a business. Growth stocks should trade at a premium to value due to the underlying growth, the only question is by how much. 

Without getting into the "by how much question" at this time, there has been a material shift in relative valuations between value and growth since those flows have piled in, resulting in a dramatic decline in the growth premium (or the value discount if you want to think in those terms). In June 2000 (around the peak of the Internet bubble), the forward P/E of the Russell 1000 Growth (large growth) index was a whopping 118% higher than that of the Russell 1000 Value (large value) index, but by June 2005 it was down to 45%, and by June 2010 it was down to 19% (right about where it currently resides).

As the next chart highlights, the relative size of the growth premium matters; the starting level of growth premium and seven year excess returns have an r-squared of 0.67. When the forward premium has been less than 40% growth has outperformed value by almost 2% / year over the next seven years, when it has been between 40-60% value has outperformed growth by ~1.5% / year over the next seven years, and when the premium has been greater than 60% value has outperformed by a whopping ~8% / year over the next seven years (again... it currently sits at ~20%).

Going back to Buffett's acquisition of Precision Castparts Corp; a multiple of 22x certainly isn't cheap, but it may be reasonable for the underlying fundamentals of the business. If the company can continue to grow top and bottom line figures by double digits, it will certainly look a lot cheaper than the average company in the Russell 1000 Value index trading at 16x that has seen a decline year-over-year in earnings.