Value, Growth & Intrinsic Investing Revisited Part II
Read Part I of this post here.
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns… even if you originally buy it at a huge discount.” – Charlie Munger
In Part I of this series, we wrote about the way that the starting cash flow yield that an investor pays for a stock combines with the growth rate in cash flow that the company generates over the long term to drive the investor’s rate of return. And we argued that “value” is best understood not as stocks with high starting cash flow yields (ie. low starting valuations based on current results) but rather as stocks that trade at a “value” price such that the combination of their cash flow yield and forecasted growth offers an attractive rate of return.
In this post, we are going to examine Warren Buffett’s investment in Coca-Cola to show that when investors hold stocks for long periods of time, elevated returns must be driven by elevated growth. Buffett himself made note of the way that it was Coke’s elevated growth that drove the success of his investment in his recently released annual letter.
“We own publicly-traded stocks based on our expectations about their long-term business performance, not because we view them as vehicles for adroit purchases and sales. That point is crucial: Charlie and I are not stock-pickers; we are business-pickers.”
He then used Coca-Cola as an example to highlight what he called the “secret sauce” of his investment approach and highlighted the long term growth in cash production the company had achieved.
“The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie and I were required to do was cash Coke’s quarterly dividend checks. We expect that those checks are highly likely to grow.”
This focus on businesses that generate long term growth in cash flow was not always Buffett’s focus. Early in his career, he pursued a more classic version of value investing that he learned from the father of value investing Benjamin Graham. This more classic version of value investing emphasizes buying stocks that have a high starting cash flow yield or that sell for a discount to the value of the assets owned by the company.
Investors who focus on a high starting distributable cash flow yield (Y) or a high growth rate (G) (see our last post for context) when seeking to generate strong rates of return, need to recognize that these distinct approaches are consistent with different time horizons. In general, the more an investor emphasizes a high starting Y, the shorter their average holding period should be. Indeed, truly deep value approaches are inconsistent with long holding periods and thus are incompatible with Warren Buffett’s favorite holding period of “forever.” In other words, as Buffett’s partner Charlie Munger puts it in the opening quote, over the long term it is the fundamental returns of the business, its return on invested capital and its rate of growth, that drive investment returns.
Let’s walk through a Y + G based analysis of Buffett’s investment in Coca-Cola, a company that most investors would agree is considered prototypical of Buffett’s investment approach. Indeed, it is one of the investments that Buffett is most highly associated with. We’re going to use reported free cash flow as a proxy for distributable cash flow. While these are not identical measures, in Coke’s case over the time period in question, the growth rates of these two cash flow measures is approximately the same.
Warren Buffett first bought Coca-Cola near the end of 1988 at a PE ratio of about 15x or a distributable cash flow yield of about 4.0%. This PE ratio and distributable cash flow yield are approximately the same as the long term average valuation of the S&P 500, which has returned 9% a year. How then did Coca-Cola go on to produce an 12.2% rate of return over the subsequent 34 years?
Coca-Cola was a Growth stock.
It is true that Coca-Cola is a slow growing company today. But when Buffett bought the stock, Coca-Cola was embarking on a long period of elevated growth. Over the first ten years after Buffett first invested, the company grew distributable cash flow at a 15.4% rate. And it didn’t stop there. Over the next nine years, Coca-Cola continued to grow at an 8.0% rate.
Over the first 19 years Coca-Cola generated a growth rate of distributable cash flow of 11.7% a year. Buffett had crushed it. He had bought Coca-Cola with a starting Y of 4.0% and captured 11.7% growth (G) that lasted for 19 years.
As we showed in our last post, Y + G = Rate of Return. Or in the case of Coke, 4.0% + 11.7% = 15.7% and that’s indeed the return generated by the stock over that 19 year time period.
The fact is that the elevated returns that Buffett achieved by buying Coca-Cola came exclusively from the elevated growth and Buffett’s willingness to hold the stock for 19 years as the growth compounded. All 6.7% in excess returns over the 9% average return of the stock market came from elevated growth (G). The stock began and ended this 19 year period with the same valuation, which was also the average valuation of the S&P 500. So none of the excess return came from an elevated cash flow yield (Y).
Does that mean that the price Buffett paid for Coke was irrelevant? No, of course not. Investment returns are driven by a combination of the starting cash flow yield and growth, so both are important.
By paying a 4.0% starting cash flow yield for the stock, Coke only needed to grow at the average 5% rate of corporate America to generate the average 9% return that the US equity market has offered over time. If Buffett had paid twice as much for Coke, a 30x PE or a 2% distributable cash flow yield, he would have required elevated growth just to earn 9%. But because in fact Coke grew at an 11.7% growth rate, Buffett could have bought the stock at a PE ratio of as much as 46.5x or a distributable cash flow yield of as little as 1.3% and still earned a 9% rate of return.
But once Coke’s elevated growth came to an end, Buffett’s investment returns ever since have been quite pedestrian. Over the past 15 years, Coca-Cola has only grown distributable cash flow at a 4.0% rate. So, with a starting Y for this 15 year period of 4.0% and only 4.0% growth (G), the stock has returned just 8% a year.
Despite the cash flow yield at the beginning of each period being the same 4%, Buffett’s returns during the two time periods were entirely different. During the high growth years, the high growth added to the 4% cash flow yield to drive an elevated rate of return. But during the last decade and a half when growth was weaker than average, Coke’s investment returns came in at 1% below the 9% long term equity market average because growth fell short of the 5% average.
The success of Buffett’s investment in Coca-Cola over its first 19 years was entirely a function of the business’s sustained elevated growth profile. The failure of Buffett’s investment in Coca-Cola to generate even average equity market returns of 9% over the subsequent 15 years was entirely a function of the business delivering an inferior growth profile.
Investors who seek to buy stocks with high current cash flow yields, or what is commonly referred to as Value investing, need to also sell when the stock’s cash flow yield returns to fair value or becomes depressed. This is what value investing is all about.
Investors who seek to buy stocks that will exhibit elevated and durable growth need to hold the stock for long periods of time for that growth to actually play out. This is what growth investing is all about.
Value investing is consistent with medium term holding periods of approximately three to seven years, over which time period it can be assumed that temporarily depressed valuations will revert to fair value.
Growth investing is consistent with long term holding periods of 10 years or more, over which time period elevated, and durable growth has the time to compound and support superior investment returns.
But in the end, it is the rate of return that investors should focus on. Superior investment returns can be achieved by targeting stocks with an elevated Y and then sold a few years down the road when the stock’s valuation reverts to fair value. Or superior returns can be achieved by targeting stocks with an elevated forecasted G and then sold many years down the road when the growth has had an opportunity to compound.
In our view, investors should not limit themselves to one approach or the other. They should fixate on opportunities that offer an attractive Y + G, not just stocks that have high Ys or high Gs. As we showed in our last post, in our portfolio we own companies like the home builder NVR that offers a high starting cash flow yield and modest potential growth, and we own stocks like Chipotle that offer a modest starting cash flow yield and high potential growth.
But if investors desire to be truly long term investors, holding stocks for decades at a time while achieving superior returns along the way, they can only achieve this by investing in companies that will deliver long periods of elevated growth.
Or in the words of Charlie Munger that opened this piece, “over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns… even if you originally buy it at a huge discount.”
Some readers may be interested in the math that underlies the Y + G = Rate of Return formula, especially in light of the fact that elevated growth rates do not continue in perpetuity. For those readers we encourage you to read on.
First we need to build on the Gordon Growth Model of valuation from Part I of this series. As noted in our last post, the Gordon Growth Model assumes a perpetual level of growth. But the fact is nothing can grow faster than the economy in perpetuity or it would become bigger than the economy itself, a nonsensical outcome. But a two stage valuation model lets us forecast a period of high growth after which the company, now mature, ceases to grow at rates faster than the economy.
For the first part of the model, we will make assumptions about the starting distributable cash flow yield and a rate of growth that will persist for 10 years. At the end of the 10 years, we will assume that the company grows at the same rate as the economy (which we will assume to be 5%) and use the Gordon Growth Model to value the stock. Note that the growth rate is of distributable cash flow, not revenue. So, in the case of the Growth Company, the 10 year growth rate comes from a mix of revenue growth, increasing cash profit margins, and/or decreasing asset intensity (because rising ROIC leads to higher levels of distributable cash flow for any given growth rate).
Growth Company we’ll assume has a starting valuation of a 2.5% distributable cash flow yield (a 40x FCF multiple) and will grow for 10 years at a rate of 15% a year. Value stock we’ll assume has a starting valuation of an 4.95% free cash flow yield (a 20.2x FCF multiple) and will grow for 10 years at a rate of 5% a year. We’ll assume they both produce $1 of distributable cash flow in year one. After the end of the 10 years, both companies will grow at 5% in perpetuity, and thus will trade at a 4% distributable cash flow yield in order to generate a 9% required rate of return.
Using these assumptions, both stocks generate the same rate of return over the first 10 year stage, and then the same rate of return over the second perpetual stage. Growth Company started off with a valuation that was nearly twice as high as Value Company, but it produced enough additional growth to make up for the higher valuation.
Notice that over the first 10 years, the stocks returned 12.2% a year or 3.2% a year better than the average stock market return of 9%. These are great returns. Compounding at a 3.2% premium over expected market returns is not easy. But beyond the 10 year period, returns fall to 9%. If both stocks are held for 20 years, they’ll earn 12.2% for the first half and 9% for the second half for a 20 year return of 10.6% a year. That’s still a nice return, but by holding the stock for a longer period of time, the rate of return declined.
The investor would have been better served if after the initial 10 year period, they had sold the stocks and bought different stocks that offered the same rate of return as the first set of stocks had initially offered. If the investor can successfully do this, they have the opportunity to earn a 12.2% rate of return over the full 20 year period.
In our example from Part I, we assumed that Value Company’s cash flow multiple increased from 20.2x to 25x in a linear progression. And we assumed Growth Company saw its growth opportunity run out over 10 years. Let’s see what happens when we play around with these assumptions.
What if the Value Company saw it valuation jump from the starting 20.2x to 25x in just one year? Given the 5% rate of growth over that time period and the starting cash yield of 4.95%, the one year return to the investor would be an outstanding 35%. Over the subsequent 9 years, the stock would return 9% a year and the investor would have been best served by selling and finding another investment opportunity that offered a superior rate or return.
In other words, time works against the value investor. Because it is the low starting valuation that drives excess returns, the more quickly the valuation increases the better the investor’s returns.
Now let’s look at Growth Company. Just like we assumed in the initial example that the Value Company would slowly see its valuation increase to fair value over the ten year time period, we assumed that the elevated growth of Growth Company would run out after 10 years. But what if that forecast was wrong? What if Growth Company is able to keep growing at 8.5% a year for another 10 years? In this case, the investor would earn 12.2% a year across the full 20 year period and holding the stock the entire time would have been best.
In other words, time works in favor of the growth investor. Because it is the elevated growth that drives excess returns, the longer the growth persists the better the investor’s returns.
What is going on here exactly? Many investors, both those pursuing value and growth strategies, often claim to be long term investors. And many of them are. But it is important to understand where elevated returns come from and the time horizons over which a high starting Y or a high G plays out.
For a Value investor, excess returns come from buying low and selling high. The opportunity arises because the stock price is depressed, and the return is generated due to the share price recovering to fair value. Thus, value investors make their excess returns in the buying and selling of stocks.
For a Growth investor, excess returns come from correctly identifying businesses that will grow at elevated rates for a long time. This is hard to do, because most companies, even those that are currently growing quickly, see their growth rate decline to the 5% average over just five to seven years. It takes time for growth to play out and the longer it stays elevated the better. Thus, Growth investors make their excess return in the holding of stocks.
In our last post we arranged the Gordon Growth Model into Y + G = Rate of Return, where Y = distributable cash flow yield and G = Growth. Value investors earn their return by buying a high Y and hoping it decreases (i.e.. the valuation increases) to fair value. The faster this happens the better. Growth investors earn their return by seeking a high G and hoping it remains elevated for as long as possible. Thus, the longer an investor holds a stock, the more their excess returns must be driven by growth and the less power a low starting valuation has to drive excess returns.
Starting valuation matters. Growth rates matter. But a stock is not “cheap” simply because it has a low starting valuation. And a stock will not generate attractive returns simply because the company grows quickly. Investors should not myopically focus on stocks with high growth rates (i.e.. growth investing) nor on stocks with low starting valuations (i.e.. value investing). Instead, investors should seek out stocks that offer a combination of starting cash flow yield and forecasted growth such that they combine to deliver high rates of return.
At Ensemble we refuse to call ourselves value investors or growth investors because we know that these terms are generally understood to characterize investors who prioritize only one half of the rate of return equation. Instead, we strive to be long term investors who seek to acquire companies, as Warren Buffett puts it, “based on our expectations about their long-term business performance” while working to ensure that we pay an initial price for the stock such that Y + G equals an elevated rate of return.
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