Dakota Office Productsgmo: The Value Versus Growth Dilemma

Abstract

The case GMO: The Value versus Growth Dilemma describes Dick Mayo’s puzzlement by the New Economy’s continuous bias toward growth-investment strategies. As one of the most celebrated value investors in the United States, he examines the basics of his philosophy versus that of a growth orientation by evaluating long-term expected returns of several value and growth stocks.

The following paper was examined to pursue several objectives: (1) to define value and growth investing вЂ" where the differences lie and whether one approach is superior to the other or whether both have merit; (2) to perform basic valuations of Cisco Systems (a growth company), CVS, R.R. Donnelly and Manor Care (value companies) and to compute their long-term expected returns; and (3) to discuss issues concerning the consistency of GMO’s investment philosophy even when the market seems to run counter to it for a prolonged period of time. In this respect we will also consider the issue if value investing can still deliver significance in this New Economy or if is it only an Old Economy concept and if we would invest in GMO.

Background

GMO was founded in 1977 by Dick Mayo, Jeremy Grantham and Kingsley Durant. From its beginning the company applied a fundamental bottoms-up approach to institutional investing, focusing on out-of-favor, sometimes unexciting domestic companies trading below intrinsic value (U.S. Active). Throughout the 1980s and early 1990s this strategy of identifying and investing in undervalued companies had paid off as U.S. Active had returned an average of 19.1% per year, 4.3% above the S&P 500 Index of large capitalization stocks (figure 1). Nevertheless, over the following years the firm broadened its scope to include international investing (International Active), and shortly thereafter, developed quantitative investment strategies. As of December 31, 1999, GMO managed in excess of $20 billion for almost 500 institutional clients, including educational endowments, corporate pension funds and private foundations, placing the firm among the top 100 money-management firms in the United States.

Figure 1:The Returns of Certain GMO U.S. Active Funds and Relevant Indices as of 3/31/00

However, during the latter half of the 1990, GMO faced several challenges and pressures, which were mainly described in the company’s under-performance in comparison with growth investing funds. But what exactly is growth investing and where lies the difference to GMO’s investment style?

Value and Growth Investing вЂ" Definitions, Differences and Merits

The following part provides a clear definition of value and growth investing вЂ" where the differences lie and whether one approach is superior to the other or whether both have merits.

Although value investing has the stigma of basically being the simple pursuit of вЂ?cheap’ stocks, this description is a gross oversimplification. Value investors look for вЂ?bargains’ typically found in stocks offered by firms that are older or “mature” in the business lifecycle, operate in slow-growth industries, or have had problems in the past that led other investors to divest a firm’s shares. The key to this strategy is the belief that a particular stock is trading at a discount relative to its intrinsic value and that the stock will increase in price once the market realizes the true potential of the company; the low price is merely a market inefficiency that will be corrected in time.

In terms of statistics, investors who pursue a value-investing strategy usually pay attention to absolute, company-specific measures and target stocks that have relatively low price-to-book, price-to-earnings , price-to-sales, and price-to-cash flow ratios. They can also be drawn to a stock because of a wide gap between a company’s earnings growth and P/E ratios, or because the firm pays out dividends to common shareholders.

With value stocks, a great deal of patience is required. It is not unusual for value investors to wait for a long time while holding onto shares of companies that are in �unfashionable’ industries or have had problems in the past. While value investors may miss out on stock price surges like those experienced back in the days of the dotcom bubble, their shares’ prices are usually less susceptible to market downturns because these investors usually do not unload their investments and flee the market when there are sudden downward swings.

In contrast, growth investing is characterized by pursuing stocks that are considered to have some above-average or exceptional future growth due to “less tangible” qualities that will produce gains higher than those of industry peers, if not the overall market. Investors can have a difficult time evaluating these stocks but are nevertheless drawn by factors such as a sustainable competitive advantage, funds set aside for capital investments in the company, or some potential market opportunity of which the firm can take advantage.

These stocks tend to have high price-to-earnings ratios, as investors have faith in the future of the company and are willing to pay handsomely for these securities, which in turn drives prices even higher. During times delineated by a bull market and/or an economic expansion, investing in growth stocks can be very lucrative as they can catch onto the market’s upward momentum and appreciate very quickly, creating opportunities for profit-taking. On the other hand, if there is a sudden downward swing in the market, they tend to be sold more quickly and drop in price more dramatically than value stocks do. In addition, the competitive advantage a firm has may be unsustainable, easily copied, or not as popular or fantastic as had been thought and once this becomes common knowledge, investors are likely to abandon the stock and it fizzles.

Figure 2: Business Lifecycle

When considering the benefits of both styles, it is important to remember that neither is guaranteed to earn gains for the investor through an increase in stock prices, nor do they insulate the investor from risk. Both value and growth stocks are still subject to price fluctuations and changes in the market itself. The return/risk trade-off is still present and considering the cyclical nature of the market, it is wiser for investors to use a combination