Ironically, despite being an intellectual giant Graham was not the greatest of investors, but one of his most able students, Warren Buffett, has proven to be so. The share price of Buffett’s firm Berkshire Hathaway, which was about US$6 or US$7 per share in the mid-1960s, when Buffett began buying, today stands at US$395,000 per share.

Not only does this highlight the power of value investing but also the power of compounding with the per-share market value of Berkshire Hathaway rising 20% per annum vs 10.2% per annum for the US S&P 500 index from 1965 to 2020.

This is not to say that value investing works all the time every year; it is important for investors to understand this. In both 2019 and 2020, the market walloped Buffett. Berkshire rose just 11% in 2019 whilst the US market soared 31.5%.

In 2020, Berkshire rose 2.4% whilst the market rose 18.4%. Despite underperforming in 19 of the last 55 years, Buffett has still been able to beat the market long term.

Buying undervalued stocks often means buying out-of-favour stocks. It requires great discipline to resist the fear-of-missing-out (FOMO) of short-term gains while winning the long game of prudent value investing.

Buffett himself notes that the sharemarket is an asset allocation machine that “redistributes wealth from impatient investors to patient investors”. 

Put another way, he says in the short term the sharemarket is a “voting machine” (rewarding popular stocks) but in the long term, it is a “weighing machine” (with the market rewarding the more substantial underlying value of stocks).

Why was value investing out of favour over the past few years? Value often underperforms in the late stages of a business cycle. This is often due to the fact that as an economic recovery matures, investor appetites have been whetted by several years of rising markets; confidence is high and memories of the last financial downturn fade.  

These late-cycle periods of rising “greed” and falling “fear” are when investors usually start to seek out more risk, like in the wee hours of a boozy party.

Many market manias have marked the last stages of the market cycle from tulip-mania in Holland in the 1630s right through to the dotcom mania in 2000.

Recent froth in bitcoin and Tesla have also been clear markers of our times. Seemingly booming and successful business during periods of easy money can disappear into a cloud of bankruptcy when sober rationality returns.

As we emerge from the free money stage of COVID-19 and bond yields start to rise, there is a large rotation underway in the market with high-flying stocks that have thrived in recent years (like buy-now-pay-later players) under pressure and solid but unfashionable value stocks making a comeback like they have so many times before.

At Perpetual, we believe active management with a focus on value and quality is critical to making sound investment decisions that will deliver investment performance over the long-term.

Our investment process firstly involves identifying companies with quality business, conservative debt, sound management and recurring earnings. We then focus on buying high-quality companies at prices below what we perceive as fair value, based on company fundamentals and prevailing market conditions. 

Growth investing is also about getting the big things right and having a fundamentally different view of a business and its future, not whether its shares should, say, sell for 20 or 22 times earnings.

Winning growth investments come in many shapes and sizes but, in our experience, it’s typical for such winners to be gaining a share of growing markets and have strong, aligned management teams.

We tend to find that such companies have one or more unique and enduring intellectual property, network effects, or extremely loyal customers.

Growth investing has a few key traits. The first is that quality growth companies rarely sell cheaply, so a business that has the potential to be the next Xero or REA will almost certainly sell on a richer multiple of earnings or revenue than a mature business more focused on paying out dividends than generating growth.

Another key trait is that the range of outcomes with growth stocks is wider than with value stocks. When things go well, they go really well. When they go badly, though, they go really badly. The upshot of this trait is that there’s more room to add value through original thinking and fundamental analysis but, nonetheless, beginning investors should know upfront that many of their growth investments will not work out.

The global poster child for growth investing is Amazon in the US. The business needs no introduction and, with a market capitalisation of US$1.5 trillion and founder Jeff Bezos’ standing as the world’s richest person, has generated tremendous wealth for long-term investors.

The Amazon ride has not always been a smooth one, though, with the share price selling for more than 25% below its previous high, 42% of the time. Volatility is an inescapable feature of growth investing, even among the greatest of investments, hence the need for a mix of patience and optimism.

Many beginning investors are surprised to learn that high growth rates do not always translate to investing success. Many fast-growing companies stumble and great expectations are oftentimes already priced into the valuations of widely loved growth companies.

Not all growth is good either. Most acquisitions fail to add value, according to research from Bain & Company, and growth that comes from reinvestment into business lines with poor returns on capital can actually destroy value.

The growth-investing style has benefited over the past few years from low interest rates as higher-growth companies are prized mostly for their bright futures, not how much cash they’re generating today. That makes them more sensitive to changes in interest rates than traditional value investments.

The sensitivity of many growth shares to interest rates has been on full display in 2021 as the rapid shift in expectations towards higher interest rates has caused the shares of many high-growth companies to pull back.

One of the joys of focusing on growth companies, though, is that regardless of where interest rates sit or which government is in power, there are always new companies coming along that are gaining a share of growing markets by providing outstanding value for customers.

For investors with patient capital and a long-term horizon, pullbacks in share prices of growth companies can prove buying opportunities.