Value vs. Growth - Howard Marks 2021 Memo

Hello investors, welcome to my Substack, where I study the best Investors and businesses from around the world. In this week’s article, we’ll go over how Howard Marks thinks about value vs. growth, which is a topic he writes about in this year's memo called “Something of Value”, which has generated a flurry of interest within the investment community.

Howard Marks is known as somewhat of a philosopher king in the world of investing. 

The co-chairman of the $153 billion Oaktree Capital Management has not only built the largest distressed-debt investment firm but also written 132 iconic memos since 1990.

Even Warren Buffett said: "When I see memos from Howard Marks in my mail, they're the first thing I open and read. I always learn something."

Marks is a great believer in the cyclical nature of markets. His book, "Mastering the Market Cycle: Getting the Odds on Your Side," which teaches investors how to identify different stages of the market, has garnered rave reviews from the hedge-fund manager Ray Dalio and the bond king Jeffrey Gundlach. 

Howard Marks describes his son, Andrew Marks, as an investor particularly in growth companies, with a focus on the technology sector. Of course, Howard Marks has gained popularity for his value investing approach, which he lays out as "quantifying what something is worth intrinsically, based primarily on its fundamental, cash flow-generating capabilities, and buying it if its price represents a meaningful discount from that value."  

In fact, he discusses this family debate at the end of the memo, and also discusses it here:

Fundamentally, value investing happens from a place of skepticism, Marks explains in the memo that  - "Our default reaction is to be deeply dubious when we hear 'this time it’s different,' and we point to a history of speculative manias and financial innovations that left behind significant carnage." At the same time, an investor requires "deep curiosity, openness to new ideas, and willingness to learn before forming a view" so as to not miss out on innovation.  

Innovation often appears "absurd" in its early days, before becoming an obvious development in hindsight. So the raging debate in the investment community over the last few decades has been the battle between two styles, value vs growth. Like two seemingly opposing schools of thought - like his way of investing compared to his sons - each has its diehard supporters and each has enjoyed periods of dominance.

But is value and growth two parts of the same coin? 

Howard Marks questions whether the two styles are really mutually exclusive at all and whether the rivalry between them may be masking a more profound change taking place in the investment world.

There are usually two schools of thought when investing:

1. Growth Investing

Growth investors are attracted to companies that are expected to grow faster - either by revenues or cash flows, and definitely by profits - than the rest. As growth is the priority, companies reinvest earnings in themselves in order to expand, in the form of new workers, equipment, and acquisitions.

Don't expect dividends from growth companies—right now it's go big or go home. Growth companies offer higher upside potential and therefore are inherently riskier. There's no guarantee a company's investments in growth will successfully lead to profit. Growth stocks experience stock price swings in greater magnitude, so they may be best suited for risk-tolerant investors with a longer time horizon.

2. Value Investing

Value investing is about finding diamonds in the rough—companies whose stock prices don't necessarily reflect their fundamental worth. Value investors seek businesses trading at a share price that's considered a bargain. As time goes on, the market will properly recognize the company's value and the price will rise.

Additionally, value funds don't emphasize growth above all, so even if the stock doesn't appreciate, investors typically benefit from dividend payments. Value stocks have more limited upside potential and, therefore, can be safer investments than growth stocks.

Howard Marks thinks that there is a cautionary tale from the 1960s for growth investors, and a chance to win big for the value investors. He argues that both of these styles of investing are equally valid.

Lessons from The Nifty Fifty

The world that existed 50, 60 and 70 years ago was a pretty static place. Things didn’t seem to change very much or very fast. The homes, cars, reading matter, business technology and general environment was pretty static. But in the memo, Howard Marks tells us of one of the biggest changes that took place in the 1960s with the emergence of “growth investing” via fast-growing companies, many of which were quite new.

The “Nifty Fifty” that he usually talks about so much ruled the stock market in the late 1960s: this group included office equipment manufacturers IBM and Xerox, photography titans Kodak and Polaroid, drug companies like Merck and Eli Lilly, tech companies including Hewlett Packard and Texas Instruments, and advanced marketing/consumer goods companies such as Coca-Cola and Avon.

These companies’ stocks carried very high price-to-earnings ratios, reaching up to 80 and 90. Obviously, investors should only pay multiples like these if they’re sure the companies will be preeminent for decades to come. And investors were sure. In fact, it was widely believed that nothing bad could happen to these companies and they could never be disrupted. This was one of post-war America’s first major brushes with newness and investors embraced these companies, with their revolutionary newness, but somehow assumed that a newer and better new thing could never come along to displace them.

Of course, those investors were riding for a fall. If you bought the stocks of “the greatest companies in America” when I started working in 1969, and held them steadfastly for five years, you lost almost all your money. The first reason is that the multiples in the late 1960s were far too high, and they were gutted in the subsequent market correction. But, perhaps more importantly, many of these “forever” companies turned out to be vulnerable to change. At least half of these supposedly impregnable companies have either gone out of business or been acquired by others. Kodak and Polaroid lost their position when digital cameras appeared. Xerox ceded much of the dry copying business to low-priced competition from abroad. IBM proved vulnerable when decentralized computing and PCs took over from massive mainframes. 

Today, unlike in the 1950s and ’60s, everything seems to change every day. It’s particularly hard to think of a company or industry that won’t either be a disrupter or be disrupted (or both) in the years ahead. According to Marks, anyone who believes all the firms on today’s list of leading growth companies will still be there in five or ten years has a good chance of being proved wrong.

Increasingly, U.S. business is virtual, digital and information-oriented, no longer devoted to agriculture or to manufacturing physical products. Even those companies that do produce physical goods or services increasingly employ information products and other aspects of technology. These elements will have a profound impact on which legacy businesses will survive, which moats will hold up, and which newcomers will supplant the incumbents, as well as what our world will look like ten or twenty years from now.

For investors, Marks believes that this means there’s a new world order. Words like “stable,” “defensive” and “moat” might be less relevant in the future since a lot of investing will require more technological expertise than it did in the past and capitalism is brutal.

So, where do you stand in the Value vs. Growth debate? What are your thoughts on the “Something of Value” memo by Howard Marks? Let me know in the comments below.

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