Warren Buffett - The most common mistakes in the “value” vs. “growth” discussion

Key takeaways at the end

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Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid?

Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).

Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield.

Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.

Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a "value" purchase.

Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. [...]

Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor. [...]

[...] The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. 

1992 Shareholder Letter

* Bold emphasis added

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Key concepts and takeaways:

• Growth and value must go together: Contrary to common understanding, these are not opposing concepts. Growth is always a component when calculating value. Moreover, according to Buffett himself, the term “value investing” is redundant.

• What can go wrong with “value” investing: Low P/E ratio, high dividend yield, or any other “attractively” looking metric does not mean that the stock is good value. Always remember this classic quote: “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” 

• What can go wrong with “growth” investing: Growth alone does not mean value creation. Growth can have both positive and negative impact on value. Although a company might be growing, if it needs to support this growth by investing large amounts of capital while producing low returns on that capital, growth will actually hurt the investor.