Elon Vs. Warren: Who Is Right?
Recently in an interview, innovator Elon Musk took a direct jab at masterful investor Warren Buffett by implying that Buffett’s famed “value investing” strategy was flawed. “Moats (aka competitive advantages) are lame” Must said. His argument was that the success of a business is much more about its “pace of innovation.” Buffett (who owns See’s Candy) hit back stating that “Elon may turn things upside down in certain areas [but] I don’t think he’d want to take us on in candy.” Elon replied and it ended there.
Two billionaires, polar opposite takes on investing. Who is right?
Although Buffett has a reputation as a strict value investor who wasn’t a big fan of growth stocks, he knows and understands that cheapness alone isn’t reason enough to buy a stock. He also looks at a company’s profitability: its past earnings, and its prospects for future earnings. And when we talk about profitability, aren’t we really talking about innovation, better known as “Growth”?
Yes and no. Growth investing is generally defined as focusing on companies with big upside: with the potential for explosive growth. Yet a number of noted value investors factor profitability and growth potential into their investing decisions. On the other side of the coin, while the cliché about growth investors is that they are willing to pay for a rapidly expanding company regardless of price (and while that may have been true for some during heated bull markets like the 90s), in today’s world most realize the importance of price, of relative value. In other words, growth investing and value investing aren’t always mutually exclusive.
It’s no surprise that Warren Buffett is a model for incorporating the best of both worlds. As a protégé of Benjamin Graham, his early focus was on bargain-hunting. But his investing philosophy evolved, and he came to realize that it is “far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price.” In other words, strong growth at a reasonable price was just a different kind of value. Buffett’s recent purchase of the railroad company Burlington Northern Santa Fe is a perfect case in point. He bought it at a P/E ratio of 20—supposedly a high price for a value investor. But the company’s earnings had been growing an average of 19% in recent years; and some analysts are saying that, even at a hefty price tag of $26.5 billion, he “stole” the company. As a column about the sale in Forbes puts it, “To Buffett all investing is about value. Assessing a company’s growth prospects is simply one part of gauging value… The distinction between growth and value is flawed.”
Another star investor who has successfully mixed both styles is Peter Lynch, best known for thirteen record-breaking years running Fidelity’s Magellan mutual fund. Between 1977 and 1990, Lynch outperformed the market by over 13% a year, turning Magellan into the largest mutual fund in the world. During the stagnant economy of the late 70s, Lynch was able to buy solid companies at bargain prices—sometimes with P/E ratios of well below 10. But as the market heated up in the 1980s, and pure value bargains became harder to find, Lynch adapted to the times, focusing on companies with big upside, but which he could still get at a reasonable price. He remained flexible; or as he put it in his book Beating the Street, he was a “chameleon,” never tied to any one investing style. The phrase that best captures his approach, “Growth at a Reasonable Price” (or GARP), is a really a hybrid of value and growth.
Earlier I mentioned how, even for the strict value investor, it is important to filter for quality. Recently, there has been an increasing amount of attention on quality filters that involve profitability—further eroding the false distinction between growth and value investing. A metric now being adopted by a number of top investors and funds is gross profitability—the ratio of a company’s gross profits to its assets. The author of a paper documenting the usefulness of this quality metric says he sees it as just a different way of looking at value. Cliff Asness, who also uses profitability in his Quality-Minus-Junk metric, also rejects the outdated notion of seeing growth investing as “simply the opposite of value… Including measures of profitability along with measures of value in the same portfolio effectively makes [for] a better value strategy.”
Although books about investing and rating services like Morningstar often pit growth and value against one another, I hope you can see that this is another aspect of investing where the choice isn’t black and white, isn’t either/or. The best investors mix both styles, based on the opportunities available to them at the time. While I am convinced that value investing remains the best long-term strategy, providing a crucial margin of safety to protect you from capital losses, growth investing also has a place. And there are certainly times when growth-based investing will outperform value-based investing. But even in growth investing, price should always be the starting point.
Musk is a master promoter. The fate of Tesla, a innovative yet very expensive company, may very well be based on its ability to raise capital in the near future (yes, I know Musk said they weren’t going to, but anyone that looks at their financials doesn’t believe that). If lenders/investors become so worried about price, the cost of raising that capital becomes higher.
 One metric that Lynch pays a lot of attention to is the PEG ratio: the relationship of a company’s P/E number to its growth numbers (as measured by earnings per share). In general, he doesn’t like paying for a company with a PEG greater than 1. (Buffett’s purchase of Burlington is a perfect example of how an apparently high P/E isn’t so high if you compare it to growth.) Fidelity offers a GARP screen that includes PEG and other measures favored by Lynch.