Growth and value: not opposites, but two sides of the same question

Investing is often presented as a choice between two camps. Value: boring, undervalued companies. Growth: fast-growing names where the future lies. That distinction is intuitively appealing, but it inherently makes no sense.

What Buffett means by value

Buffett has never made it complicated. In his 1992 letter, he falls back on a definition from Williams' The Theory of Investment Value from the 1930s: the value of a stock, bond, or company is determined today by the cash inflows and outflows, discounted at an appropriate interest rate, that one can expect over the remaining life of the asset. Period. Intrinsic value is the sum of all future cash flows, discounted to the present.

Crucially, growth is simply included in that. A company that grows its cash flows faster is, assuming an equal discount rate, simply worth more. Hence his famous statement that growth and value are "joined at the hip," with growth as a component of the valuation calculation whose importance can vary from negligible to enormous. In that same 1992 work, he adds a jab: those who look at the cheapest DCF outcome do not care whether the company is growing or not, whether its profits are volatile or stable, or whether it is trading at a high or low price relative to current earnings and book value. Incidentally, for him, book value is at best a rough, often misleading surrogate for the true value of a company.

And then came the academics

In their influential three-factor model (1993), Fama and French took that same concept of "cheap versus expensive" and made something immeasurable measurable by simply dividing book value by market value. Their HML (High Minus Low) value factor measures the return difference between a portfolio of stocks with a high book-to-market ratio and a portfolio with a low ratio.

R(i) − R(f) = α + β₁(R(m) − R(f)) + β₂·SMB + β₃·HML + ε

An elegant regression. But academic elegance is not the same as economic correctness. The problem: book value is a balance sheet figure from the past, not a prediction of future cash flows. According to this definition, "value" stocks are fundamentally riskier: they are often companies in financial distress or with an uncertain future. In other words, the factor also selects for companies that are cheap for a reason. A high book-to-market ratio can point to a company in trouble, whose future profits are unlikely, and which therefore appears to trade at a low price.

It is also telling that Fama and French themselves, twenty years later, had to expand their model with two additional factors: RMW (profitability) and CMA (investment, how disciplined a company allocates capital), precisely because HML by itself did not sufficiently distinguish between cheap quality companies and cheap, capital-destroying companies. But the damage was already done. The theoretical (and erroneous) division has persisted.

The difference that matters

Buffett starts from: what are the future cash flows worth, and is the current price a discount on that? Growth is a feature, not a bug, provided that growth is profitable and driven by capital discipline.

Fama's HML factor starts from a static, historical balance sheet figure and therefore systematically picks up companies that are cheap because they are structurally weak performers: low returns on capital, shrinking margins, sometimes outright capital-destroying. Not because the market is mistakenly overlooking them.

That is precisely why "value" as an investment style has gained such a bad reputation among those who confuse it with Fama's HML: it too often results in value traps, not value.

Why this is relevant to us

For a small- and mid-cap investor, this is not an academic footnote. It means we do not look for cheap for the sake of cheap: book-to-market tells us little about what a company is truly worth. We look for companies whose future cash flows, including real growth potential, are trading below their true value today. Growth is often the most important part of that value: not something we place in opposition to "value," but something that is an essential part of it.

That is why Value Square does not look for the companies with the highest book value, or with the optically lowest valuation parameter. Instead, we look for companies that are growing their book value, or earnings, EBITDA, and EBIT, the fastest at an attractive valuation.

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Author: Wouter Verlinden