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The Long-Term Growth Conundrum

ARCHIVED - 01-Sep-2014

Eric Voravong

ESG Analyst / Portfolio Manager

The long-term growth conundrum: by what long-term outperformance mechanism could certain categories of growth stocks repeatedly exceed market expectations and see their value continue to sustainably appreciate?

INTRODUCTION

We believe a very common limitation in the way market players approach valuation is that, in essence, they view it as a photograph instead of a film. They look at snapshots instead of a motion picture. They always seem to think that at each point in time, the value of a company is a fixed, determined object and fail to see that it is more of a living organism. There is a dynamic of both value appreciation and logical price evolution that is thereby missed. A few misconceptions or contradictions ensue.

As a case in point, many market players claim to be long-term investors, when they are in fact traders. This is because their investment strategy consists in buying assets at prices below their so-called “intrinsic value” with the expectation that later prices will converge towards this defined value. The corollary of that logic is that once the market perception of the asset as expressed by its price is back in sync with its value, there is no more justification for the investor to keep holding the asset (that is as long as (s)he is dedicated to outperforming the average market return). So the rationale of buying below intrinsic value and waiting for prices to catch up with value is really a buy-and-sell strategy, in other words a trading strategy. 

Of course, it may take a while for the gap to close. But the key point is that the objective interest of such a strategy is fast rotation because the excess return will be inversely related to the time taken by the market to align prices with value. If for example we suppose that an asset intrinsically worth 100 is bought at 50 and sold one year later at its appropriate updated value (108 assuming an 8% discount rate), the return will be 116%. Yet this return will drop to 26.5% if sold after the market takes 3 years to recognize the value (then at 126). So the strategy will be all the more successful that positions can be quickly liquidated and replaced by new ones, in line with a trading approach.

TIME FAVOURS A GROWTH INVESTOR:

THE EXPONENTIALITY OF LONG-TERM GROWTH LEADS THE WAY TO EXCESS RETURNS

In contrast, the genuine long-term investor is one whose objective interest is to keep holding the asset. What kind of investor would benefit from a true buy-and-hold strategy? The quality-growth investor. Why? What is different in the case of growth investing? Why would this decreasing return phenomenon not apply to all growth stocks too?

Indeed, isn’t it simply a universal truth of sound investment1 that, whatever the form and underlying merit of any financial operation, its return may only exceed the cost of capital – or discount rate – if it is bought at a price below value and sold at a price closer to or at value. Thus, shouldn’t a growth investment also benefit from a fast rotation? Why then would growth investing be more prone to buy-and-hold?

There is a little mystery here that needs to be further looked into. We call it “the long-term growth conundrum”. As we will see, to unravel it requires thinking in a dynamic rather than static way in order to understand that value sometimes is not stable but can evolve and increase overtime.

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This paper was originally written in 2014 and has not been updated since publication. 


1
The notion of “sound investment” is meant to exclude the speculative cases where an asset may be bought at a price irrespective of its underlying value, thus potentially above value, and profitably sold back at an even higher price.

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