CASE ANALYSIS: GMO: THE VALUE VERSUS GROWTH DILEMMA Submitted to: Mr. Sabin Bikram Pant, Course Instructor: Investment Management, Kathmandu University School of Management Submitted by: Group 4 Manita Pokharel (12324) Murary Prasad Roy (12325) Nikkey Shrestha (12330) Shivshankar Yadav (12336)
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CASE ANALYSIS:
GMO: THE VALUE VERSUS GROWTH DILEMMA
Submitted to:
Mr. Sabin Bikram Pant,
Course Instructor: Investment Management,
Kathmandu University School of Management
Submitted by:
Group 4
Manita Pokharel (12324)
Murary Prasad Roy (12325)
Nikkey Shrestha (12330)
Shivshankar Yadav (12336)
MBA, Term-IV
February 25, 2013
Case Analysis: GMO: The Value versus Growth Dilemma
Synopsis
Investment is a widely discussed topic around the world and investors are guided by various
philosophies and investing styles. The case has discussed the benefits and risks associated with
both value and growth investing styles along with several challenges being faced by Dick Mayo,
(one of the founding partners and portfolio manager of GMO) in analyzing whether the value
investing strategy used at GMO has been able to prove a better strategy for the investors’ or not.
The trend that was emerging in the particular economy, i.e. popularity of growth investing
strategy (price appreciation) and outperformance of growth stocks compared to value stocks, was
puzzling Mayo about market and investors’ behavior. In this context, Mayo along with the
decision making team have also analyzed some value investment stocks like CVS, Donnelly, and
Manor for further investment prospective. With the value investing style that Mayo has been
focusing for the company, there is a concern whether continuation of same investment style as
considered by Mayo can generate relative benefits for the investors in that particular situation.
This case analyzes the merits and demerits of value and growth investing styles and relates to the
situation of Mayo in determining the investors’ perception about the company’s investment
strategy.
Key Issues
Dick Mayo has been facing a sensitive issue that is of concern for most of the stockholders.
Since the focus of the company has been investment in value stocks that have been mispriced
and that can provide benefits in the long term, Mayo is worried about the trend that has been
arising in the economy. The emerging popularity of the company’s price appreciation in
investors’ decision making had raised some serious questions regarding the investment
consideration in terms of value investors.
The major issue that has been explained in this case is “Can value investing still be a better
strategy in this changing economy? And how can the investors are convinced about benefits of a
particular investment style matching to their needs rather than deciding their investment based on
the market trends?”
1. Value vs. Growth Investing: Differences (Merits/Demerits and Superiority)
The tremendous investment concepts and theories generated over years have been able to
distinguish various investment styles based on the strategies applied. Investment styles provide
investors with a vast number of approaches that may or may not fit their criteria. Two of the
most popular investment styles: Value Investing and Growth Investing have been discussed over
years, and decide which style is correct; yet is a matter of study over time.
Value investing considers buying stocks that are undervalued, but the value investment can
provide with benefits only if the company selected is financially sound and the stock mispriced
(undervalued) is based on temporary market inefficiencies.
Growth investing are considered for investment if the trend shows that they are providing with
above market rates of earnings growth, but they also carry the risk of the stock performance
below expectation of investors.
The value and growth investment style mainly differs in the way in which they are perceived by
the market and ultimately, the investors. Both investment styles seek for maximizing the returns
by seeking the lower priced stocks either underpriced in compared to intrinsic value or expected
high returns through growth of the company. Beside this, the given two investment styles can be
distinguished on following grounds:
Basis Value Investment Style Growth Investment StyleFocus of the investors
Finding an outstanding company at a sensible price
Value investors focuses on the price (P) of the stock at the expense of the earning (E)
Finding a company with high growth prospects with a willingness to pay premium price.
Investors focus more on earning of the company rather than the price incurred to acquire the stock.
Emphasize on less tangible characteristics such as sustainable competitive advantages of the selected company
Investment Philosophy
Identify the undervalued stock with an optimistic view to market correction
Buy a stock no matter what its price is at market and sell it for more prices.
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Investment Risk At bear market, prices of stocks might fall dip further with the market slump; at bull market that appeared overvalued at one time, the prices might rocket further along with the market.
Difficult to identify the right market timing i.e. to find the price of company to buy and the timing of selling
Evaluation of stocks as ‘ good value’ is misread
High probability of losing money in short period of time.
The market downturn hit growth stocks far harder than value stocks. For instance, the growth investors lack the fundamental basis of reasoning their investments thus herd mentality can influence the investor psychology which drive them towards risk of huge price swings.
Future growth does not occur as expected
Nature of stocks Value stocks are considered to be undervalued by the market.
Traded at a lower price relative to their fundamentals or say trading at a discount to ‘intrinsic value’
Investors purchases value stocks in the hope that they will increase in value when the
Growth stocks deals with the high-quality, successful companies whose earnings are expected to continue growing at an average rate relative to the market.
Growth stocks may be seen as expensive and over-valued
Typical Features Low current price-to-earnings ratios
Low price-to-book ratios Higher dividend yield
High price-to-earnings(P/E) ratios High price-to-book ratios Pay lower or no dividends and focus
on the capital appreciationStrategy Low P/E strategy: focus on
defensive, cyclical and out-of-favor industry groups
Contrarian Strategy – interested in stocks with low valuations relative to book value
Yield Strategy – purchases the stock of firms with above-average dividend yields that are expected to maintain or increase their dividend
Consistent Growth Strategy – follows high quality firms with continually growing earnings
Earnings Momentum Strategy – Purchases the stock that display accelerated earnings growth in the near future.
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Business
Lifecycle
Value investors consider the mature companies or companies in slow-growth and companies that paid dividends to shareholders
The growth companies are merely at the early stage of the company’s business cycle or have huge potential to emerge in the market.
Neither value nor growth guarantees appreciation in stock market value because of the
investment risk associated with each. The superiority of any approach depends upon the nature
of the investors, market conditions or economic cycle, investment risk, etc. Both approaches
have their own merits and demerits.
For instance, Value manager may fall into the value trap believing that the market has
overreacted but what if that is not the actual scenario or manager fail to identify the correct
intrinsic price due to biases in picking out the calculating elements such as earning of the
company. Whereas the growth strategy may not perform as expected if the company fails to
materialize the expected growth.
In order to minimize the risk associated with each investment style, the investors can look for
holding both value and growth stocks since the growth and value investments is highly
correlated, so holding both investment styles offers no significant diversification benefits i.e. no
risk leads to no return.
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2. Is Value Investing Wrong Strategy in the New Economy?
From the case it can be analyzed that the time period that considered the issue was relatively
strong economy compared to the periods of economic downturns. As given in the case, the new
U.S. economy was strong with less significant inflationary effects, low unemployment,
increasing productivity. The influence of internet and technology was slowly observed even in
the investment environment. This was leading to investors’ focus on price appreciation on
investments rather than the earnings growth.
Value investing can be a difficult approach for the investors, because the analysis of intrinsic
value can be done through use of different approaches. Since, during the new economic
condition, the value stocks have shown less performance than expected, it can create a doubt
among investors on whether the value investing strategy can provide benefits in the coming time
period. The earlier periods showed a distinct pattern on performance of value and growth stocks.
But, the trend had been disturbed. The investors not just passively waited for long term value of
stocks, but were rather interested in the stocks that could provide capital returns much sooner.
This signifies whether the value investing strategy sustain in long run in the midst of the ever
changing environment.
As in the exhibit 4, the cumulative return of BARRA S&P 500 Growth/ Value Indices vs. the
S&P 500, the value investment (BARRA Value) was raising high since January 1975 than other
investment styles i.e. growth investment style (BARRA Growth) and indexing investment
styles(S&P 500). After the 1997, the trend reversed and Growth investment indices rose higher
than other indices, the reason could be change in the investors’ perspective towards the new
economy, arrival of new technology and long term growth prospects of the companies,
emergence of globalization and its inevitable impact over the competitive periphery of the
companies, change in investor’s preference for risk return trade off, etc. This shows how the
growth investment styles has outperformed over the value investors with change in pace of time.
Similarly, the exhibit 1, Capital appreciation of major indices, shows that indexing investment
styles i.e. S&P 500 index and NASDAQ Composite index have outperformed the value
investment style i.e. Russell 1000 Value in both two year and one year index capital
appreciation. The lower capital appreciation would lower confidence in the investors.
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Analyzing the return from the different investment styles in the exhibit 2, Total Returns of
Certain GMO U.S. Active Funds and Relevant Indices, the return from GMO value investing
lays below the given indexing investment styles. As per the case, the 5 years return of GMO
Pelican Fund is lowest i.e. 15.57 in comparison to the NASDAQ 100 composite i.e. 41.61%.
This signifies how the use of automated technology can assure NASDAQ to outperform other
indices in the market.
From the analysis of the Exhibit 1, 2, and 4; the trend shows that with the change in economy
pace the investment styles too change. So, the superiority of any investment styles whether
value, growth, momentum and indexing are highly influenced by the external factors such as