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 SynopsisInvestment 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 companys investment strategy.

Key IssuesDick 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 companys 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 Focus of the investors

Investment Philosophy

Value Investment Style Growth Investment Style Finding an outstanding Finding a company with high company at a sensible price growth prospects with a willingness to pay premium price. Value investors focuses on the price (P) of the stock at the Investors focus more on earning of expense of the earning (E) 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 Identify the undervalued stock Buy a stock no matter what its with an optimistic view to price is at market and sell it for market correction 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 Growth stocks deals with the highquality, 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

Nature of stocks

Typical Features

Strategy

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 Low current price-to-earnings ratios Low price-to-book ratios Higher dividend yield Low P/E strategy: focus on defensive, cyclical and out-offavor industry groups Contrarian Strategy interested in stocks with low valuations relative to book value Yield Strategy purchases the stock of firms with aboveaverage dividend yields that are expected to maintain or increase their dividend3

High price-to-earnings(P/E) ratios High price-to-book ratios Pay lower or no dividends and focus on the capital appreciation 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.

Business Lifecycle

Value investors consider the The growth companies are merely mature companies or at the early stage of the companys companies in slow-growth business cycle or have huge and companies that paid potential to emerge in the market. dividends to shareholders

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 investors 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.5

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 economic cycle, change in technology, inflation level, customers confidence level, availability of the information, accuracy of the fundamental analysis, etc. Thus, any investment style by itself may not be right or wrong, but the proper strategies in investing and generating returns at correct time is very crucial for the decision makers.

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3. Why wouldnt GMO include Cisco System, an otherwise excellent company, in its portfolio at this time? Why is it willing to consider CVS or RR Donnelley? What are the long term expected returns for those stocks?Calculation for Stock undervalued/ overvalued identification : In 2000 Cisco CVS R.R Donnelley Current price PS Book value per share EPS PS LT growth Rate Treasury bond rate Yield on AAA rated bond 132.06 5.01 1.17 30 Given Federal Reserve Economic DataLink: http://research.stlouisfed.org/fr ed2 Calculation Price/ book Vale 26.36 2.96 2.08 1.31 6.1 7.04 28 9.46 1.8 17 6.1 7.04 19.38 9.3 2.45 12 6.1 7.04 Manor Care 12.56 9.58 1.28 15 6.1 7.04

Price/ earnings

112.87

15.56

7.91

9.81

Price for standard

(

)

69.44

66.29

68.99

42.70

Expected LT rate of return on stocks

(

)

9.2 Given

(0.23 (1+.17))/28+ 0.17= 17.9%

(0.88 (1+.12))/28+ 0.12= 17.08%

15% same as growth rate

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Decisions basis

Decision criteria for value investors

1. PBV ratio

lower is the best

Overvalued

undervalued

Undervalued

Undervalu ed

2. PE ratio

Lower is the best

Overvalued

undervalued

Undervalued

Undervalu ed

3. Graham's method

If the stock traded at less than

overvalued

undervalued (28