Dakota Office Productsgmo: the Value Versus Growth Dilemma

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The case GMO: The Value versus Growth Dilemma describes Dick Mayo’s puzzlement by the New Economy’s continuous bias toward growth-investment strategies. As one of the most celebrated value investors in the United States, he examines the basics of his philosophy versus that of a growth orientation by evaluating long-term expected returns of several value and growth stocks. The following paper was examined to pursue several objectives: (1) to define value and growth investing – where the differences lie and whether one approach is superior to the other or whether both have merit; (2) to perform basic valuations of Cisco Systems (a growth company), CVS, R.R. Donnelly and Manor Care (value companies) and to compute their long-term expected returns; and (3) to discuss issues concerning the consistency of GMO’s investment philosophy even when the market seems to run counter to it for a prolonged period of time. In this respect we will also consider the issue if value investing can still deliver significance in this New Economy or if is it only an Old Economy concept and if we would invest in GMO.

GMO was founded in 1977 by Dick Mayo, Jeremy Grantham and Kingsley Durant. From its beginning the company applied a fundamental bottoms-up approach to institutional investing, focusing on out-of-favor, sometimes unexciting domestic companies trading below intrinsic value (U.S. Active). Throughout the 1980s and early 1990s this strategy of identifying and investing in undervalued companies had paid off as U.S. Active had returned an average of 19.1% per year, 4.3% above the S&P 500 Index of large capitalization stocks (figure 1). Nevertheless, over the following years the firm broadened its scope to include international investing (International Active), and shortly thereafter, developed quantitative investment strategies. As of December 31, 1999, GMO managed in excess of $20 billion for almost 500 institutional clients, including educational endowments, corporate pension funds and private foundations, placing the firm among the top 100 money-management firms in the United States.

Figure 1:The Returns of Certain GMO U.S. Active Funds and Relevant Indices as of 3/31/00 However, during the latter half of the 1990, GMO faced several challenges and pressures, which were mainly described in the company’s under-performance in comparison with growth investing funds. But what exactly is growth investing and where lies the difference to GMO’s investment style?

Value and Growth Investing – Definitions, Differences and Merits The following part provides a clear definition of value and growth investing – where the differences lie and whether one approach is superior to the other or whether both have merits. Although value investing has the stigma of basically being the simple pursuit of ‘cheap’ stocks, this description is a gross oversimplification. Value investors look for ‘bargains’ typically found in stocks offered by firms that are older or “mature” in the business lifecycle, operate in slow-growth industries, or have had problems in the past that led other investors to divest a firm’s shares. The key to this strategy is the belief that a particular stock is trading at a discount relative to its intrinsic value and that the stock will increase in price once the market realizes the true potential of the company; the low price is merely a market inefficiency that will be corrected in time. In terms of statistics, investors who pursue a value-investing strategy usually pay attention to absolute, company-specific measures and target stocks that have relatively low price-to-book, price-to-earnings , price-to-sales, and price-to-cash flow ratios. They can also be drawn to a stock because of a wide gap between a company’s earnings growth and P/E ratios, or because the firm pays out dividends to common shareholders. With value stocks, a great deal of patience is required. It is not unusual for value...
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