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Cheap versus Expensive

Go to Morningstar's website and you'll notice the "U.S. Barometer" in the top-middle of the page. The barometer shows nine boxes, with "Growth - Core - Value" across the top and "Small cap - Mid cap - Large cap" down the side.  It's known as the Morningstar style box and purports to give a view of U.S. stock market action by market cap and by style (that is, if you treat "value" and "core" and "growth" as investing styles).


Value stocks are generally defined as those meeting some variation of metrics that include low price/earnings ratio, low growth, low price/book ratio. Growth stocks are generally thought of as the opposite.


We do not think about businesses (or stocks) this way. We think about what we must pay (i.e., price) and what we get in return (i.e., the durability and - yes, likely growth - of earnings, cash flows, assets). Sometimes businesses that have relatively low price/earnings ratios and don't grow a lot can be expensive. And sometimes businesses that have relatively high price/earnings ratios and do grow a lot can be cheap. Such is the nature of market cycles as themes and concerns rise to the forefront and then fade away. As you will often hear us say: price is what you pay; value is what you get.


Bill Nygren at Oakmark summed up this concept nicely in his 3Q 2023 letter to shareholders(1):


"The idea that value investing is limited to outdated, competitively disadvantaged companies selling at low P/E ratios couldn’t be further from our definition of value. In fact, one of my favorite questions from investors is, “What would you do if ‘value’ got expensive?” What they are really asking is how we would respond if below-average businesses sold at average prices. Well, then they wouldn’t be undervalued. But the better businesses that should be selling at higher P/E ratios would be. Buying great businesses at average prices is just as much value investing as buying average businesses at great prices…It is simply inaccurate to position value as the opposite of growth. I like what Buffett said, “Growth is part of the value equation.” Investors should pay somewhat more for faster growing businesses, though the premium is often more than we can justify. But when the market underprices growth, buying faster growing businesses is value investing."


So we don’t think of “growth” as a style. It is just one (important) part of how to evaluate a business.


If it were up to us, we'd modify Morningstar's style box by changing "value" to "cheap" and by changing "growth" to "expensive" (and of course changing the metrics for segmentation accordingly). Then we could have interesting conversations with active fund managers about why they own more or less of the cheapest or most expensive stocks. 


Turns out it is the cheapest segment of the U.S. stock market that is on sale today. As the chart below(2) from GMO shows, the segment that represents the cheapest 20% of the largest 1,000 U.S. stocks is trading at the 5th percentile of its history with no discernible difference in quality (i.e. this segment has only ever traded at a lower valuation 5% of the time in the last 30 years).  Whereas other segments of the market are all trading at rich valuations (86th percentile or higher) relative to their history.

Which rhymes with Bill Nygren's concluding comment that "the Oakmark Fund today looks more like a traditional value fund than it has in a long time."


But make no mistake, it's not about value versus growth - it's about cheap versus expensive.


  2. GMO 2023 Conference, "Profiting from Dislocations: Designing Strategies to Exploit the Deep Value opportunity," John Thorndike and Simon Harris, November 2023


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