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Buying Growth Stocks at Reasonable Prices Is Value Investing

While value investing is often confused with value stocks (businesses that trade at a low multiple but have a low-growth or no-growth prospect), we think that the approach should by no means exclude growth business as long as their shares aim to be bought at reasonable prices. As a matter of fact, Warren Buffett (Trades, Portfolio), the legendary value investor, never seems interested in categorizing stocks between value and growth. During the 2000 Berkshire Hathaway (BRK.A)(BRK.B) shareholder meeting, he said:

"There is no distinction in our minds between growth and value. Every business we look at as being a value proposition. The potential for growth and the likelihood of good economics being attached to that growth are part of the equation in the evaluation. But they are all value decisions."

Charlie Munger (Trades, Portfolio) went on to say that "all intelligent investing is value investing - you have to acquire more than you really pay for."

Value and growth stocks can arguably be comparable to each other through the total return valuation metric. To elaborate, let's take a look at the following two technology companies.

Israeli-based Check Point Software Technologies (NASDAQ:CHKP) recently traded at around a price-to-free-cash-flow of 15 times. The corresponding yield of nearly 7% appears attractive. At the same time, the cash flow should be predictable. This is because the business harvests stable recurring revenue streams from subscriptions, software updates and maintenance and protects its profits well through a high switching cost and a high reputation in the mission-critical space of cybersecurity. The top line at Check Point is growing at 5%, 6% and 8% on a three-year, five-year and 10-year basis. For the current fiscal year, the company is delivering a 14% return on assets, 23% on current equity, 20% on invested capital and 73% on three-year incremental equity.

It does not pay a dividend, but instead retains all earnings for reinvestments (including share repurchases). According to industry studies, the cybersecurity market is expected to grow at an at least high-single-digit rate through 2023. Considering the management's capital allocation record, the defensible and capital-light business model and an industry tailwind, we may safely assume a mid-to-high single-digit growth rate in free cash flow over the medium term (defined as the next five to 10 years) as the base-case scenario. As a result, a low-to-mid-teens annual total return of the stock is quite achievable here, mostly thanks to the high current free cash flow yield.

Now consider Denmark-based SimCorp (OCSE:SIM). The stock of the leading software provider for asset managers, asset owners and adjacencies is currently yielding only around 2% in free cash flow. But if you assume that high multiples always mean less value, you may want to think again. As with Check Point, SimCorp also possesses a competitive moat primarily derived from a high switching cost and a niche focus. We have observed that it is extremely rare for the company's client to switch to a competitor's solution.

The cash flow of the business is also forecastable thanks to the recurring sales and asset-light operations. If the company does not grow, it can be reasonably expected that a 2% return is all investors can get in the long run. Fortunately, SimCorp, even as the global leader in the niche, only shares 15% of the total market, leaving plenty of runway for further growth. With massive investments in technology (typically 20% of revenue), the company seems to have competed favorably against peers like BlackRock's Aladdin and Charles River Development as well as in-house solutions when it comes to winning new clients. The top line at the business grows at 15%, 14%, and 10% on a three-year, five-year and 10-year basis. The company is delivering a 27% return on assets, 49% on current equity, 38% on invested capital and 33% on the three-year incremental equity.

Usually, 30% to 50% of earnings are paid out as dividends. In light of the superior track record of capital allocation, return on investment and expanding the install base, we are confident that a mid-teens growth rate in free cash flow can be attainable at least over the medium term. Therefore, shareholders can expect an annual total return of 15% as the base case or 20% as the bull case, according to this calculation. The main contributor, this time, would be the future growth of the low yield at current.

Despite the high multiple of the shares, investors may want to opt for SimCorp rather than Check Point if they are confident about the growth estimates outlined above. As we can see, both stocks should offer value to those with a 10% hurdle rate, although in a different way. Instead of the growth/value category of stock, we would concentrate on figuring out the total return of those high-quality businesses.

Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Check Point and SimCorp.

Read more here:

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This article first appeared on GuruFocus.