Musings on Markets: Snowmen and Shovels: Investing Lessons?

I live near New York and woke up this morning to our first snowstorm of the winter (we had a freak one in the fall but no snow in November and December). As I looked out of my window, I heard two sounds. The first was of small children squealing in delight, as they tromped through the snow and started building snowmen and throwing snowballs. The second was the grating sound of snow shovels being used by their (mostly morose) parents to clear the snow from their driveways. Three things came to mind. The first was the oddity of the same phenomenon (a snow storm) evoking such different reactions from two different groups. The other was the irony ?that the parents were one day (long ago in the past) happy to see the snow and today's ?happy children will one day grow up and be wielding their own snow shovels. The third is that a week from now when it warms up, the snowmen will melt away, and the unshoveled driveways will look just as good as the shoveled ones.

I am sure that there are some deep life lessons in this phenomenon but I am not a philosopher. I do see some investing and valuation lessons in snowmen and shovels. After all, you can divide the world of active investors into two broad camps: growth investors and value investors. Consider the extremes in each camp. Extreme growth investors (you know the ones.. they go for momentum, love IPOs and are dazzled by high growth) remind me of the happy children, looking at snow and seeing snowmen, whereas extreme value investors (and you also know these ones.. they love net net investing and read Ben Graham's Security Analysis for inspiration) ?more closely resemble the snow-shoveling parents. Each group views the other with disdain. Extreme value investors consider growth investors to be dilettantes, unserious and unwilling to grow up, who see the world through rose-colored lens. Extreme growth investors view value investors as boring, stuck-in-the-mud pessimists, who see only the dark side of things.

So, which side is right? I think both sides are right and both are wrong. While each side sees a portion of reality, each side is also missing a piece of the real world. While the value investing group is right in its view that most growth companies will not make it through the challenges of the real world, the growth investing group is also right in its view that some of these growth companies will be the big winners of the future. By staying dogmatic, both groups open themselves to significant investing/valuation mistakes.?A growth investor who closes his eyes to the very real likelihood that a growth company will not survive will over value that company. By the same token, a value investor who insists on incorporating only the worst case scenarios, estimates cash flows ?conservatively? and then applies a huge ?margin of safety? before investing will never find growth companies to be bargains.

The key to investing, as in so much in life, is to maintain balance, recognizing that dreams sometimes come true, while keeping your feet grounded in reality.?Put in valuation terms, the key to valuing a company well is to estimate what will happen (to earnings and cash flows) not only in good scenarios (let?s call these the snowman scenarios) but also in bad ones (the shovel scenarios). ?It is a challenge I face whenever I do valuation. As I value a company, I have to constantly stop and look at the assumptions I am making and whether I am tilting too much to one side (snowman or shovel). If I find myself tipping too much into the ?snowman? camp, I have to bring in some of my ?shovel? side to play to get back to synch. If, on the other hand, I am letting my pessimistic shovel side dominate, I have to consciously force my fun snowman side come into play.?

So, here is how I am going to start today?s path back to balance. I shoveled this morning, just before I came in and wrote this post. My kids are too ?old? to enjoy building snowmen, but I am not. I am going to go out and build a snowman, make a snow angel and perhaps throw some snowballs. Why should those kids have all the fun?

Source: http://aswathdamodaran.blogspot.com/2012/01/snowmen-and-shovels-investing-lessons.html

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