In the investing world, investors are always trying to find an edge to beat the market. One of the fundamental ways many investors try to find this edge is by deciding between a growth investing strategy or a value investing strategy. Growth investing involves buying shares at a relative premium in companies that are growing quickly. Typical examples include stocks like Amazon and Tesla. Value investing involves buying stocks that are undervalued compared to what their results indicate. Examples include Goldman Sachs immediately after the financial crisis and Coca-Cola in the early 1990’s. Value stocks usually sell at low multiples and are not in business sectors that are popular or trending.

Many people have spent a lot of time analyzing the two styles of investing and their results over time to try and discern which strategy is superior. Their results and conclusions often contradict one another. The debate was put back into the spotlight when David Einhorn, a value investor and founder of Greenlight Capital, commented on the debate in one of his quarterly letters last year. Einhorn said that growth stocks had been outperforming value stocks and the market as a whole over the past few years, and that he worried that “the market has adopted an alternative paradigm for equity value.” He also stated that he didn’t know when value investing would yield superior results again.

The letter made waves in the finance community. Many took it to mean that he felt that value investing was no longer a viable way of achieving good returns in the market. Einhorn later clarified himself, saying that he still believes that value investing is the best way to invest and that his fund still uses this style of investing, but that he didn’t know when it would be very effective again. Nevertheless, his remarks highlight a fundamental and unavoidable debate in the world of investing.

It’s relatively easy to see why growth investing makes sense: growth is good for business. Companies like Amazon and Tesla are expensive by normal measures, but they’re also important companies that offer products and services that people love. The thesis for investing in these companies is that the value of their business will grow as the company continues to grow quickly. As Einhorn points out, a shareholder of Amazon, Facebook and Tesla would have earned a great return in recent years. As LPL Financial reports, growth stocks have outperformed value stocks by as much as 50 percent over the past decade, a huge and remarkable return.

However, there are a couple pitfalls to this kind of investing. First, growth stocks typically become popular and increase in price after they demonstrate their growth. By the time most investors catch on, much of their profit margin has disappeared as people have bought into the stock. This also ties into a second pitfall with this kind of investing: the lack of contrarianism. Every trade made in the stock market represents a disagreement between someone selling a stock because they don’t want it and someone buying a stock because they do. This obviously happens when growth stocks change hands, but the people that are selling the stock have probably already made a big gain and are choosing to cash in on their winnings, leaving much less to whomever buys the stock. However, as mentioned earlier, the performance of growth stocks and some growth companies can’t be denied.

Value investing began as a philosophy espoused by Ben Graham and David Dodd in the early 20th century but has grown immensely popular over the past few decades as the result of its most famous practitioner: Warren Buffett. In short, value investors are bargain hunters. They look for companies that are undervalued; to the general investing community, this means that a stock is selling for a low P/E or P/B ratio. As shown by the success of Buffett, Einhorn and others, value investing can be a very profitable strategy. The idea of buying a share in a company at a discount and waiting for the rest of the market to catch on to the bargain is a low-risk way of investing. In addition, a value investor’s focus on the company’s performance in the present moment as a measure of its value also reduces risk. It’s much easier for investors to discern whether companies will continue to perform as they are than it is for them to predict their rate of growth years into the future. Despite value investing’s success over many decades, however, it has not been the most profitable strategy over the past decade. Value investments have made money, but as shown earlier, they’ve been handily beaten by growth stocks. All investors want to invest in the companies that give them the greatest return, and the ones that have looked for those returns in growth stocks have done better in recent years.

It’s clear, after going through the advantages and disadvantages of each type of investing, that there is no outright winner. However, what’s less clear is that the debate itself is fundamentally flawed. The problem is that investors have historically confused strategy with philosophy. When people debate these two styles, they debate them as strategies – the growth strategy involves identifying companies with a strong growth history and potential and lots of public visibility, while the value strategy involves identifying companies with low P/E and P/B ratios. What people ought to be doing is analyzing the two philosophies. Philosophy involves understanding what one wants in an investment and why a particular style of investing works, while strategy involves the methodology with which an investor finds investments that fits a particular philosophy. The growth philosophy is to find businesses that are growing at a quick pace that with profitability on the horizon and the value philosophy is to treat stocks as shares of a business and only buy at discounts to intrinsic value. Having a solid understanding of the philosophical side of an investment style provides the bedrock for formulating a solid strategy. The debate over which style of investing is superior is flawed because many investors skip over philosophy and jump straight to strategy.

When framed this way, the debate gets much clearer, and investors realize something crucial: philosophy is essential to strategy, since it creates the foundation for good strategy. Not making this distinction forces people into making rushed decisions. For example, many investors perform top-down research, which involves identifying a trend or quality in the market and looking for companies that fall into that trend or have that quality. In this case, growth investors could just screen every stock in the market and invest in those that are growing revenue at a certain percentage and value investors could just screen for companies that are trading with a low P/E ratio. However, the people that buy stocks based on this methodology aren’t staying true to either philosophy. Just because a company is growing quickly doesn’t mean that it can turn that growth into profit, and a company that is selling at a low P/E ratio might be doing so because it’s a horrible business. It’s extremely easy to fall into this trap and lose sight of why someone looked for value stock or a growth stock in the first place.

A bottom-up approach, where investors go from company to company identifying the ones they like: either based on profitable growth or undervalued assets, would be a more appropriate way to go. This approach would force investors to focus on philosophy first and thereby avoid making investments that seem great but really aren’t.
Understanding this distinction also helps reinforce the idea that it’s unclear which style is “better”. Value investing, despite what some seem to believe, is still extremely profitable for well-managed funds like Allan Mecham’s Arlington Value, which was up 29 percent last year and Mohnish Pabrai’s Pabrai Funds, which has returned over 1100 percent since 2000, have done well employing a bottom-up approach and a strong understanding of value philosophy. Einhorn’s fund has averaged a 16 percent return net of fees since 1996. These funds are evidence that value investing is still a very profitable philosophy if applied with patience and deliberation, as opposed to a haphazard strategy. The same is true for growth investors. Sequoia Capital, for example, has become the most respected venture capital fund in the world despite investing in new technology start-ups because it has a strong understanding of philosophy and a great strategy.

In the investing world, investors are completely reliant on how many opportunities they can identify and exploit. So, it’s easy to understand why investors want to rush to identify opportunities based on a stock’s popularity or P/E ratio. It’s impossible to really know which type of investing is better, since that would require going through each stock in the stock market, identifying its investment merit and then seeing if it’s a growth or value stock. But this is the point. Investors ought to first understand a philosophy well, and then employ that philosophy in a strategic way. The greatest investors, from Ray Dalio to Warren Buffett, have demonstrated that the deliberate application of a philosophy is the best way to consistently achieve superior results.

Art Valuation

In the world of venture capital, there exists a special class of startups that attracts the attention of investors from nearly all backgrounds: Unicorns. These firms consist of private startups that are worth at least one billion dollars. The taxonomy goes further in order to identify the truly massive startups called “decacorns,” referring to their valuations in excess of $10 billion. Companies like Uber, Snapchat, AirBnb and SpaceX are among the best-known unicorns.
Conversations about the size of the valuations seem just as ubiquitous as the companies themselves. Headlines read of Uber’s $62 billion valuation, which easily surpasses Ford’s $50 billion market capitalization, and of AirBnb’s $25 billion valuation, which similarly trumps Hilton Group’s $22 billion market capitalization, despite having only eight percent of its revenue. In response to these astonishing sums, skeptics reverse engineered the growth expectations via traditional valuation techniques and found that, with astonishing frequency, unicorn valuation depends purely on optimism. Optimism, however, is not a new element in Silicon Valley’s expectations or in inflated valuations. The cause for this trend in inflating valuations is best explained by the changing nature of venture capital as it pertains to unicorns, and as a consequence, it is clear that valuations do not attempt to represent concrete value.

New considerations have been included into the valuation calculus. Average funding round size has increased dramatically in recent years, with some suggesting that “Series A round is the new Series B round,” referring to the notion that funding typically increases in each successive round. Over the course of 2014, average Series A funding rose 6 percent, Series B rose 20 percent, Series C rose 31 percent and Series D rose an astounding 100 percent. The increase in Series D funding picks up on a new strategy used by technology companies like Uber, in which mature companies stay private for longer and sustain operations with large, late-stage funding. Indeed, part of the inflation trend is due to the prestige of unicorn status itself, which is evidenced by the fact that Fortune Magazine lists just fewer than 100 companies that have valuations of one billion dollars, out of a total of 229 unicorns. CEOs and investors may see a startup’s unicorn valuation as a way to legitimize the company, attract new talent and over time, justify the overly ambitious valuation. Another part of the valuation inflation is due to the popularity of “downside protection provisions” as elements in funding agreements that shield investors from risk. For example, senior liquidation preferences are one common downside provision, and specify that an investor has its investment returned before other preferred stock or common investors should the company be liquidated. Another common downside protection is a provision that guarantees an investor additional shares if the company raises funds based on a lower valuation, thereby preserving the value of the investor’s stake in the company. Such stipulations have been increasingly popular as a method to shield against risk from investors, which consequently frees investors to make larger investments. As a result, it is clear that the inflation seen in valuations of unicorns represents the fact that the valuations are not pricing risk accurately.

Notable individuals from the worlds of technology and business have voiced concerns over some outlandish calculations. Jim Breyer, prominent investor and partner at Accel, a venture capital firm in California, commented early this year that he expects only 10 percent of current unicorns to survive and the remaining 90 percent either to fail or be revalued. Assuming his estimation is correct, only about 23 companies have accurate, or at least sustainable, valuations. In fact, skepticism is not uncommon. Bill Gates is wary of the future of unicorns as well, and warned of “overenthusiasm” in startups during a February interview with the Financial Times.

Regardless, some investors remain bullishly optimistic on unicorns. Scott Kupor, chief operating officer at venture capital firm Andreessen Horowitz, attempted to disabuse skeptics of the notion of a second tech bubble in a presentation this past year. He highlighted several key differences between 1999 and today, most notably the dramatic increase of Internet users (900 percent), the amount of funding (only 32 percent of the 1999 level) and the much lower median time to IPO (four years today versus 11 then), among other metrics. Evidently, he failed to convince many of his colleagues. A survey of 500 startups conducted by First Round Capital found that 73 percent of responders affirmed the existence of a technology bubble. The proportions of this bubble do not approach the frenzy of the late nineties, but there still remains an implicit understanding between startup owners and venture capital firms that valuations do not exactly equal value.

These mismatched valuations explain in part the scarcity of technology sector IPOs in 2015. Once public, markets will decide the true value of companies, so startups need to delay public offerings until fundamentals can support IPOs that reflect private valuations in order to protect investor value. Both Box, a cloud storage company, and Square, a payment service company, went public with offerings priced below their private valuations, providing a cautionary tale for executives and investors at other unicorns who have their eyes on the public market.

Like the valuations themselves, the disagreement over the existence of a second technology bubble can only be decided by the market itself in the years to come. Many of these unicorns have indeed reached incredible sizes with incredible speed. In seven years, Uber became the world’s largest taxi provider; it took AirBnB eight years to become the world’s largest hotel-provider. Perhaps it seems likely that the upper-echelon of the “decacorns” has substantial overlap with the ten percent mentioned by Jim Breyer. Yet, considering the 100 or so startups that may have wrangled for a billion-dollar valuation only for the title, many unicorns are simply overvalued, despite the “enthusiasm” attached to their future prospects. Silicon Valley and its bankrollers ought to remember that while enthusiasm is a critical asset for any startup, it is only as valuable as it is monetizable.

Hulu.com was initially launched in 2007 as a defensive move by television networks to address the growing unlicensed television content being shared illegally over the internet. Television network executives at NBC Universal, Fox Entertainment and ABC created the website as a joint venture with the intention of avoiding the outcome of the music industry, in which third party applications, such as iTunes, became the ultimate profiteers of web-delivered content. By hosting high-quality, full-length television episodes, Hulu successfully ensured networks compensation for their content. The challenge currently facing the website lies in outlining a sustainable business model that can support its content and interface while still generating profit. Kim Joar Bekkelund’s analysis of the “freemium” business model provides the perfect platform to analyze the impact of Hulu’s newest feature, Hulu Plus, a subscription service that charges users for access to increased content on a wider range of platforms. This analysis shows us that, given Hulu’s costs and pricing options, the website is currently a poor candidate for the freemium model.

Prior to mid-2010, Hulu’s sole source of revenue was from the short fifteen-second to two-minute advertisements shown before and throughout videos. Although episodes streaming on Hulu have significantly fewer minutes of commercial than traditional television episodes, the website brings in considerable revenue because of its high traffic. Hulu presumably also charges advertisers a premium for the controlled quality of its content library, the interactiveness of its commercials, and its interface’s ability to tailor advertising to specific audiences. In 2009, Hulu’s revenue from its then entirely advertisement supported site was $108 million and the site’s annual advertising revenue has only grown since. Its costs are also significant, however. Although the company’s general administrative costs and the cost of supporting the website’s bandwidth should be relatively insignificant, Hulu must pay television network “content partners” 50 to 70 percent of its advertising revenue for permission to stream their video content.

Hulu added its second revenue stream in June 2010. Hulu Plus charges users a monthly fee of $9.99 for access to full seasons of television shows and the ability to use Hulu on select non-computer platforms, including iPads, iPhones, Blu-ray players, and certain Samsung televisions. (The price of the service has since been lowered to $7.99.) Notably, Hulu Plus is also ad-supported, suggesting that the company does not see subscription fees as a replacement for advertising revenue. The paid service is instead being positioned as an upgrade to the free version of Hulu. With this second revenue stream in place, Hulu has essentially transitioned itself into a variation of what is known as the freemium business model.

In his paper Succeeding with Freemium, Bekkelund outlines eight preconditions necessary for a freemium model to be effective.  Hulu meets most conditions: the site has a large addressable market, its interface makes the benefits of Hulu Plus clear to nonpaying users, and initial advertising for the free product was primarily driven by word of mouth. Hulu, however, fails to meet one key precondition—a low marginal cost. In theory, a freemium company uses its free product as a marketing tool to convert general users into paying customers and revenue from paying customers to finance the free product. Thus, it is in a freemium company’s interest to attract as many free users as possible to widen its pool of potential paying premium users. For the revenue from premium users to cover the costs of a high number of free users, marginal cost must be low. Hulu’s high content cost prevents it from meeting this condition.

It may seem that, because Hulu brings in advertising revenue from videos streamed, its high marginal cost should not be an issue; this is unfortunately not the case. If profit margins from Hulu Plus users were significantly higher than those from free users, Hulu Plus subscription fees could cover the majority of Hulu’s business costs and profit expectations. Advertising revenue from free users would then be supplementary and Hulu would essentially operate under an adapted freemium model. However, because Hulu Plus offers much more content than the free version of Hulu, streaming full seasons of shows rather than four or five recent episodes, Hulu Plus’ content costs are also higher. As a result, the profit margins of Hulu Plus are likely similar to those of Hulu. If Hulu was unable to sustain itself with only advertising revenue from its free service (which seems the case given that adding a pay wall on a previously entirely free website runs the risk of alienating existing users), the addition of Hulu Plus is unlikely to help the situation.

Bolstering Hulu’s profitability by adjusting the price or product mix of Hulu Plus is also not an option. In fact, given the company’s unique constraints, there is in fact no possible price point or product mix combination at which Hulu Plus would be profitable. Media feedback and the company’s decision to reduce Hulu Plus’ price shortly after its launch indicate that users are reluctant to pay for the service. Because Hulu needs permission from television networks to provide content, it does not have the option of improving Hulu Plus’ content offer and driving up the subscription fee. Furthermore, since television networks are accustomed to higher compensation for their content from other distribution channels (network television, DVD sales), Hulu is unlikely to negotiate its content costs down.

Adjusting free and premium product mixes is often used as a method of encouraging premium service sales. By reducing the quality of their free service, companies can make their premium service more desirable in comparison. However, because Hulu faces stiff competition from other video providers in the market, artificially decreasing video content or increasing the amount of advertising on the free service, would drive users away from the website completely. Besides online pay-per-view service websites (iTunes, Amazon) and other subscription based video services (Netflix), Hulu competes against illegal video sharing and file sharing sites that offer video content for free. Such sites have nonmonetary costs for users, such as a risk of computer viruses, risk of prosecution, and a level inconvenience. Even still, if the quality of Hulu’s free service declines excessively, users may nonetheless return to these options for their online video needs.

Thus, as the service currently stands, Hulu Plus is a poor application of the freemium model and not a viable long term business plan. In fact, content partners may actually be the main beneficiaries of Hulu Plus. Television networks have long complained about the compensation they receive for their content from Hulu and Hulu Plus could very well have been intended as an addition revenue stream designed to appease them. Hulu was founded as a joint venture between television networks but, as an independent company, its current priority should be to establish a business model that optimizes its long term profitability. This version of “freemium” is clearly not the answer.