I remember when I just started to think about my first investments, I struggled with choosing the ‘right’ investment approach. It took me quite a while to understand what was going on (dozens of books and articles, hundreds of hours of videos and years of practice ). I am a slow learner. I hope that what I wrote below would help all investors who are just starting on their journey.
There are two ways to describe Value Investing and this is what causing the confusion.
Strictly defined, Value Investing is buying stocks at prices below their intrinsic value. As a famous investor and author, Joel Greenblatt, likes to say, ‘Figure out what the business is worth and pay a lot less for it’. There is little argument here. There are other methods, which are not based on business fundamentals, such as technical analysis, momentum, quantitative strategies and others. If you think who the richest investors are and how many super rich technical analysts are out there, then it becomes obvious that value investing (as defined above) is the superior method. Very few truly successful investors make decisions based on macro or other, non-fundamental factors like Stanley Druckenmiller, George Soros, Ray Dalio.
Even richest businessmen, such as Jeff Bezos or Bill Gates, got to the top by making decisions on where to invest their time and capital based on fundamentals (future demand, competition, costs etc).
Warren Buffett wrote a very good article in 1984, called ‘The Superinvestors of Graham-and-Dodsville’ (the link to the article is in My Library). Just in case you are still debating on what investment approach to use I recommend you read this article by Buffett.
What is the real challenge?
So why then do you read articles on Whether Value Investing is Dead? Or What is Wrong with Value Investment Approach? - you can easily ignore them. Nothing can be wrong with paying less for something that is worth more.
But here comes the tricky part: How to establish the fair value of the business?
Theoretically, a business is worth all the cashflows that it will generate in the future discounted to today. The idea of discounting is to reflect time value of money and alternative options. The alternative to investing in a business is putting money in a bank which in good old days would generate 3-5% interest income. You could use a higher discount rate for your investment into a business to reflect extra risks (e.g. 10%). So you become indifferent between having $100 in one year after investing in a business or having $90.9 cash today. Invested at 10% return, this $90.9 cash would turn into $100 in one year. In other words, cashflow that your investment would generate in one year is only worth $90.9 today. The further we go into the future, the less valuable cashflow becomes in present terms.
For now, there is nothing to disagree with as is all quite theoretical.
But how do you know what cashflow the business will earn in Year 2 or Year 10 and whether it will even remain in operation in the future. To complicate matters, what if the government raises taxes in the future which would reduce company’s income? Or, what if some of company’s products are sold abroad in foreign currency? How do you know that exchange rate would remain the same and if it changes, by how much then?
I think this is where the disagreement begins. A narrow, more traditional Value Investing approach would put more emphasis on the current or historic performance and avoid making long-term projections. Investor using such approach would also look into current assets and liabilities. The logic is that if a company has historically earned $100 in annual profits (over the past 10 years, for example) and has invested back (spent on capex) the same amount as its depreciation charge in the P&L statement, generating the same $100 of free cashflow (FCF), then it is likely that this company would earn similar profits in the future, perhaps slightly higher if adjusted for inflation.
So a traditional value investor would not want to pay more than $1,000 for such business (if he uses 10% discount rate). He will also get additional comfort if company’s book value of assets is $1,000 (as reported in the latest balance sheet). If there is no debt (construction of assets was financed with shareholders’ capital), then company’s equity would be the same - $1,000.
He may even get more interested in the opportunity if the business earned just $50 in profits in the latest year, having earned $100 for 10 years prior to that as long as he is confident in this business. One idea that is often used by traditional value investors is Mean Reversal. Returns on capital, profit margins and other key ratios may deviate in the short-term but tend to go back to their historic averages in the long-term. If it costs $1,000 to build a new plant, but current industry conditions reduce profits to only $50 a year, no new plant would be built (as you would get only 5% return on your investment). Reduction in supply would rebalance the market and bring profits back to historical ($100) level.
Businesses that experience deterioration in their financial performance tend to be valued at a discount. Market would apply higher discount rate (lower earnings multiple) to reflect additional uncertainty and possible further decline in profitability (if recent trends are extrapolated).
So a business whose earnings dropped 50% may be valued at 7-8x, instead of 10x, or as low as $350 (7x PE multiple X $50 earnings; or $50 earnings capitalised at 14.2%).
For a value investor this could offer a double opportunity - recovery in earnings and normalisation of earnings multiple (reduction in discount rate). As long as the business is not in permanent decline.
A usual short-cut is to rank companies by main valuation metrics such as PE, Dividend yield, P/B and pick companies with the lowest multiples. For almost a century, companies that were ranked lower outperformed companies with higher multiples. Not every year, but over the medium to long-term.
However, since the Great financial crisis of 2008 low PE stocks have underperformed more expensive stocks. Overall returns of low PE stocks were about 10% p.a. which is in line with historic market performance, but US market (measured by performance of S&P500) has delivered substantially better returns (c. 15.5% including dividends from 1 Jan 2009).
Reasons behind recent underperformance of Value Investing (narrowly defined)
There are at least 5 reasons why such method has underperformed the broader market. The good news is that 4 reasons are temporary.
1. Interest rates - as rates dropped almost to zero (when I am writing this, 10-Year US Treasury yields are at 1.63%, German 10-year government bonds at negative -0.13%) the value of cashflow that would be earned far in the future became more valuable in today’s terms, while the value of near-term cashflow did not change as much. As a result, companies with potential to earn considerably more in 5-10 years became more valuable compared to more stable businesses. This is a temporary issue and with more signs of rising inflation, we could even be at an inflation point today (in late May 2021).
2. The rise of passive investing - technological revolution allowed to create low-cost funds (ETFs) that track the broader market as well as specific industry and regions allowing retail investors to participate in the stock market more actively. As a result, ETFs have seen huge inflow at the expense of actively managed funds (where portfolio managers choose stocks based on fundamental indicators). ETFs make decisions on buying and selling not based on valuation of companies, but based on flow of money in and out of such funds, while individual stock selection is based on SIZE. So companies with rising market capitalisation attract more demand from passive funds which leads to additional growth. This is also a temporary factor as the market cannot be fully owned by passive funds. In fact, from late 2020 actively managed funds have started to see positive inflows (see chart below).
Until recently, actively managed funds have suffered outflows
Source: EPRF, Financial Times
3. Disruption - as new technologies are more actively used in various industries, this shortens product life cycle, allows consumers to switch to new offers and makes traditional competitive advantages (moats) less relevant. If previously Gillette razors (now produced by Product & Gamble) were the only ones that could afford to spend billions on TV advertising and that scale was their key competitive advantage, now new start-ups like Dollar Shave Club or Harry’s can find their customers with more niche and low-cost advertising on Internet. As a result, past earnings become much less useful in understanding future earnings potential of the business. Many low priced companies turned out to have serious issues with their business models and were permanently impaired (e.g. US brick-and-mortar retailers). Ability to envision the future has become more important. Soft factors including management’s skills, innovative culture of a company often become more relevant than physical assets. Investments in innovation are just salaries paid to engineers as well as marketing expenses to promote new products and bring new customers. Such expenses are recorded in the P&L boosting costs and reducing profits, unlike purchases of equipment which are recorded in cashflow statement, as well as in balance sheet through additions to assets and equity (via earnings). As a result, a company which heavily invests in new technology can be loss making with very light asset base - a combination that will hardly make it appealing for traditional value investors. Yet, the real value that such company can generate in the long-term can be significant.
4. Faster earnings growth of tech giants - new technologies opened new markets and forced companies from old sectors to adopt to a new digital world by purchasing new services (e.g. cloud) - exactly as market participants expected in late 1990s bidding up stocks of young tech companies to the sky. However, just a handful of companies managed to capture most of the benefits (often grouped under the FAANG acronym). These companies continued to generate earnings growth well over 20% for more than a decade. Formally, stock return is the sum of (i) Change in PE, (ii) dividend yield and (iii) and Change in Earnings. If a company does not pay any dividends and trades at the same multiple, then it’s stock return would match earnings dynamic. In case of FAANG stocks, investors could have achieved 20% appreciation in the value of their stocks simply through this earnings growth. Traditional companies - a focus for value investors not less because of past earnings and visible tangible assets - had to spend more on new technologies and faced competition from new players which negatively impacted their sales. In the end, margins of many traditional companies were squeezed on top of declines sales - hardly a winning formula even for low-priced companies.
5. Computers made financials transparent - low priced stocks have become quickly discoverable. In Snowball, a biography book on Warren Buffett, the author described how the legendary investor would travel to a different town to get hold of an annual report of a particular company. 50 years ago, your advantage could have been in seeing financials before everyone else. There was nothing illegal in this, rather just lack of technology and focus. These days, not only you can get the latest financials in 2-3 clicks, but you can slice and dice all financial information as you wish. In fact, you don’t need to do it yourself, an algorithm would do it faster and with fewer mistakes. As a result, if a private investor screens for low PE stocks now, most names he finds would be companies in real trouble (‘value traps’) facing huge debt problems, products becoming quickly obsolete or other challenges.
This last factor is definitely permanent making traditional method of analysis less useful. However, the first four are likely temporary. Disruption and Faster earnings growth of tech giants (Reason 4 and 5) cannot last forever. In fact, there were many other periods in history when technology changed our lives like automobiles at the beginning of the past century (as Buffett mentioned this year at Berkshire’s shareholder meeting), or invention of radio, TV, airplanes, personal computers and so on. Earnings cannot continue to grow at 20% for ever if world’s economy is only growing at 3% (maybe 5% with inflation).
But my point is not that traditional Value Investing will start working again. I think there is too much focus on low multiples that people expect Value Investors to pay. My main point is that Value Investing is not just picking stocks with low multiples. As I discussed at the beginning, Value Investing is paying less for what the business is worth.
A normal multiple of 15x PE (average for S&P 500 for over 100 years) may underestimate company’s value if a company can double its earnings in three years and then double again in the following three years (26% CAGR). Just focusing on the price you pay when computers have screened thousands of companies already may not be enough to identify value.
Other investors (including Warren Buffett and Charlie Munger) look for value that the company can generate over time. This depends not just on past investments, but on investments yet to be made. Capital allocation, management team, ability to innovate and other factors (not easily quantifiable) are as important as the price you pay.
In fact, two quotes are important. One from Buffett and the other one from Munger.
- ‘It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price’.
- ‘Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result’.
Advantages of Value Investing defined more broadly
So in the first, more narrow definition of Value Investing, you attempt to capture the discount (spread) between today’s market price and company’s fair value (based on current assets, less liabilities underpinned by near-term earnings and dividends). In the second, broader definition, you try to take into account how much value can yet be created.
Besides evaporating opportunities as Internet and computers uncover remaining corners of financial world, there are other disadvantages in the first method. If you buy a stock at a price that is two-thirds of its intrinsic value, you can achieve 50% return once the price reaches the fair value. But if takes 3 years, then your annualised return drops to 14.5%. The fair value could also decline in the meantime (if you bought a brick-and-mortar retailer for 10x PE hoping it will be valued at 15x, but retailer’s earnings continue to decline by 10% while you are waiting for the re-rating). You also need to pay tax each time you realise gain, you pay your broker twice (when buying and then selling the same stock) and you also need to find a new idea to put your money.
Instead, if you owned just one company which reinvested its earnings at 20% return over 10 years, you would have paid less tax, less commissions and would avoid idle time when you looking for new ideas.
What it takes to succeed
To succeed in investing, especially in the second method of estimating intrinsic value, you have to be a good business analyst, not just financial analyst. The first method requires you to be contrarian and indecent thinker. Low PE stocks are generally experiencing some problems and there is lots of news and opinions on never ending problems of a particular business. Both methods require patience. You need to let great companies compound and not sell them too early. You also need to wait for the turnaround to happen and for the market to be appreciate the progress.
Understanding company’s competitive position and whether it has any edge is very important in both methods. Competitive advantages (or ‘Moat’ as Warren Buffett calls it) determines how long a company can enjoy superior growth. In the first approach, it is also important to avoid value traps and for the company to deliver a turnaround and understanding business drivers helps a lot.
In the end, there could be nuances between various methods, but in essence all Value Investors follow the same principles:
- They view stock as a share of business. ‘Behind every stock there is a business’, as Peter Lynch used to say.
- The value of a stock is based on all future cashflows that a company will generate discounted to present.
- They are humble and realise that there are many unknowns so having a view on every stock is impossible. They try to have an edge in analysis. They are quick to accept mistakes.
- They look to take advantage of market moves and changes in sentiment, rather than to follow it. Graham famously wrote in his Intelligent Investor book, that ‘In the short run, the market is a voting machine but in the long run it is a weighing machine’.
- They have patience to wait for the right opportunity, for the turnaround plan to start delivering results and for great business to compound capital.
- They protect downside risks by focusing on margin of safety, making sure they don’t overpay even for wonderful companies.
I hope that above was useful. The last message I would to leave you with is this: Value Investing may not be easy, but it is the surest thing to achieve the best investors results in the long-term.