Is Value Investing Dead?
In the 6 Levels Wealth Karate, I talked about the importance of creating a superfund income. We do this via investment. Right now, there is a fierce debate on whether value investing is dead. To all value investors, we know that price is an important component of value. That’s why we’re called value investors. I challenged The Moss Piglet on his investment thought process and we want to share with you if value investing is dead or not.
In one of his recent blog post, he opined that it is time to update our approach to value investing for a changing world. In this article, he would elaborate more on his view of this new paradigm of value investing.
Brief History of Value Investing
The father of value investing was Benjamin Graham. He gave birth to this term roughly 100 years ago. During that time, the Dow Jones industrial average comprises of only industrial companies like Anaconda Copper and National Lead. Consumer marketing was still in its infancy. The closest thing to a consumer products company was probably General Motors.
Attracted to the upside of equities, Graham set about trying to figure out a predictable, systematic way to make money in stocks. He turned to corporate financial statements to look for answers. Graham saw that while stock prices fluctuate in the short run, a company’s tangible assets had a solid, precise value. By calculating value and then comparing it with price, Graham found he could make sense of markets. Thus was born the book “Security Analysis” and, with it, value investing. With his focus on liquidation value, Graham tended to buy boring, beaten-down businesses (Sidenote: I’m looking at this hidden gem at this moment in time). This was also known as cigar butt investing.
Then came a young man from Omaha who studied under Graham at Columbia. This man was none other than Warren Buffet. Surveying the economy of the mid-1950s, Warren Buffet saw that it was very different from the one Graham had encountered when he was young.
The Dow Jones Industrial Average now contained companies like Procter & Gamble, Sears, and General Foods. These companies were fundamentally different from an industrial company: The primary driver of their business had little to do with hard assets. Rather, the value had to do with the company’s brands and the loyalty and familiarity that comes along with it. The emotional ties to products like Budweiser and Jell-O allowed businesses to charge a premium for their goods.
At the same time, the rise of national television enabled strong brands with deep pockets to flood the television networks to reinforce a culture of homogeneity. This setup a vicious cycle for dominant brands like Coca Cola and Nike as they went from strength to strength while lesser brands slowly withered away. With that, Buffet was more willing to apply a more qualitative assessment of companies than Graham.
Defining Value Investing
At its roots, value investing is simply a framework for investing that involves buying stocks for less than their underlying value (Side read: Is Ant Group Overvalued?). As Warren Buffet says,
“Price is what you pay, value is what you get.”
The definition of value investing varies widely even among value investors. Damodaran has an interesting take on defining value investing where he classifies value investors into four groups. This depends largely on their approach of finding value stocks.
Passive Value Investing
Also known as the buy and hold strategy, investors screen for companies using criteria that they believe will lead to value stocks. Once they bought the stocks, their patience will pay off as “the market is a voting machine in the short run and a weighing machine in the long run”. We see screens ranging from “low P/B” and “low P/E” and “Quick Ratio” to more qualitative screens like good management and the use of Piotroski F-score and Benenish M-score. (One application is picking up quality companies during COVID19)
Contrarian Value Investing
In contrarian value investing, you focus on companies that have seen steep drops in stock prices. Investors believe that markets tend to overreact to news and that corrections will occur eg. Uranium trade and tanker trade.
Activist Value Investing
This style is a lot like contrarian investing, except the target companies are cheap companies where the investor believe that value can be unlocked through management action. Some examples of potential management actions that can create value include spinning off subsidiaries, share buyback, dividends etc. After acquiring a large portion of the company, the activist investor will often publicly lobby the Board of Directors to adopt their proposed changes to unlock value. The whole process can take a long time and activist investors need to be patient and persistent.
Valuation Challenge of an “Asset-Light” Economy
Warren Buffet’s ideal businesses were generally capital-intensive industries such as insurance and railroads, or they produced a widely advertised consumer products. However, it is becoming increasingly clear that we are now looking at a new breed of asset-light compounding machines with huge network effects.
Unlike the 1980s where most corporate investments were in tangible (physical) assets, we now have companies which value originates in intellectual property such as invention, knowledge and software. Yet all these asset light companies are harder to value because intangible assets are difficult to estimate. Technological change is very rapid and the risk of disruption is higher than the more traditional industries with predictable revenue, cash flow and earnings.
Modern accounting also failed to reflect the real values of intangible assets on the balance sheet, hence rendering the book value valuation (P/B Ratio) useless. A research paper from NYU Busines School titled “Explaining the Recent Failure of Value Investing” goes into much further details on this topic.
Today’s valuation problem is in fact more challenging because the proportion of assets that are intangible and immeasurable is even larger.
We present to you: Value Investing 3.0
The high level concept of value investing is always useful, to buy with a margin of safety, at a discount of intrinsic value. However, the application method is going to change, especially in this easy money environment. In the past companies would have to wait for profits before expanding business by reinvesting the profits. Now, the company doesn’t need to do that anymore. Eg. Tesla can issue new shares to raise capital for building new factories in Germany and China. Never in the history of capitalism has no much wealth been created using so little capital.
The good news is, even in an economy transformed by technology, many principles of value investing still apply.
1) Always look for businesses with a clear-cut competitive advantage. These companies should also look to build and maintain market share. Eg. Amazon has a stranglehold on e-commerce, Google owns search. Value investors have to think about how a company will be able to earn outsize profits over the next generation.
2) Traditional value investors view margin of safety as a “discount” to their intrinsic value, where you price in the risk of investment mistakes. For me, the margin of safety now lies not in the tangible assets but rather in the sustainability of the business itself. I still prefer to find cash producing businesses in strong financial condition selling at undemanding valuations. Of course, with these margin of safety criteria, I will most probably be looking at large, diversified and mature tech companies.
3) If Value Investing 2.0 is about consumer brands like Coca Cola operating with economies of scale, Value Investing 3.0 stocks relies on the network effect. A company will become more valuable as more people uses its products and services. Examples are Match Group (MTCH) and Google (GOOGL), where their users tend to come back for more. Match Group owns a portfolio of dating website and apps, which grew large due through significant network effects. Google gained an early edge due to its superior search algorithm and now “google it” became a verb meaning to do an online search.
Value investing is affected by the complexities of evaluating companies in the new asset-light and knowledge economy. Relying too much on historical data would lead investors to focus too much on companies whose peak growth has come and gone. What worked in the past often does not necessarily work in the future. Investors should not only consider Value Investing 3.0 prospectively but also to give some thought to the vulnerability of Value Investing 2.0 companies (RIP Robinsons).
However, the essence of value investing philosophy has not changed – merely the environment. From the 1930s to the 1960s, value investing was centered around cigar butt stocks. Over the next 50 years, it shifted toward consumer brands, economies of scale and capital-intensive commodity businesses. Now the best value investing opportunities can be found in asset-light compounders with huge network effects.
I would like to end this post with a quote from a book, The Intelligent Investor:
“The underlying principles of sound investment should not alter from decade to decade, but the application of these principles must be adapted to significant changes in the financial mechanisms and climate.” – Benjamin Graham
The Moss Piglet is a financial blogger who enjoys expressing his findings and opinions about the financial markets. He is always on the hunt for irrationally beaten-down stocks as well as lesser known companies that are of value. Follow his investing journey at https://themosspiglets.com/.
Final thoughts by Wealthdojo
Times may change. But the investing principles will remain the same. Whether if is value investing 2.0, 3.0 or even investing using an investment linked policy, please treat your investment seriously. My wish is for everyone to invest wisely. If you have not started investing, there are basically 2 ways to do so.
- Do it Yourself (DIY) – Learn about investing successfully and invest on your own.
- Do For You (DFY) – Get someone who can invest successfully to invest on your behalf
We wish you good fortune for the rest of 2020. It is not too late to start.
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Chengkok, Sensei of Wealthdojo.