Value investing as a strategy has come under question over the past few years. Some thought it will never return. An investment strategy that created wealth for investors over many decades is being questioned as ‘visibly cheap’ stocks continued to underperform the ‘seemingly expensive’ ones. For the past few years up to the pandemic, the ‘value’ factor was underperforming the ‘quality’ factor. There were many reasons sighted for this: low interest rates, scarcity of growth, new digital economy, business disruption etc.
But value investors are making a strong comeback. Value indices are outperforming across the world, as economies are coming out of recessions and embarking on a strong recovery path. However, this time, investors are using different tools used to hunt for value.
The super investors
Most of the time, when I talk to investors about value investing, they still picture buying a company with a low price-to-book or price-to-earnings ratio. Or, they look for good dividend yield. While these are short-cuts to assess the relative value of a company, value investing in not about buying the cheapest companies on these parameters. Value investing is a broader philosophy that involves buying company at a price that is lower than its intrinsic value.
In 1984, in a famous speech titled “the Super Investors of Graham and Doddsville,” Warren Buffett highlighted the tremendous success achieved by nine value investors during those times:
These investors followed the value philosophy outlined by Graham and Dodd, and delivered superior returns on their portfolios. They placed significant importance to evaluating risk and adhering to Graham’s first principle: Never lose money. Since investors can go wrong in forecasting the future, all of them talk about keeping a margin of safety. And all of them believe markets are inefficient, so current prices do not correctly reflect the intrinsic value of companies. The core ingredients remain the same. However, all except Walter Schloss gave a different angle to the pure value parameters that were suggested by Graham and tweaked the value investing style to suit the evolving business landscapes.
You will find Tweedy Brown in the investor list of Google; and Warren Buffett in shareholder list of Amazon. How come there are value investors in a couple of FAANG stocks? Have these investors changed their philosophy? No. They insist that Google and Amazon were bought only when they fit into their criteria as value investments and they have justified the same in their letters. It is however important to understand that value investors evolved their analysis and valuation tools. Let’s clear some myths about value investing.
Myth 1: Value investing focusses only on assets and current earnings
Value investors focus on intrinsic value rather than just asset price or earnings multiple. Asset-light companies don’t necessarily fit asset value multiples, but can be businesses great cashflows. Also, cyclicals look expensive on earnings basis during downturns, even when their stock prices are at a trough. They look cheap at the top of the cycle with the best of earnings. Intrinsic value considers many different parameters and uses them to put the right value to the business. Private market value is another method used by many value investors. A similar transaction in the industry by M&A or private equity funding can give the investor a peek into what private market value a company can hold.
Myth 2: Value investing implies buying any business that is cheap
Graham proposed the “Cigar Butt” approach wherein one buys discarded stocks that were trading below their net current assets. This is like picking up a Cigar someone has discarded but still has a few puffs left in it. For someone who picks up such an investment, those few puffs are essentially free. One would make a value arbitrage if the stock moves up or the company goes into liquidation. The reason one would find such opportunities in normal times was due to a company having unattractive business fundamentals. Value investors have moved away from this approach, as these businesses would frequently keep running into problems and don’t deliver much upside. They moved to buying good businesses at a fair price, rather than bad businesses at attractive prices.
Myth 3: Value investing doesn’t focus on future growth
Growth creates value; but it is difficult to accurately make long-term forecast of business growth rates. Value investing draws comfort in deriving a large portion of total value of the company from its present operations. Benjamin Graham has written in the book, The Intelligent Investor that “the growth stock approach may give us a dependable margin of safety as is found in the ordinary investment – provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid.”
Myth 4: Value investors ignore intangibles
Value investors did prefer companies with tangible assets as they looked to reduce the risk of downsides. However, it is not so now. Investors like businesses that deliver good compounding over the long term. But a good business will often attract competition and the superior returns will deteriorate and ultimately disappear. Hence, value investing looks for businesses that have an economic moat – those firms that can protect their turf better and have a competitive advantage. The sources of moat are often intangibles and investors value those while examining the companies and provide appropriate valuation.
Value investing has evolved to shore up its weaknesses and increased its circle of competence. It doesn’t change the basic philosophy of buying a company below its intrinsic value, it just gets better at it.