Value or growth? It is an age-old debate and, as Giles Parkinson argues, a slightly irrelevant one given the changing makeup of the economy and the gentle decoupling of intrinsic value from financial statements.
Growth investing has been in vogue over the last decade, at least judged by comparing the relative performances of the Russell 1000 growth and value indices. Market strategists inform us that 2020 saw value hit one of the deepest drawdowns against growth in recorded history.1,2 This coupled with a rebound in the first half of 2021, arouses curiosity among mean-reversion contrarians: surely it is now the turn of value to outperform growth on a sustained basis?
However, using these crude style category terms mis-frames the issue. Growth and value have been co-opted by academic practitioners, borrowed by marketing departments, and defined into irrelevance. There is now value in value investing because there is always value in value investing – so long as it is properly understood. Moreover, authentic value investors should reclaim the language of value investing.
Figure 1: ‘The beatings will continue until morale improves’: Total return performance of Russell 1000 Value versus Russell 1000 Growth indices (per cent)3
Source: Bloomberg, data as of May 20, 2021
Adding to ‘value’
First, a basic principal. There are only two sorts of stock: cheap and expensive. This is because stocks only outperform if they are bought at a discount to their worth, as determined by the present value of future cashflows.
Indeed, this outperformance is Mr Market’s reward for contributing to market inefficiency by correcting undervaluation.4 The godfathers of value investing Benjamin Graham and David Dodd coined the term ‘margin of safety’ to describe this gap between market price and intrinsic value.5
The term ‘margin of safety’ described the gap between market price and intrinsic value
However, in the aftermath of the Great Depression and a World War, the practical application of this by the Graham-Newman Corporation was to scoop up shares trading at a discount to their balance sheet liquidation value.6 In a speech originally given at USC Marshall School of Business in 1994 Charlie Munger described the initial success and subsequent shortcomings with this approach:
“People were so shell-shocked for a long time thereafter that Ben Graham could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on. … At any rate, the trouble with what I call the classic Ben Graham concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and it wouldn't click.”7
Graham subsequently went on to publish various iterations of formulae for quantifying this nebulous intrinsic value. Criteria such as low price-to-earnings, high dividend yield and low price-to-book featured prominently, all measures now commonly regarded as value factors.8 The idea of value stocks being statistical bargains has stuck ever since, despite the earliest practitioners quickly evolving away from the narrowest confines of this approach. As Munger continued:
“But such is the nature of people who have a hammer—to whom, as I mentioned, every problem looks like a nail that the Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they'd always done. And it still worked pretty well. So the Ben Graham intellectual system was a very good one.”9
Graham felt obliged to admit that more than half of his investment returns had come from a single stock
By the time he wrote the fourth, and final, edition of The Intelligent Investor in 1973 Graham felt obliged to admit in a postscript that more than half of his investment returns had come, not from the ‘net-net’ approach for which he is most famous, but from a single stock – GEICO – which had compounded at twenty two percent for the preceding 25 years.10 GEICO was a tremendous success not because it was purchased below book value, but rather because it was able to grow premiums and policyholders at such a phenomenal rate thanks to the durability of their low-cost competitive advantage, as Graham’s disciple Warren Buffett perceived in 1951.11,12
So, even as we can point to Buffett’s purchase of Sanborn Map Company in 1958 as classic Graham – trading at half book value largely comprised of a marketable securities portfolio with a profitable operating business on top – around the same time he was putting twenty percent of his net worth into Mid-Continent Tab Card Company, a start-up technology company competing against IBM, for a thirty three percent return compounded over eighteen years.13,14 Munger concluded:
“And, by the way, the bulk of the billions in Berkshire Hathaway have come from the better businesses. Much of the first $200 or $300 million came from scrambling around with our Geiger counter. But the great bulk of the money has come from the great businesses.”15
Elusive intrinsic value
What is going on here?
Sometimes, book value is a proxy for intrinsic value. Accounting standards dictate that identifiable projects – such as the cost of constructing an oilfield or factory – go through the cashflow statement onto the balance sheet. Net asset value was thus a reasonable proxy for replacement cost, earnings potential and, hence, intrinsic value.
Prudent investors waited for market pessimism to push prices below book cost
Prudent investors waited for market pessimism to push prices below book cost, bought the stocks, and waited for eventual normalisation. At a push, they could wrest control of the company from the board and liquidate the business. In contrast, less defined investments, such as brand advertising or generic research and development, are expensed through profit and loss statements as incurred costs and never touch the balance sheet.
To see how this distortion works in practice, let’s take a hypothetical company, perhaps from the branded consumer products industry which is perceived by most market participants to be populated by high return, albeit high multiple, businesses.
Book value is 100, the return on equity is 15 per cent, the earnings are therefore 15; the stock is priced at 300 and trades on 20 times earnings and three times book value. Yet, if we treat the historic brand advertising investments as traditional capex depreciating over thirty years, the balance sheet swells, earnings increase, and these figures change to 250, eight per cent, 12 times and 0.8 times respectively.16
The business hasn’t changed, only our perspective
The business hasn’t changed, only our perspective. This stock wouldn’t pass the low price-to-earnings, low price-to-book hurdles of an unreformed value investor’s screening tool. But viewed through an alternative lens that more closely matches economic reality, it could be attractive more authentic value investors who understand intrinsic value and seek to purchase undervalued stocks with a margin of safety.
In 1984, Buffett penned an article “The Superinvestors of Graham-and-Doddsville” as a rebuttal against the efficient-market hypothesis by identifying a group from “a common intellectual home” whose outstanding performance track records defied dismissal as mere statistical luck.
Starting with “a group of four of us who worked at Graham-Newman Corporation from 1954 through 1956”, he also listed Charlie Munger (whom “I ran into … in about 1960”), Rick Guerin (“After I got to Charlie, Charlie got to him”) and Stan Perlmeter (“We happened to be in the same building in Omaha. In 1965 … it took five minutes for Stan to embrace the value approach”).17
This is also an unintentional description of how the intellectual torch of value investing was propagated, almost like a ‘good’ infection not of communicable disease but of ideas, which could even leap across time and space through the written word.
Many of today’s leading technology companies invest fearsomely through their income statements
Take Peter Cundill, for example, who had a Damascene moment with the writings of Graham and Buffett on an aeroplane in 1973. Within a year he had taken over the All Canadian Venture Fund and written a letter to investors, including a Graham-eqsue checklist (“the share price must be less than book value” … “the price earnings multiple must be less than ten”). However, shortly thereafter he bought Tiffany, having recognised the intangible value of the brand carried on the balance sheet for nothing, applying Graham’s principles in a way that stays within an intrinsic value framework.18
This holds true not just for Tiffany or the branded consumer products company in our earlier example. Many of today’s leading technology companies, such as Alphabet, invest fearsomely through their income statements.19
Beyond balance sheets to understand change
Since present intrinsic value hinges on future cash generation, the direction and magnitude of which can only be estimated from imperfect quantitative measures and inferred from qualitative criteria, businesses by definition will always be mispriced because of the uncertainty that surrounds their future. Beyond a certain point, the crystal ball always goes dark. This can be particularly pertinent as industries change over time and financial statements become a less reliable guide.
Investors who focus solely on low multiples and await ‘overdue’ reversions are likely to come unstuck
As the economy becomes more ‘asset-light’, assets unrecorded on the balance sheet – such as customer relationships, research knowhow and brand awareness – will continue to grow in importance. While low multiples are frequently an indication of cheapness, investors who focus solely on low multiples (defined by accounting values) and await ‘overdue’ reversions are likely to come unstuck.
As intrinsic value gently decouples from financial statements, the traditional understanding of value and growth is losing relevance as a tool for describing and assessing an investment approach. In this sense, there is no value in value investing. But, for those who seek to exploit the difference between the market price of a business and its intrinsic value, there is always value in value investing. The central lesson of intangibles is, as Albert Einstein reportedly put it, “Not everything that counts can be counted, and not everything that can be counted counts.”20