Is value investing dead?
The WSJ article, “Investors Finding Little Value in Value Stocks, So Watch for the Rebound,” states the following:
The U.S. stock market is showing the biggest divergence between cheap and pricey stocks since the aftermath of the dot-com bubble, as investors chase the performance of companies with rising earnings.
Valuation of growth companies-those able to show rising earnings, typically priced at a premium-have soared this year even as price/earnings ratios of cheap, so-called “value” stocks slid, an unusual separation.
Growth and value stocks in the U.S. returned the same from the start of the post-Lehman recovery in 2009 until January this year, thanks to a surge in cheap stocks after the U.S. election a year ago. Since then, the 19 percentage-point outperformance of growth stocks is the most in such a short period aside from the last year of the dot-com bubble….
A New Era?
This year’s divergence suggests investors are starting to bet on a new era, that new technologies will disrupt business plans. A firm belief in a modern age of technology has been behind many historical bubbles, from the canal mania of 18th-century Britain to the brief over excitement about 3-D printing in 2014. I do believe in the new era where new technologies will transform industries, but I do not think the growth in earnings projected for the growth companies is sustainable, and that over-hyped stocks will get too expensive while cheap stocks will get too cheap due to investor sentiment. It will get to a point where you have a value gap that is so extreme that quite often that can act as a catalyst for the value stocks (cheap stocks) to rebound by itself. The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.
Why Projected Earnings For Certain Companies Are Unsustainable
Here is why I think the projected earnings for certain growth companies are unsustainable:
The faster these companies grew, the more expensive their stocks became. And when stocks grow faster than companies, investors always end up sorry. Growth stocks are worth buying when their prices are reasonable, but when their price/earnings ratios go much above 25 or 30, the odds get ugly.
Journalist Carol Loomis found that from 1960 through 1999, only eight of the largest 150 companies on the Fortune 500 list managed to raise their earnings by an annual average of at least 15% for two decades.
Looking at 5 decades of data, the research firm of Sanford C. Bernstein & Co. showed that only 10% of large U.S. companies had increased their earnings by 20% for at least 5 consecutive years; only 3% had grown by 20% for at least 10 years straight; and not a single one had done it for 15 years in a row.
An academic study of thousands of U.S. stock from 1951 through 1998 found that over all 10-year periods, net earnings grew by an average of 9.7% annually. But for the biggest 20% of companies, earnings grew by an annual average of just 9.3%.
Why I Think Putting All Eggs In One Basket Isn't The Way To Go
The intelligent investor, however, gets interested in big growth stocks not when they are at their most popular-but when something goes wrong.
Also, obvious prospects for physical growth in a business do not translate into obvious profits for investors. While it seems easy to foresee which industry will grow the fastest, that foresight has no real value if most other investors are already expecting the same thing. By the time everyone decides that a given industry is “obviously” the best one to invest in, the prices of its stocks have been bid up so high that its future returns have nowhere to go but down.
The majority of companies have come to follow what may be called a standard dividend policy. This has meant the distribution of two-thirds of their average earnings, except that in the recent period of high profits and inflationary demands for more capital the figure has tended to be lower. However, an increasing number of growth companies are departing from the once-standard policy of paying out 60% or more of earnings in dividends.
On The Other Hand
Having said that, Charlie Munger would rather pay a fair price for a quality company than a cheap price for a stinker.
Questions
Is value investing dead? Do you think the earnings projections for certain growth stocks are on the wild side? What growth stocks are you bullish on, monkeys?
this kinda stuff ebbs and flows over time. people called warren Buffett a has-been in the late 90s. weakness in financials and energy has really hurt the space, but they will have their time to shine eventually.
Contrarian Value Investing: Going Against the Flow (Originally Posted: 06/20/2012)
Nokia came out with an awful earnings report yesterday, with warnings of more bad news to come, and its stock price, not surprisingly, plummeted.
While investors are fleeing the stock and a ratings downgrade looms, is it a contrarian play? What about JP Morgan Chase? Or Research in Motion? Netflix or Green Mountain Coffee, anyone? By focusing on stocks that other investors are abandoning, contrarian value investing is the "anti-lemming" strategy, but it takes a unique personality and a strong stomach to pull off successfully.
The basis for “contrarian” investing:
The core belief that underlies contrarian investing is that investors over react to both good and bad news, pushing prices up too much on the former and down on the latter. If you carry this view to its logical conclusion, it then follows that prices will reverse in both cases as investors come to their sensesWhile you may believe that investor overreaction is the norm, is there evidence to back up the claim? The statistical and the psychological evidence is mixed and contradictory. On the one hand, there is significant evidence that investors under react to news stories (earnings reports, dividend announcements), leading to momentum (and drift) in stock prices, at least over short periods. On the other, there is also evidence that investors over react to information, with price reversals occurring over longer periods. In behavioral finance, as well, there are two dueling "psychological" characteristics at play: the first is that of "conservatism", where individuals, faced with new evidence, update their prior beliefs (expectations) too little, thus creating under reaction, and the second is "representativeness", where individuals over adjust their predictions, based upon new information. To reconcile the co-existence of the two, you have to bring in two factors. One is time, with under reaction dominating the short term (days, weeks, even months) and over reaction showing up in the long term (years). The other is the magnitude of the new information, with over reaction being more common after big events.
Contrarian investing strategiesWithin the construct of contrarian investing, there are at least four variants. In the first, you invest in the stocks that have gone down the most over a recent period, making no attempt to be a discriminating buyer. In the second, you focus on sectors or markets that have been hard hit and try to identify individual companies in these groups that have been "undeservedly" punished. In the third, you look at companies that have taken hard hits to their market value but that you believe have underlying strengths which will help them make it back to the market's good graces. In the final approach, you buy stock in beaten up companies with the same intent (and expectations) that you have when buying deep out of the money options. You know that you will lose much of the time but when you do win, your payoff will be dramatic.
1. The Biggest Losers
If you believe that investors tend to over react to events and information, the effects of that over reaction are most likely to be seen in extreme price movements, both up and down. Thus, stocks that have gone down the most over a period are likely to be under valued and stocks that have gone up the most over a period are likely to be over valued. It follows, therefore, that if you sell short the former and buy the latter, you should be able to gain as the over reaction fades and stock prices revert back to more "normal" levels.
In a study in 1985, bbs/images/upfile/2011-11/2011112221858.pdf" target="_blank">DeBondt and Thaler constructed a winner portfolio, composed of the 35 stocks which had gone up the most over the prior year, and a loser portfolio that included the 35 stocks which had gone down the most over the prior year, each year from 1933 to 1978. They examined returns on these portfolios for the sixty months following the creation of the portfolio and the results are summarized in the figure below:
An investor who bought the 35 biggest losers over the previous year and held for five years would have generated a cumulative abnormal return of approximately 30% over the market and about 40% relative to an investor who bought the winner portfolio.
Looks good, right? Before you rush out and load up on the biggest losers of the last year, a few notes of caution:
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There is evidence that loser portfolios are more likely to contain low priced stocks (selling for less than $5), which generate higher transactions costs and are also more likely to offer heavily skewed returns, i.e., the excess returns come from a few stocks making phenomenal returns rather than from consistent performance.
If you feel that, in spite of these caveats, this strategy may work for you, you can take a look at a list of the 50 companies that have gone down the most (in percentage terms) over the last 52 weeks (June 2011-June 2012). I have added a stock price constraint (to ensure that you don't end up with low-priced stocks) and reported the dollar trading volume per day (as a red flag for trading costs). I have compiled the list for the US (with price>$5), Europe (with price>$5), Emerging Asia (with price>$1), Latin America (with price>$1) and global (with price>$5). Your timing is off (since it is not January) but you can still browse for bargains. You can also adapt the screening plus strategy that I talked about in my post on passive screening and subject the companies on these lists to follow up analysis (intrinsic valuation or qualitative assessments)>
2. Collateral Damage
It is not uncommon for markets to turn negative on an entire sector or market at the same time. In some cases, this is justified: a big news story that affects an entire sector, or a macro economic risk that hurts a market. In others, it may represent either an over reaction by investors to the idiosyncratic problems of an individual company in a sector or a failure to consider that companies within a market/sector may have different exposures to a given macroeconomic risk. As an example of the former, consider how banking stocks were punished on the day that JP Morgan Chase reported its big trading loss. As an illustration of the latter, you can look at the Spanish stock market, where investors have punished all companies (though some are less exposed to Spanish country risk than others) over the last year.
About a decade ago, I penned a paper on measuring company risk exposure to country risk that argued that we (as investors) were being sloppy in the way we assessed exposure to country risk, using the country of incorporation as the basis for measuring risk exposure. With this view of the world, US and German companies are not exposed to emerging market risk, an absurd argument when applied to companies like Coca Cola and Siemens that derive a large chunk of their revenues from emerging or risky economies. By the same token, all Brazilian companies are equally exposed to country risk, though some (such as the aircraft manufacturer, Embraer) derive most of their revenues from developed markets. This laziness in assessing country risk does provide opportunities for perceptive investors during crises. This was the case when Brazilian markets went into a tailspin in 2002, faced with the feat that Lula, then the socialist candidate, leading in the polls, would win election to lead the country. As Embraer fell along with the rest of the Brazilian market, you could have bought it at a "bargain basement" price. If you are interested in following this path, here is my suggestion. Start putting together a list of companies like Embraer, i.e., emerging market companies that have a significant global presence and then wait for a crisis in the emerging market in question. When there is one (it is not a question of whether, but when....), and your "global" company drops with the rest of the market, you are well positioned to take advantage.
It is trickier, though, playing this game within a sector. Consider the JP Morgan Chase case. While the trading loss was clearly specific to JPM, you could argue that the event affected the values of all banks at two levels. The first is by increasing the chance that the Volcker rule, barring proprietary trading at banks, would be adopted, it affects future profitability at all banks. The second is the fear that in response to the loss, the regulatory authorities would require higher capital ratios be maintained at all banks. If those are your concerns, you should focus on banks that do not make have a large proprietary trading presence and are well capitalized. If investors have over reacted across the board, those banks should be trading at attractive prices.
3. Comeback Bet
When stock prices drop precipitously for an individual stock, there is usually a reason. If the drop reflects long term, intractable problems, there may be no reversal. If the drop reflects temporary or fixable problems, you are more likely to see prices reverse. As you look at the reasons for the price drop, you should keep in mind your overriding objective, which is to find a company whose price has dropped disproportionately, relative to its value
Here are some possible reasons for a stock price collapse, with the ingredients for a comeback:
a. Unmet expectations:
When expectations are set too high or at unrealistic levels, it is inevitable that investors will be confronted with reality not matching up to expectations. When that happens, they will abandon the stock, causing stock prices to drop. (Netflix and Green Mountain Coffee, both of which make the list of biggest losers over the last year are good examples of what happens to high flyers when they disappoint...)
Ingredients for a comeback: Expectations have dropped not just to realistic levels but below those levels. Investors have over adjusted.
b. Corporate governance issues:
Events that lay bare failures of managers and oversight by the board of directors shake investor faith and, by extension, stock prices. A case in point would be Chesapeake Energy, where the CEO, Aubrey McLendon, stepped down after evidence surfaced that the board of directors had allowed him to use $800 million in personal loans to acquire stakes in company-operated oil wells.
Ingredients for a comeback: (a) A new CEO from outside the firm, (b) with a full cleaning out of management team and revamping of board of directors, and (c) an activist investor presence.
c. Accounting fraud/ manipulation:
As investors, we start with the presumption that financial statements, while reflecting accounting judgments that may work in the company's favor, are for the most part true. Any suggestion of accounting fraud can lead to a meltdown in the stock price, not to mention open the company up to legal jeopardy.
Ingredients for a comeback: (a) Full reporting of all accounting misstatements, with (b) removal of top management, and (c) no legal jeopardy.
d. Operating/Structural problems:
Operating problems can range from problems with a key product (see Dendreon, on the list of biggest losers last year) to deeper structural problems, where the company's products just don't match up well to consumer demands or to the competition.
Ingredients for a comeback: (a) Management that is not in denial about operating problems and (b) a realistic plan for dealing with operating problems.
e. Financial problems:
When operating problems combine with significant debt burdens, you have the seeds of distress, which can spiral very quickly out of control, as suppliers, employees and customers react pushing the company deeper into trouble.
Ingredients for a comeback: (a) A clear debt restructuring/repayment plan, (b) Solid operating performance.
Whatever the reason or reasons for a price collapse, investors have to follow up by asking and answering three questions:
1. Is "it" a one-time or continuing problem?
While the line between one-time and continuing can be a shade of grey, the answer is critical. One time problems tend to have much smaller impact on value than continuing problems, and are easier to deal with and move on.
2. How fixable is the problem?
Some problems are more easily fixable than others. In making this judgment, you should look at three factors. The first is whether the problem is entirely an internal problem or whether it is partly or mostly due to outside or macro factors. Internal problems are easier to remedy than external ones. The second is whether the solution can be "quick" or will take "time". Thus, a firm with significant debt may be able to restructure that debt quickly, whereas a firm that has deep-rooted structural problems will need more time. The third is whether the managers of the firm seem to have both a reading of the problem and a solution in hand.
3. Is the market decline disproportionately large?
To make this assessment, you have to work through the consequences of the problem for the determinants of value: its effect on current cash flows, the expected value of growth (both the level and the quality) and the risk in future cash flows.
Using this framework, let's look at JP Morgan Chase. At first sight, it looks like a slam dunk. The trading loss was reported to be $2 billion at the first announcement and it seems like a fixable problem in the short term, with better risk management in place. The fact that the market capitalization went down by more than $30 billion on the announcement of the loss seems to suggest an over reaction, but there is more to this story than meets the eye. The first is that the trading loss of $ 2 billion is an estimate and the actual losses may be higher (the rumor mill suggests that they could exceed $5 billion). The second is that the loss will reduce the current regulatory capital and may increase the target regulatory capital ratio that JP Morgan aspires to reach over time; the combination of a lower current capital ratio and an increasing target capital ratio will translate into lower returns on equity, going forwards, and lower cash flows available to stockholders in the future (in the form of dividends or buybacks). To make a judgment on whether the stock is a bargain at the current price, I used a simple test. The price to book ratio for a mature bank can be written as:
Price to book ratio = (ROE - Expected growth)/ (Cost of equity - Expected growth)
Conservatively, if you assume a growth rate of 1.5% in perpetuity and a cost of equity of 9% (about 1% higher than the cost of equity for an average risk company), the return on equity implied at the JPM's current price to book ratio of 0.73 is about 7%:
0.73 = (ROE - 1.5%)/ (9%-1.5%)
Implied ROE = 6.98%
The ROE in the most recent year for JPM, prior to its loss, was 10.34%. Even allowing for higher regulatory capital requirements (which will increase book equity) and lower profits (perhaps from the Volcker rule), the adjustment seems like an over reaction. I know that there are other fears hanging over large banks, but I have a spreadsheet that I think contains a a conservative valuation of JPM that yields a value of about $46/share, well above the current stock price of $35. You can use it to make your own judgments for JPM or any other bank.
4. "Long odds" option
There is one final scenario: a company whose stock price has collapsed, with good reason and where a turnaround is neither anticipated nor expected. In other words, the stock looks fairly priced, given its prospects and problems today. However, let's assume that the firm has proprietary assets is in a risky business, where technology shifts could make today's winners into tomorrow's losers and vice versa. You could consider investing in this company's shares, for the same reasons that you buy an out of the money option.
In effect, you are leveraging the fact that equity in a publicly traded company has a floor of zero and that your losses are therefore restricted to the prevailing market value of equity. For your option (equity investment) to have a big payoff, though, you will need the value of the firm's assets to increase significantly from existing levels (because of a new product, market shift or an eager acquirer) and that will require that your firm have a proprietary technology/product/license and operate in a shifting, risky business. While the value of the assets could drop just as precipitously, you care less about downside because you don't have much to lose (since your equity value is so low).
Nokia (NOK) and Research in Motion (RIM) come to mind as potential option plays. They both have proprietary technologies and patents (though the market does not think that either technology looks like a potential winner in the market today) and operate in a risky business where the landscape can shift dramatically over night. While the Blackberry technology is a more reliable cash provider for RIM, there are three factors that tip me towards Nokia. The first is Nokia's stock price has dropped far more than RIM's over a shorter period, reducing the cost of my option. The second is that Nokia's debt burden is a mixed blessing: it could cut my option game short, if Nokia defaults, but it also leverages any upside in value. Small changes in Nokia's asset value will translate into big changes in equity value. The third is that the turmoil in the Euro zone adds to the value of my option. Put differently, I like Nokia because it is riskier than RIM, but risk is my ally, not my enemy, with an option. If you plan to invest in Nokia, do so with the full recognition that you may have to write off the entire investment a few months or years from now, but if the stars align, watch out!!!
Value Investing: An Identity Crisis? (Originally Posted: 06/13/2012)
Any post about value investing always evokes strong responses, but I thought I would start this one by turning the focus inwards. So, here are a few questions for you :
1. Would you classify yourself as a "value investor"?
a. Yes
b. No
2. If yes, what makes you a value investor?
a. I try to estimate the value of a stock before I invest in it
b. I only buy stocks that trade at attractive multiples (low PE, low PBV etc.)
c. I do my homework, looking at the fundamentals, before I invest
d. I don't know. I just am.
3. Finally, do you think that value investors collectively do better than other investors in the market?
a. Yes
b. No
c. Not Sure
If yes, what is the source of their advantage? If not, why do you think they fail?
What is the key characteristic that separates value investors from the rest of the world? In my view of the world, and I understand that yours might be different, the key to understanding value investing comes from breaking down a business into assets in place and growth assets.
a. Passive Value InvestingIt is this mechanism that I used to my posts on estimating how much you are paying for growth and how much that growth is worth.
If you are a value investor, you make your investment judgments, based upon the value of assets in place and consider growth assets to be speculative and inherently an unreliable basis for investing. Put bluntly, if you are a value investor, you want to buy a business only if it trades at less than the value of the assets in place and view growth, if it happens, as icing on the cake.
It is how you find investments that sell for less than the value of assets in place that provides a framework to understanding the different strands of value investing, and there are three ways you can go about this mission:
The oldest strand of value investing traces its lineage back to Ben Graham and his use of screens to find cheap stocks. Reviewing those screens, which combine market and accounting data, from Graham's book on security analysis, you are looking at stocks that trade at low multiples of earnings, pay a high proportion of these earnings as dividends and have a high proportion of assets that can be liquidated for close to their book value. In the years since, investors have added other screens (good management, stable earnings, strong competitive advantages etc.) that are all designed to reduce the potential for downside on the investment.
b. Contrarian Value InvestingIn contrarian value investing, you adopt a different tack. You look for companies whose stock prices have collapsed for one reason on another. In its least sophisticated variant, you just buy the biggest losers (at least in terms of stock price), on the assumption that markets generally over react and that the portfolio of these losers will bounce back over time. In its more refined forms, you add other criteria to the mix. Thus, you may buy stocks that have gone down but only if they have a strong brand name and/or little debt.
c. Activist Value InvestingIn activist value investing, you focus on poorly performing companies and look at the value of its assets in place, with better management in place. You then try to change the way the company is run by either acquiring control of the firm or putting pressure on existing management. Activist investing requires far more resources than either passive or contrarian value investing.
The skills and strengths you need to succeed in each of these value investing approaches is different and it is not clear than an investor who succeeds using one strand of value investing will be comfortable with the others.
In the next three posts, I will focus on each of these strands of value investing. In the last post, I will examine the most contentious issue of all, which is whether value investors collectively generate value from their efforts or whether this too is "fool's gold".
Value Investing: Where is the beef? (Originally Posted: 07/04/2012)
In my first post in this series on value investing, I noted that value investing is a broad brush that covers a range of different approaches, ranging from screening for cheap stocks to looking for bargains in the "loser" bin to being catalysts for change in poorly managed, mispriced companies.
There is one characteristic that some value investors seem to share, which is that they are the grown-ups in the investing world, and that investors with different views of the world (a belief in momentum, hope for growth or that markets are efficient) are deluded. Implicit in this view is also the belief that value investors are the long term winners in markets, but is this a belief that is backed up by the evidence? Or as one of my favorite commercials of all time would put it:
Does spending more time researching a company’s fundamentals generate higher returns for investors? More generally, does active value investing create value? A simple test of the payoff to the "active" component of value investing is to look at the returns earned by active value investors, relative to a passive value investment option. In the figure below, I compute the excess returns generated for all US mutual funds, classifed into small cap value, mid cap value and large cap value, relative to index funds for each category. Thus, the returns on small cap value mutual funds are compared to the returns on index fund of just small cap, value stocks (low price to book and low price to earnings stocks).
While the average returns earned by small cap and large cap value funds did beat their respective indices over a 5 year period, the active value funds underperformed the indices in every other comparison, with small cap value funds delivering almost 2% less than the small cap value index over the last ten years. These results are not due to negative returns at a few really bad funds, either, since 55% of large cap value fund managers, 64% of mid cap value fund managers and 56% of small cap value fund managers under performed their respective indices between 2002 and 2011. In fact, even over the 2007-2011 period (the most favorable period in the comparison), using the median return rather than the average return across value funds makes the excess returns negative. Lest you attribute this to the time period of the analysis, you can look at this study from 1992-2001 and this one from 1971 to 1991 to see that the findings apply over time.
If you are an individual value investor, you may attribute this poor performance to the pressures that mutual funds managers operate under to deliver results quickly and their tendency to drift from their core philosophies, and argue that disciplined individual value investors do better. Since it is difficult to track the performance of individual investors, the question of whether individual value investors deliver better results than mutual funds has no clear empirical answer. However, there are some intriguing findings in the literature.
While none of these studies of individual investors classify superior investors by investment philosophy, the collective finding that these investors tend not to trade much and have concentrated portfolios can be viewed as evidence (albeit weak) that they are more likely to be value investors.
Faced with this evidence, some value investors fall back on the old standby, which is that we should draw our cues from the most successful of the value investors, not the average (or the median). Arguing that value investing works because Warren Buffett and Seth Klarman have beaten the market is a sign of weaknesss, not strength. After all, every investment philosophy (including technical analysis and charting) has its winners and its losers. A more telling test would be to take the subset of value investors, who come closest to the meeting the purity standards of value investing, and see if they collectively beat the market. Have those investors who have read Ben Graham's investment tomes generated higher returns, relative to the market, than those who just watch CNBC? Do investors who trek to the Berkshire Hathaway annual meeting every year have superior track records to those who buy index funds?
I don't think we will ever know the answers to those questions, but I am willing to hazard a guess. I don't think that value investors as a group, no matter how tightly that group is defined, beat the market. I also think that some value investors do beat the market consistently, and that their success cannot be attributed to luck. I would go further and argue that they share some common characteristics:
This is the last in a series of posts that I have on value investing. You can read the paper that I have on value investing (see link below) and I did make many of these points in a presentation (Warning: It is a little caustic...) in Omaha this year at a value investing conference, just before the Berkshire Hathaway meeting.
Everything is cyclical. I repeat, everything is cyclical.
One of the best things you can do to improve yourself as an investor is to learn how the business cycle impacts the investment process. I recommend this to start. https://www.fidelity.com/viewpoints/investing-ideas/business-cycle-inve…
The greatest determinant in a portfolio's performance to the market in the vast majority of cases is not individual security selection, but allocation to different sectors and asset classes. If you hold lower allocations to tech, especially FANGs, you are underperforming right now. If the market turned and you hold higher allocations to Consumer Staples and Telecom you will outperform.
The next thing you can do is learn about Behavioral finance. Humans determine markets. It is human nature for people to expect current trends to continue into the future....until something unexpected happens. A stock is worth what the consensus is willing to pay and the price consensus is willing to pay is based on the expectations for future business performance. Eventually a negative event will occur drastically shifting market expectations and you will see two types of stocks underperform. 1. High growth stocks aka stocks with high expectations factored into valuations and 2. companies that have high operating leverage and earnings volatility. At this time value investing should in theory outperform due to margin of safety.
Analyzing something on a period less than two economic cycles is dangerous, as you need to know what happens when both ends of the spectrum occur. Yes this stock may have high upside, but do you know it's peak to trough draw-down? Look at the stock chart of Winnebago (WGO), the RV manufacturer. See the draw-down from 2007 to 2009? Now look at how it has performed recently, do you think it would have a similar draw-down if the market turned?
Value managers were getting slaughtered during the tech bubble for having lower allocations to tech stocks, but outperformed after as they had much a much lower draw-down and now a greater universe of relatively cheap stocks to choose from.
This is why it is important to have a diversified portfolio between different investment styles and asset classes because it is extremely difficult to time cycles, but the investment styles, asset classes, and sectors that outperform in down markets will decrease portfolio risk.
The value imposers (Originally Posted: 03/18/2015)
I was riding on a ski lift with an apparently successful investor from New Zealand. Each January he flew to Utah to ski for three weeks with his family. I couldn't even imagine how much airfare and lodging must have cost. Our conversation naturally drifted to investing. He asked what type of investor I was to which I responded "a value investor." He had a puzzled look and said "what does that mean?" I said "I look for undervalued stocks, companies trading for $,.50 that are worth $1." The man laughed and said "Isn't that what all investors are doing? Looking for undervalued stocks?"
That ski lift ride was 10 minutes long, but the conversation has stuck with me the last three years. It serves as a constant reminder to invest differently.
As Warren Buffett's investing style has shifted from small neglected companies to elephants the sentiment of value investing seems to have shifted with him. Articles about value investors from the 1970s and 1980s are full of quotes about finding companies the market has left for dead yet full of value. Companies where their real estate is worth more than their market cap alone, or companies where coffers stuffed with cash are disregarded because there is no growth.
Buffett is arguably one of the most successful investors of all time. He might be outdone by Rockefeller or Carnegie, but until Buffett passes from this life into the History Channel no one's counting. Buffett has matured from a small time investor at the fringe of the market to a star that the rest of the market orbits around. If Buffett wants to speak anyone with a camera listens. His quotes have found a home in almost any market situation. Even a trader might be caught saying "Be fearful when others are greedy." Buffett quotes are like horoscopes, ambiguous enough that they apply to any investor in any market situation.
As Buffett's company Berkshire Hathaway grew from cigar butt stocks (small neglected companies) to larger names his strategy shifted. He started to buy larger companies whose growth wasn't appreciated. After all with billions of dollars in capital he was effectively forced out of smaller names. When Buffett bought undervalued growth stocks, the market purchased it too. Then another shift happened, Buffett could no longer buy undervalued growth and simply had to look for wonderful companies selling at any price that wasn't outrageous. If a large enough company comes calling and they aren't asking too much he'll probably buy. Why? He has to keep feeding the beast. Berkshire Hathaway is a victim of compounding. The company has grown so large and so successful they have an increasing amount of cash that needs to be put to work each year. Buffett could hardly be criticized, he has built one of America's largest companies and made himself into one of America's richest men in the process. So what if he has to lower his standards a bit?
Berkshire Hathaway's pool of potential investments is limited to maybe 100 public companies and a similar number of private companies. But just because he's limited doesn't mean we should be limited. Buffett will probably outperform the market over the next decade, but my guess is Berkshire's returns gently glide to be inline with the market. Why? Because at a certain size his company is a proxy for the market. As the American economy goes, so goes Berkshire Hathaway.
My point is that Buffett has become the market, and at this point mimicking what he does gives results no different than what the market generally does. Why not buy an index fund?
If as an investor you want different results from the market you need to do something different than the market. Everyone in the market wants growing companies. How do I know this? Browse the mutual fund selection at any discount brokerage. What is the term that appears most? Growth. I did a quick search and Fidelity offers me 374 growth funds verses 288 value funds. But I'd say this number is skewed. I read the summaries on a few of the value funds and they all mentioned they look for growing high quality companies in a value manner. Even the value funds are growth funds.
Is growth bad? Not at all, we all want things to grow. If something isn't growing it's shrinking. I want my portfolio to grow, my relationships to grow, my knowledge to grow, my kids to grow, everything to grow. And so does everyone else. We all want growth. If most mutual funds are looking for the same thing is there any question as to why most slightly under-perform roughly by the amount of their fees? Of course not, it's because they're all doing the same thing, looking in the same places for the same types of companies doing the same things.
When everyone is doing the same thing an industry becomes an arms race. Who can find the growth the quickest, who has the better tools, who has the smartest analysts and who can get better information. This is the efficient market, the knowledge arms race for growth.
This arms race extends beyond mutual funds to hedge funds. Many hedge funds think differently together resulting in crowded trades. Individual investors see these clusters of fund managers in the same names and naturally gravitate towards the same companies, like moths to a light.
There is an alternative. For those of us without Wharton, Harvard, or Columbia analysts or those of us who aren't managing billions, or even for those of us who are. The answer is to think and act differently.
One of the reasons value investing was so unique when Graham first wrote about it was because it was so different. At the time investors wanted high yielding stocks. A high yielding stock was desirable. It didn't matter what assets or earnings the company had, only their dividend. As time has progressed the metrics the market considers important have shifted. Instead of dividends it's ROE, growth, moats and EV/EBITDA multiples.
If you want different results from the market then you need to think and act differently. There will always be a few managers who win the arms race, but silently mimicking them isn't helpful unless you want to join the race. One needs to look at things differently. If the market is looking for growth and high ROE then what are they glossing over that's important? The key to success is finding what others have missed.
Being different is difficult, there are few friends and you need to pave your own path. I have never marched with the crowd, for some reason I came out of my mother's womb wanting to go my own path. To me marching in a different direction is natural, I'm curious, I follow seemingly endless hunches or attractions and hope to learn a little on the way. This extends to my investing, I'm attracted to the nooks and crannies of the market simply because no one else is there. If what I do is unnatural for you that's fine, don't mimic me, do your own thing. To me the key to success is being different and thinking differently.
I find success fascinating. There are plenty of high powered CEO's who grew up in the right suburbs, went to the right colleges and climbed the right ladders. The financial media loves them, but to me they're boring. I find the successful entrepreneurs fascinating. People who never went to college and own multi-million dollar landscaping companies. People who left high powered jobs to start something different like a cupcake business. The ones who saw opportunity and acted on it. The ones who risked failure, or the loss of their reputation to do something different. People who are obsessed with something and won't give up until they are satisfied with a solution. These are the success stories I love to hear about.
While I love success I am even more fascinated by failure. There are common failure paths that most companies or individuals take. These are well trod out paths that some can see coming. Why do so many companies with well educated executives fail so miserably? As an investor spotting failure and avoiding it can be extremely profitable. Most companies that fail follow the crowd, they fail to take risks and do things differently. Some industries fail together as each company marches in lock step toward imminent death.
Buffett's success came from being different. He created a new type of investment company. It's a shame that instead of learning that lesson from him investors have instead embraced trying to copy him. If you want different investment results than the market, you need to think and invest differently. If you don't you might as well invest in an index fund and forget about the market.