Two types of Value Investors and Why Value has Underperformed

The structure of the modern company – indeed of modern business operations – represents a big challenge in the frameworks that value investors use to think about company values and in particular risk, reward and safety.  Two structural factors: the impact of intangible assets – and asset-light business and operating models - on business value and quality AND the consolidation of industries into global players, are making the calculus more difficult, particularly for one type of value investor.

Value investing, properly understood, is an approach to taking financial risks that seeks to minimize the risk of loss while allowing for reasonable expectations of upside gains at rates of return that allow you to get rich (and not just stay rich. “Get rich” returns have to be MUCH higher). Value investing therefore is primarily focused on “safety first”.  That safety is usually thought about through looking at worst case scenarios and trying to buy at a price so low that it offers a positive return even if that outcome occurs, or at least, only a very low probability of loss, and near certainty that the loss cannot be very large, not more than a few percentage points of the capital at risk.

Value investing as a mindset comes in two flavors: quality and cheapness.  Both concerns are important.  Quality matters, because crappy assets, or even decent assets trapped inside of a crappy operation, tend to diffuse over time and become impaired.  They don’t compound – or do so at very low rates - and so even if they are distributed at some point in the future, the returns over time are modest. Worse, distribution often happens at times of stress when the assets yield the lowest values. Without quality there can be very limited expectation of upside, unless the investor can wrest control of the assets and force some sort of asset conversion – a liquidation, a merger, a recap, a new line of operation or business.

But paying too much for even a quality asset can produce the same outcome.  Needing an asset to “grow” into its valuation embeds years of low or modest INTERNAL returns (market returns can be robust) while waiting for the value to catch up to the price paid.

Value investors debate these two poles frequently – and often bitterly.  I often find myself debating with other investors (and sometimes with myself) about the relative merits of the two in the case of a potential investment, or in comparison of a few investments. At issue is really a question of margin of safety, which, I believe is the true hallmark of value investing (the estimation of which I am working hard at improving).  A big part of this divide now, I think, is tied to the dominance of intangible assets in (post)modern business: they have much greater tail outcomes than physical assets do.

Low price seems to offer a much more straightforward route. It has a lot of appeal, in part because it is so quantitative.  You can look at the market values of the assets of the firm and if you can purchase them at a significant discount, then even if they are producing modest, perhaps non-economic returns or just barely earning their costs of capital, you still feel you have a margin of safety.  In the event of liquidation, the securities/interests you hold expect to receive a payout sufficient to at least return the capital invested if not more.  That is having a margin of safety.

Consider, tho, what sort of things this investor wants to buy – if the focus is on liquidation value, then the investor wants many, ideally liquid, SEVERABLE assets.  These are the sorts of things that are easy to auction to many bidders: receivables and rights to payment, inventories (in some cases, quick inventories at least), assignable leases, real estate (esp cash flow real estate), even property plant and equipment has value, especially to strategic buyers who may take a portion of the operations and may pay for some of that business value.

This investor likes things like banks, old line industrial firms, asset heavy companies with lots of liquidation value. His problem is that in a world heavy on intangible, asset light models, what does he have on liquidation?  Often not much in the way of safety.  Intangible assets have much fatter tails.  If they retain their quality; then the strong operating characteristics of the business – which often require little or no reinvestment – mean that returns on capital will be genuinely wealth creating, but in the event of impairment, they are often worth next to nothing.  These assets can be goodwill, which is great while it is in place, but often worth nothing if customers flee. Even the most “severable” of intangible assets, brand names, can often have huge tail risks.  Other intangibles, like tax NOLs, are impaired upon transfer – by rule!

You can see the dilemma this poses for the value investor: he sees a Facebook and can only think about MySpace and he is not wrong to think this way.  But – at least in my case – I think the tendency is to *assume* no moat for Facebook; that it can fall out of fashion and be yesterdays news in a matter of months.  The implosions can be spectacular.

In cutting himself off from that left side of the distribution, though, our price and liquidation value focused investor is cutting himself off from many investments on the right side of the distribution set.  These businesses produce a very disproportionate amount of the value and so he underperforms.  Constantly. As he waits for asset heavy models to return to favor.

Worse, in a world with fewer competitors, the liquidation value of many of the assets is also lower.  There are simply fewer strategic buyers in nearly any traditional business line to purchase the operating assets AS OPERATIONS, which always command a higher price.  So the discount that has to be applied is larger.

Instead, the value investor has to focus more on paying up for quality – which is harder and more “qualitative” which is also more subjective. It requires thinking differently about what value means – that it is possible for a person and a webcam to generate some incredible content and a following that produces (if it remains topical) the potential for residual income streams in the form of the modern form of “syndication” – the YouTube suggestion set.  These residuals can go on for years. They can also disappear either from audience preference changes, or from decisions by the platforms on which many of these businesses depend.

Quality – and being able to assess that quality – is more important.  Moreover, it may be necessary to think differently about “quality” – that it is not always a permanent annuity.  Perhaps it is something in which the investor can realistically get a significant return in the near term – and thinking differently about how manage that position (he will need a market outcome in most cases, and will have to manage the position to capture and retain that gain.  This, tho, might be thought of as sepcuatlive and not value investing at all), in order to earn a solid return.  Is it so bad to know that you are “guaranteed” a solid return – enough to recover your capital and more – over a two to three year cycle, so long as you make sure to sell, because the long term prospect is the business is a $0.  This might be like investing in newspapers.

I think this paradigm really is a tough one for value.  Value works because of cheapness and protection, but it also assumed that financial capital would have considerable power in the structure of the firm – that financial capital controlled the purse.  But in an asset light world – very little financial capital is required.  Financial capital is going cap in hand and begging entrepreneurs to let them put money into their ventures.  What is the likelihood that this changes? The value investor is going to need to rethink the frameworks for investment, I think.  To find a different way of seeing margin of safety and perhaps to change thinking around how to provide / ensure that margin of safety.