There has been much gnashing of teeth over the past several years about the persistence of "underperformance" of "value", particularly when compared to large cap growth. These categories are, in a sense, an artificial construct of Morningstar, and much of the comparison, I think is based on mutual funds; constrained as they are by various regulatory and strategy restrictions.
But the truth is, if you have been investing in traditional value sorts of investments - overcapitalized companies, cheap cash generators with limited growth or growth potential, expecting some sort of mean reversion on valuation, you have likely been disappointed. You may have fared better with special situations, but then again, you were likely betting on some really dramatic idiosyncratic adjustments to the income statement, the balance sheet or both. Changes that might have turned that "value" company into a "growth" company, at least insofar as earnings or cash generation per share were concerned. Other popular strategies, like investing in holdcos that can in turn make control investments in (sometimes private) businesses has similarly produced dismal results, even when seemingly smart allocators were in charge.
So why has value been so "unsuccessful"? There have been two arguments that are generally advanced, which are variants of the same hypothesis: assets, particularly large cap growth, is just unreasonably valued. I think both of these have merit, but fail to explain the other potential issue, which is rarely discussed - that the locus of value and value creation may have shifted and have done so in ways that are particularly at odds with the investment characteristics value investors need. Before we turn to this, let's quickly review the arguments about the market today.
The first is that large cap growth is simply in a bubble that has completely insane valuations against which no "investment" strategy worthy of the name can expect to compete. A common explanation for this is the rise of indexation as an investment strategy. It is understood that indexation is a cheap way to get exposure to a particular asset class - in this case stocks - with minimal fees and costs. In theory, it should offer diversification, but in practice, it is something of a momentum strategy, in which inflows occur not based on market conditions but, in most cases, based on cash flows from participants in savings schemes like 401(k)s. That money makes automatic bids for securities, and inevitably allocates the most money to the most valuable firms, which are the largest and most expensive ones. Given these automatic bids, prices tend to levitate and in the same spirit of "to whom much is given, much more is given" the bigger the market cap gets, the MORE inflows there are competing for what are usually smaller and smaller floats. It should be observed that this is the opposite of what neo-classical economics would suggest (I want to revisit this theme in other articles). Here, HIGHER prices INCREASE demand, they do not reduce it. Is such a setup natural? Can it even be said to be a market if price signals are ignored and ultimately produce the opposite effect of what market theorists say? Possibly, but it should give us pause.
A second theory is similar to the first, which is that many investors have been conditioned to believe that markets basically move in one direction and that novice investors looking to make "fast money" find themselves obsessed with these names. Since these companies are well known and their products and markets are well understood by retail investors, there is more confidence for retail investors in putting their money into such investments. Also, they have been rewarded for making that decision.
So both are forms of the argument for "irrationality". But while both of these no doubt hold some credit, they aren't that satisfying, since "value" investors have largely missed out on these stocks when they and their businesses were much smaller and there was incredible value being created. These firms, it should be noted, do this often with very low amounts of capital employed. True, they pay their workers (and when the true comp of these people is factored in - so much of that comp is supplied by the capital markets rather than the income statement - their profits are decidedly lower). Yet, firms like Google were incredible values at $85 when it went public. Value investors saw only insane pricing and passed. Why?
Ron Chernow, in his biography of John Adams, that had Adams chosen to invest in US Treasury securities rather than in Massachusetts land in the 1780s, that he would likely have become the 2nd or 3rd richest man in America (behind Washington). But his insistence that the true source of all wealth was land caused him to pass on buying US obligations essentially in default just before changes in government were about to restore those assets to be good credits. He could not see how those pieces of paper could create huge wealth for the holders and for the country through liquifying capital and money. It just didn't "make sense" that these contracts could create more value than "productive" assets like land.
I think today, value investors have some of the same problems - they see these SaaS companies and other "asset-light" models as somehow, phantom. They don't seem to require much capital and therefore they don't fit. It's not that value investors don't understand that low capital demands make for amazing ROCE and cash generation. It's that it short circuits certain demands "value" investors have for investment.
Let us recall that a "value investor" is not someone who buys "cheap" assets. That is a speculator. Hoping that with a fistful of cheap assets some of these things will turn out to have big value down the road is speculation and there is significant chance that many of the individual assets will have no value. It is a fine system - many VCs and other types who play percentages build portfolios just like this, with mostly losers and a few spectacular winners. But this is not "value investing". Value investing starts with LOSS AVERSION. That is why the hallmark is margin of safety. That margin is often provided in part by the cheapness of the assets, but one can quickly see why these sorts of modern growth companies cannot work for the value investor. They are too speculative. from a value standpoint.
Value investors usually look at all of the different "worst case" scenarios and are able to conclude that there is no way in which - barring losing a war on your home soil or asteroids vaporizing the Earth - for them to lose. Why? Because even if the business fails the assets can almost always be repurposed. Factories and equipment can be sold to competitors or scrap yards, securities can be sold, inventories liquidated, land sold or converted to some other form of value such as a REIT or land trust. Even the brand name might hold residual value. That is, the value investor almost always is assured of recovering nearly all of his investment in liquidation, if worst comes to worst. (Hell, sometimes, he could get an immediate return in a liquidation, because the firm is a "net net"). If business improves and becomes valued based on multiples of the income statement, he makes a great return while never really putting his capital in danger.
This simply cannot be said of the "asset-light" model. In nearly all cases, the true asset is consumer goodwill and THAT, every value investor knows, can be very fleeting indeed. Even the legendary brands like Coke have issues when consumer tastes shift to water and sports drinks. Beer companies find themselves struggling with competition from spirits, and also with non-alcoholic beverages. These are at least businesses with physical assets. What do you do with Facebook? Every value investor who has passed on FB will remind you, kind reader, to consider "MySpace"... how long did it take to vaporize hundreds of millions there? Three months?
Consumer tastes are too fickle for a value investor, no matter how good the near term economics might appear. Google's lead in search is massive, and yet even that moat is suffering as consumers looking to really buy something often do searches directly within Amazon. Advertisers follow consumers and well, if they dry up, you might look like local news, for goodness sake!
This, I think is the real problem for value investors. They cannot get over a business model in which all of the assets are intangible and not really severable from the business itself. Marty Whitman, who implores us to be "modern" value investors and consider how a balance sheet can be sliced and diced, refinanced, sold, spun, merged or otherwise repurposed in thinking about both cheapness AND safety finds little to love in the modern asset light firm.
And value guys aren't entirely wrong - if social media is too unfair, consider asset light models in traditional businesses, look at Enron, an energy company that also wanted to be asset light, at least in terms of physical assets; preferring to model themselves on a financial institution where assets could be created with signatures. In the end, the only assets it had were the low growth, low margin highly regulated utility assets of Enron International, the overseas assets, largely that the Fastows and Skillings found pointless and boring.
Yes, those assets were never going to drive the premium valuation - but they were going to prevent goose eggs in a downturn.
Value investors struggle, and likely always will struggle to invest in firms whose assets are largely people and brains that can walk out the door taking their complex web of human networks with them. Value investors want the sorts of businesses in which the people are cogs and the physical assets, the kind that can be possessed, drive value creation. This is why they struggle to buy the sorts of firms that have created brand new markets and have therefore benefitted from extraordinary returns.
At some point, of course, these markets are likely to be exhausted. Ad based models have consolidated into a few firms and those firms have needed much less physical equipment to win those ad dollars. But advertising is limited, structurally to something around 1% of output. More than that and the marginal value of the next sale approaches zero (the sales leverage of a marginal dollar of advertising constrains ad spending at around that 1%), so most of those models have simply taken market share and now hold so much market share that they will find it hard to increment sales much more; valuations there will suffer. That will not make value investments "better" (though, one supposes, it might make them less bad). Value will, then outperform, but not by having huge returns, I expect, but rather by avoiding some massively negative ones.
But maybe, like the Adams family, value investors have to think differently about value creation and about how margin of safety could work in an asset light environment. That is a topic for another day as well.
Those that pronounce value investing a dead horse – perhaps it should be a dead cat because it seemingly has multiple lives – are generally referring to mechanical notions of value such as low P/E and low P/B. However, low ratios have never been the heart of the value investing approach except perhaps in the very beginning of the discipline. The core of the approach, as you note, is triangulating an intrinsic value of an asset and buying when one has a significant MOS to compensate for errors inevitably made in such a calculation. While in practice this has some connection to tangible assets in theory that is not at all required.
ReplyDeleteBruce Greenwald has talked endlessly about the transition of the modern economy from a goods-based one to a service based one. The significance of this is of course that services tend to be local in nature which makes them much more apt to have dominant competitive advantages that allow for sustainably high(er) returns on capital. His favorite example is that of John Deere that transitioned from an equipment manufacturer to a service provider given all the electronics / complicated assemblies inherent in modern equipment.
You hint at the above in your final line of the entry. Value investing proper is not dead but mechanical notions of value probably are given the transition of the economy from goods to services. However, even if that transition was not taking place, mechanical notions of value would probably underperform given the proliferation of stock screeners and statistical techniques that can easily take advantage of such anomalies.
I am confident that given the less than desirable tendency of market participants be all too human at the wrong times value investors, in the proper sense of the term, will be able to profit in the long run. In the end all investing is value investing.