Oaktree Capital Co-founder and Co-chairman Howard Marks has renewed the debate on value versus growth investing with his recent memo titled ‘Something of Value.’
It reflects Marks’ clarity of thoughts, historical perspectives and insights on the subject of value investing, and will be poured over time and again by investors seeking the precise meaning of value and growth investing, which has evolved since Benjamin Graham.
Value investing refers to the identification and quantification of the inherent worth of a company, which is based primarily on its ability to generate cash flow and to buy the stock of the company if its prevalent price represents a reasonable discount from the inherent worth or the intrinsic value.
The worth of a company can be broadly calculated by summation of all estimated cash flows as far into the future as possible and then subsequently discounted at a realistic rate.
The realistic rate is nothing but the summation of a “risk free rate” (applicable on government instruments) and a “risk premium” to compensate for the uncertainties arising from the macro and micro economic factors. However, determining the value is more than just a simple mathematical calculation. It involves making informed judgements on relevant inputs.
This discounting cash flow (or DCF) is the primary method for value investors to arrive at their investment decision on the basis of long-term company fundamentals.
The important bit to realize is that the intrinsic worth of a financial instrument may be very different from what is being quoted in the market, and the job of the value investor is to primarily identify stocks, which are trading at a discount from their inherent worth or intrinsic value, thereby creating portfolio value.
Value investing has evolved in a big way over the years. In earlier times, efficient market hypothesis did not necessarily hold true. The competing players in the market were far fewer and access to information was relatively difficult.
Without the current toolkit of computer terminals, software and spreadsheets, the information was more difficult to discern at that time. Further, access to real-time information was far more limited with investors relying primarily on newspapers or publications to undertake research of a stock.
The scene was such that even gaining access to a company’s annual report was a tedious task. Warren Buffett coined the term “Cigar Butt” approach to refer to value investing famously initiated by Benjamin Graham wherein he would stress on searching for companies whose shares were selling at a discount in relation to the liquidation value of balance sheet assets. Buffett compared this approach to searching for used cigar butts having that last puff left in them.
In the old days, it was easier for knowledgeable investors to buy stocks of these companies owing to information silos where attractive deals were out in the open.
However, the scenario has changed completely at present. With the availability of real-time, updated information at the disposal of even laymen, efficient market hypothesis hold good. The focus has moved away from identifying observable information to focus on superior judgements regarding qualitative factors and the ability to reasonably predict future trends.
Low valuation does not necessarily translate into good value. A stock trading at a low Price-to-Earnings (P/E) ratio may appear attractive in the current state. But the important aspect to be considered is whether the current earnings are indicative of the strong fundamentals of the company and whether they can serve as a predictor for the sustained performance of the company.
Howard Marks writes...
“It’s easy to be seduced by the former (low value stocks), but a stock with a low P/E ratio, for example, is likely to be a bargain only if its current earnings and recent earnings growth are indicative of the future. Just pursuing low valuation metrics can lead you to so-called “value traps” - things that look cheap on numbers but aren’t because they have operating weaknesses or because the sales and earnings creating those valuations can’t be replicated in the future.”
The evolution of growth investing occurred primarily at the start of the 1960s, which was characterized by increasing investor interest in rapid growth stocks. It was during this time that the Nifty Fifty came into being and became the focal point of leading institutional investors.
In the initial phase, the Nifty Fifty displayed stellar performance and their valuations rose to great levels before rapidly falling between 1972 and 1974.
Due to this fall, the Nifty Fifty returns turned negative for several years. However, it must be highlight-ed that even in the Nifty Fifty, nearly half the companies gave reasonably good returns, even keeping pre-crash levels of 1972 as yardstick. This suggests that even higher valuations can be justified to an extent for exceptional companies.
“The two approaches – value and growth – have divided the investment world for the last fifty years. They’ve become not only schools of investing thought but also labels used to differentiate products, managers and organizations,” said Howard Marks.
Value and growth approaches have historically been viewed as distinct and have largely divided the opinions of the investment world. Given the trends over the past decade or so favoring growth investing approach over value investing approach, there is an increase in echo from the investment community that the value approach of investing is past its sell-by date.
However, proponents of value approach are of the view that the resurgence of the approach is due any moment. While there are notable differences in the approaches pertaining to choice of business models, outlook to investment and response to interest rate corrections, investment wizard Howard Marks believes that the two approaches are not meant to be mutually exclusive. According to him, this distinction is counterproductive. Given the potentially complex interconnected world, the combination of both approaches is the way to go.
Considered in silos, there is an inherent bias and danger in both approaches. Given the complex macroeconomic and micro economic environment, the companies today are exposed to further sensitivity presenting both positive and negative outcomes.
From growth investing aspect, successful businesses have ample room for growth and durability and the ability to generate high returns. On the flip side, there is an increasing possibility for overvaluing, undeserving companies.
He writes...
“Growth investing often entails belief in unproven business models that can suffer serious setbacks from time to time, requiring investors to have deep conviction so as to be able to hang on. When they’re rising, growth stocks typically incorporate a level of optimism that can evaporate during corrections, testing even the most steeled investor.”
Similarly, Howard Marks writes :
“Much of value investing is based on the assumption of ‘reversion to the mean.’” In other words, “what goes up must come down (and what comes down must go up).”
Value investors often look for bargains among the things that have come down.
Their goal, of course, is to buy under priced assets and capture the discounts. But then, by definition, their potential gain is largely limited to the amount of the discount. Once they’ve benefited from the closing of the valuation gap, “the juice is out of the orange,” so they should sell and move on to the next situation.”
He further adds...
“In Graham’s day, cigar butts could be found in good supply, valued precisely, bought very cheaply with confidence, and then sold once the price had risen to converge with the value.”
Given the inherent scepticism built into the value investing approach, it can lead to a bias. Too much focus on price and precise calculation of the intrinsic value and applying margin of safety may not always work.
That bias could lead to outright dismissal of certain investing opportunities. Value-based investing needs to adapt with changing times and not focus exceedingly on formula-based investing as this will likely lead to massive errors in turbulent times.
The natural mind-set of a value investor is biased towards scepticism. This leads to a limited response approach in fluid, changing times. Value investors justify this by pointing at historical bear runs that cause large sums of value depletion.
While it is true that this scepticism reduces the probability of losing money, it is also true that the same reduces the probability of making adequate returns. In today’s world change is the only constant and the world is rapidly evolving and the scepticism should be paired with a more receptive and open-minded approach. Then only a view should be formed.
Innovators are often disregarded as absurd in the beginning when compared with the prevailing yardstick. Once the innovation becomes successful, the seemingly crazy and absurd idea becomes the norm. Just like low price doesn’t mean good value or high price doesn`t mean bad value, a mutually exclusive approach will be inadequate in the given scenario. A fluid approach combining the aspects of both is the way forward.
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