One of the most popular and frequent articles that pop up recently are those discussing value versus growth. These articles typically define value investing as stocks with a low multiple (eg. low price to book) and growth investing those with high multiples. Usual conclusion is the value hasn’t been working for years and that value investing is dead. Now unless you are a systematic investor (i.e. buying/selling whatever a specific automated system or model tells you) or a passive investor these articles are usually a waste of time. If you’re a stock picker then just swipe left and spend your valuable time elsewhere because real value investing can not die.
Value investing is not buying low multiple stocks. Academics have used low multiples as a proxy for value investing but value is investing is not low multiple stocks. Value investing is buying the stock of a company that is trading below it’s intrinsic value. The intrinsic value is the presented value of a company’s projected future cash flows. Obviously estimating these cash flows and putting together a spreadsheet takes time. It requires researching the company and industry in-depth. To understand the potential and the risks. You can’t take the accounting numbers and throw it into a model and come out with an answer. Academics and some practitioners have used low multiples as a proxy for value investing. It makes number crunching and writing papers easier. When these methods are backtested the historical results over the very long term (think 50+ years, not just last 5 years) look in favor of value investing. But why is that?
It’s not because low multiples is the secret formula. Backtested results have looked good because of the periods were low multiple investing did extremely well. And when was that? Coming out of recessions. What happens coming out of a recession? Almost all stocks are cheap, and they trade at a discount to their intrinsic value. Hence the stock is cheap compared to its intrinsic value and it’s trading at a low multiple. Low multiples and intrinsic value discount are in agreement. I have shown this several times in past letters to subscribers using the Global Financial Crisis (GFC) as an example. During that time, stocks were hit hard and hence their discount to intrinsic value was extreme. What do you think dropped more during the GFC, Coca-Cola or some cyclical stocks (eg. auto, leasing, etc). Obviously the later. Hence the large returns from low multiple stocks. So when you take multiple decades which include several downturns where you have stocks trading at a discount to their intrinsic value and low multiples then the overall study will show that low multiple investing looks good. But essentially it’s the discount to intrinsic value which really results in the performance.
Some people like low multiples because that’s what Benjamin Graham (Buffett’s mentor, Columbia professor and author of the Intelligent Investor and Security Analysis) used. But investing 85 years ago was a lot different than today. In those days all the companies had significant fixed assets (manufacturing companies) and information was not readily available. Today a significant amount of companies are asset-light, and company data is available with a click of a button. Cash flow statements have only been made mandatory in the last 30 years! So markets were less efficient and so also fluctuated a lot more wildly. Hence Ben Graham who was looking at manufacturing companies with limited data used large discounts to book value. Back then everything was trading at ridiculous discounts to book value.
Moving forward since the GFC, low multiple stocks have not done so well. Why is this? It’s simple. Many stocks with low multiples were no longer trading at a discount to intrinsic value. So a company with a low multiple may still be trading at a premium to its intrinsic value and hence not cheap. They have a low multiple for a reason. A multiple is just one statistic. On its own it is meaningless. It’s a piece of the puzzle. 4 common reasons for low P/Es and important factors that affect them (and other multiples) are predictability of cash flows, growth, return on capital and capital structure. A company with lower growth obviously is less valuable than one with higher growth and hence the lower P/E. If the company sells a commodity product where it has no power over its pricing will have large swings in its cash flow. An investor in such a company doesn’t really know if this year’s profits will be repeated next year. So if you’re such an investor, would you pay more or less for the commodity company? One day I was discussing a profitable investment I made in a refiner with my good friend Kevin Waspi. I was making money and it looked like it was time to sell. The street was still very excited about the stock and buy recommendations were popping up all over the place (citing the low P/E). To me it looked fairly valued at best. Kevin turns to me and says, “You know, I buy refiners where they don’t have a P/E and sell them when they do”. The point is that companies with no competitive advantage producing a product which is just like any other is riskier due to the unpredictability of cash flows. And you see this in both the equity markets and bond markets where commodity companies’ bonds trade at higher yields because they are much more likely to default. The third most common explanation is that the company is growing its profits at a return on capital BELOW it’s cost of capital. Would you borrow at 8% to invest it at 5%? Obviously not! But we see it all the time in the market. A company that is essentially destroying shareholder capital will trade at a lower P/E. Another big one is capital structure or in simple terms how much debt versus equity. A company with a lot of debt will trade at a lower P/E. So as you understand there are multiple reasons for a low multiple. Hence a low multiple does not mean a stock is cheap. At the same time, I’m not saying a high multiple is cheap. But it could be.
The high P/E could be justified and the stock could still be cheap! A high P/E doesn’t mean it’s expensive. For example, Visa (V) has always traded at a P/E between 20-40. Had you bought Visa before the GFC in mid-May 2008 at around $20 (forward P/E of around 33) then you would have achieved a 933% return over the last 12 years compared to 176% for the S&P 500. Visa trades at a high P/E because it generates a return on capital of over 20%, has EBITDA margins of 70%, and operates the world’s largest payment system with over 3 billion credit cards in circulation globally (predictable, stable cash flows). So as you understand, the P/E means little without studying the company, industry and prospects. The same holds true for entire markets. If an index is dominated by bank stocks, what do you expect the multiple for that country to be? High or low? So the index composition is very important and it’s meaningless to say X country is cheaper than Y company on P/E alone. The same can hold true for the SAME country over time. There was a Credit Suisse study that showed that the market in the U.S. has changed. There are fewer listed companies than in the past, and that the newly listed companies are older at time of listing. This means we have larger, less riskier firms and IPOs of companies that have already been around for a while and less likely to go out of business. Finally the companies that are listed have higher margins and better returns on capital than in the past. So if all that holds wouldn’t it make sense for the index as a whole to be worth more (all else equal)? So comparing across markets or even across time without looking beyond the headline numbers is superficial.
So I hope you know understand that true value investing can never die. As Charlie Munger put it, all smart investing is value investing (eg. buying Visa example above was value investing). He certainly doesn’t define it in the same manner as academics or the investment bank analysts. Along with his partner Warren Buffet they look for companies that are trading at a discount to their intrinsic value. At the end of the day, value investing is human nature. We are always looking for a good deal. We don’t just buy the cheapest TV on the market. We do our research and find out the features and quality of the brand. We ask our friends and read reviews. Then when we get the opportunity to buy it cheaply (eg. Black Friday) we pull the trigger. Multiple investing is the lazy man’s approach but you can use it to screen for opportunities. Just don’t stop there. If you find a stock with a low multiple, and after you do your homework, you come to the conclusion that the reasons for the low multiple are wrong or the company is trading at a discount to its intrinsic worth then you found a great opportunity. Keep in mind though that markets are a lot more efficient than we think. It’s human nature to want to try and find the hidden gem, the low P/E company that the market is wrong about, and we are correct. But most of the time, the market is about right with valuation. That doesn’t mean active investors can’t do very well.
But you have to put in the work. It would be very nice if we could just form portfolios of low multiples or just high growth companies and sit back. Markets don’t work like that. And the one luxury we don’t have enough off is time in a day. In today’s world, we are bombarded with things to read. And we only have so much mental energy so you need to maximize your return on that energy spent. Dig deep into information that will help you the most, like reading a conference call transcript, the company’s 10-K, watching their investor day (if they do one) or reading a book. If you have too many subscriptions that you miss the good stuff then start unsubscribing. Can a stock picker make money off of all this commotion on Value vs Growth? No, so just don’t bother.
