Growth investing has been in vogue over the past decade. Mean-reversion contrarians are understandably asking whether it is now the turn of value to outperform growth on a sustained basis?
However, using these crude style category terms mis-frame the issue.
Growth and value have been co-opted by academic practitioners, borrowed by marketing departments, and defined into irrelevance.
There is now value in value investing because there is always value in value investing – so long as it is properly understood.
Moreover, authentic value investors should reclaim the language of value investing.
Adding to ‘value’
First, a basic principal: there are only two sorts of stock: cheap and expensive.
This is because stocks outperform only if they are bought at a discount to their worth as determined by the present value of future cashflows.
The godfathers of value investing Benjamin Graham and David Dodd coined the term ‘margin of safety’ to describe the gap between market price and intrinsic value.
However, in the aftermath of the Great Depression and a World War the practical application of this by the Graham-Newman Corporation was to scoop up shares trading at a discount to their balance sheet liquidation value.
Graham subsequently went on to publish various iterations of formulae for quantifying this nebulous intrinsic value.
Criteria such as low price-to-earnings, high dividend yield and low price-to-book featured prominently, all measures now commonly regarded as value factors.
The idea of value stocks being statistical bargains has stuck ever since, despite the earliest practitioners of value investing quickly evolving away from the narrowest confines of this approach.
By the time he wrote his final (fourth) edition of The Intelligent Investor in 1973 Graham felt obliged to admit in a postscript that more than half of his investment returns had come not from the ‘net-net’ approach for which he is most famous but from a single stock – GEICO.
GEICO was a tremendous success not because it was purchased below book value but because it was able to grow premiums and policyholders due to the durability of their low-cost competitive advantage.
Elusive intrinsic value
What is going on here?
Sometimes, book value is a proxy for intrinsic value.
Accounting standards dictate that identifiable projects – such as the cost of constructing an oilfield or factory – go through the cashflow statement onto the balance sheet. Net asset value was thus a reasonable proxy for replacement cost, earnings potential and hence intrinsic value.
Prudent investors waited for market pessimism to push prices below book cost, bought the stocks, and waited for eventual normalisation.
At a push, they could wrest control of the company. In contrast, less defined investments such as brand advertising or generic research and development is expensed through profit and loss statements as incurred costs and never touches the balance sheet.
Since present intrinsic value hinges on future cash generation, the direction and magnitude of which can only be estimated from imperfect quantitative measures and inferred from qualitative criteria, businesses by definition will always be mispriced because of the uncertainty which surrounds their future.
Beyond a certain point, the crystal ball always goes dark.
This can be particularly pertinent as industries change over time and financial statements become a less reliable guide. As the economy becomes more ‘asset-light’, assets unrecorded on the balance sheet will continue to grow in importance.
While low multiples are frequently an indication of cheapness, investors who focus solely on low multiples are likely to come unstuck.
For those seeking to exploit the difference between the market price of a business and its intrinsic value, there will always be ‘value’ in value investing.
The central lesson of intangibles is, as Albert Einstein reportedly put it, “Not everything that counts can be counted, and not everything that can be counted counts”.
Giles Parkinson is a portfolio manager at Aviva Investors