Value investing is usually described in one of two ways, the first is buying assets at a discount a la Ben Graham. The second is buying good businesses at low or fairly low prices and letting the superior business compound, the Warren Buffett approach. I want to explore a third option in this post that's overlooked and misunderstood.
I've heard some value investors describe value investing as "buying something for less than its worth (intrinsic value)." I was skiing last winter and rode a lift at Solitude with a Kiwi who was a stock broker. I mentioned I did some investing and searched for undervalued stocks, looking to buy for less than intrinsic value. The guy laughed and said "that's the name of the game, who isn't trying to do that?" Which is of course true, what sort of investor looks to buy companies at high prices and hope things work out?
In economic terms a company that earns abnormal returns must have some sort of competitive advantage or as Buffett calls it a moat. If the business didn't have an advantage entrepreneurs and other companies would see the fantastic returns, enter the business, compete and lower everyone's returns. I think it's indisputable that some companies have moats, the ultimate moat is a monopoly or oligopoly situation. Another great form of a moat is government regulation. A regulator serves as a gate keeper to an industry. It's no coincidence that Berkshire has been investing in regulated companies over the past few years.
There are plenty of ordinary businesses that earn abnormal returns as well. Why aren't there competitors reducing the abnormal return down to an economic return? Consider an example, a bait and tackle shop on the only access road to a state park with a nice lake. The shop has no pricing power over suppliers, has a low barrier to entry, and doesn't even require specialized skills. Yet the location of the shop, being the only one on a specific road allows it to charge a bit more and earn above average returns. The bait shop has a small niche, serving fishermen at the local state park, yet they don't have any classic competitive advantages, there are many businesses like this.
I believe the difference between a niche and an economic moat is the ability to scale. The bait and tackle shop can earn abnormal returns at their original location it's unlikely they will be able to replicate it unless they find a second location with the exact same characteristics as the first one. I can think of a few companies off the top of my head that I own that fall into this category. They operate in a niche and earn excellent returns yet they don't have additional reinvestment opportunities and will most likely remain the same size forever.
Niche companies are moat impostors and most investors get them mixed up. I'd say the biggest mistake I've seen investors make is to see competitive advantages where only a small niche exists. Paying a moat price for a niche is a mistake. If a company appears to have a competitive advantage yet they can't scale their business I would guess the company only has a niche.
The third way
What about all those companies just earning normal returns on equity? For the most part they're ignored, these are not great businesses. You'll never wow anyone at a party announcing you own shares of a tiny plastics manufacturer, or a family held leather boot company. So are companies earning lower steady rates of return un-investable? I would say definitely not, with a caveat, and additionally they offer great hunting grounds because most investors ignore these companies.
To understand why and how a company with average returns can be a great investment it's helpful to consider a little example:
A company earns 8% on their equity, pays no dividends, book value grows 8% per year.
Book value is $100 per share
A investor pays $100 per share for a piece of the company.
Each year book value grows 8%, so the first year book value increases from $100 to $108, and then to $116.64, $125.97 and so on. An investor buying at book value will see their investment compound at 8% a year.
Buying shares in our example company at anything less than book value will result in a higher compounding figure. So buying shares at $75 p/s will result in 10.6% compounded per year. Why is this?
Book value is still compounding at the same rate of 8%, but since the investor pays less than book value their basis is lower. So let's look at the math:
Year 1 the company grows book value from $100 per share to $108 per share an increase of $8. The key is the investor only paid $75 per share, an $8 return on their $75 investment is 10.6%.
The math here is very simple, buying at lower multiples of book value result in a higher return on investment. While the company is only growing at 8%, buying at 50% of book value is a 16% return a year. The bigger the discount to book value the bigger the return on investment.
If this is the first time you've ever seen this you're probably not still reading, you're probably playing with a screener looking for 8% book value growth with a P/B of .5x. The rest are probably thinking these sorts of investments might exist on paper but not in real life. I would disagree, I posted a while back about Hanover Foods (part 1, part 2). They're a very boring frozen food company earning around 8% a year, yet they're only selling at only 35% of book value. This means buying at today's price results in a 22% per year return on investment. A nice benefit of these lower return companies is the investor doesn't have to worry about competition as much, the industry is mature. There will be innovation, but it's not like every high school kid in a garage is dreaming of how to freeze veggies better, they're all thinking about how to invent the next Facebook.
I mentioned these stable but low returning companies can be great investments with a caveat. The caveat is to not overpay. A nice bonus with this strategy is an investor doesn't need to be a genius or even that fast moving to implement it. Be patient, buy a few steady companies at sizable discounts a year, and be patient.
I like to buy companies at a discount, either a net-net with a tangible asset discount, or a company with a stable return at a discount to book value. I post more frequently about net-nets, but I really don't have a preference between a stock like I describe above and a net-net, both are profitable. This method is probably more hands off and will result in lower portfolio turnover, but is just as safe. The key is to ensure the company is actually growing book value. Of course if they earn 8% on equity and return 50% of it as a dividend book value only grows at 4%, but as an investor you still get your 8%.
As the universe of net-nets dries up beyond its already parched state I'll probably be posting more about stocks that fit the characteristics of this post.
Talk to Nate
Disclosure: Long Hanover