Value investing myths

If something is repeated often enough people will eventually start to believe it.  Buffett always buys "good" companies, and Graham bought companies on the verge of bankruptcy.  Investors who buy into good companies doen't need to worry about the price they pay.  Whereas Graham investors need to be worried because eventually all net-nets go to zero.

Sometimes the truth is more nuanced.  Would Buffett disciples be surprised to read a story about Buffett buying in and out of a small stocks in his personal portfolio?  Would investors be surprised to read a quote by Graham about preferring quality factors in companies they look at?

On Buffett: In 1999 he purchased a $3.3m stake in Bell Industries.  The technology company was in the process of restructuring and had sold off a large division.  Buffett purchased his Bell stake in December of 1999 and by January 18th of 2000 he had already sold out for a quick 50% gain.  The famed 'buy and hold' investor had purchased into a tiny tech stock and flipped it for an 80% gain in less than two months.  The LA Times sums up the investment perfectly:

"Buffett, 70, made his wealth and reputation as a long-term, buy-and-hold investor by using Berkshire as his vehicle for buying major stakes in companies and then patiently waiting years for those investments to soar in value.

But as his earlier experience with Bell showed, that's not always Buffett's practice when he pulls out his own wallet. In that case, Buffett bought a 5.3% stake in Bell in early December 1999, triggered a surge in Bell's market price, and then dumped his stake a month later for a profit of about $1 million, or 50% on his original investment." (source)

Now onto Benjamin Graham.  Graham is often associated with purchasing stocks feature low statistical measures such as price to book, or price to earnings.  One area that Graham has left a mark is by suggesting investors who purchase companies trading below NCAV can consistently outperform the market.  Lost in the past 70s years has been some of Grahams warnings and suggestions around buying net-nets.  Graham as shown below suggested investors purchase net-nets with high earning power, high returns on equity, or an imminent catalyst.  His original framework has been diluted to "buy anything trading below NCAV no matter how terrible the company is".  Here is what Graham originally wrote:

"Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category. He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above. Or else he will be partial to such as reveal other attractive statistical features  besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past. The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so." (Security Analysis p595-596)

His plea to appreciate quality wasn't isolated to those paragraphs.  Sprinkled throughout Security Analysis are recommendations that investors look for higher quality companies over lower quality companies.  At one point he even recommended that investors simply buy the best company in each industry when the entire industry hit its low point in the business cycle.

How is it that these messages have been lost to the sands of time?  But more importantly does that mean anything for us now?

CreditBubbleStocks has captured the current sentiment towards value investing with his post titled "Value Investors Obsessed With "Compounders", ROE; Don't Care About Liquidation Value Or Margin Of Safety"  The post is short and worth reading, his point is that what is considered value investing today bears little resemblance to what value investing has traditionally been.

Value investing has morphed from buying average things cheap to buying companies with high returns on equity.  I have read a few blog posts where Buffett disciples proclaim that there is no price too high to pay for a company with high returns on equity.  Of course this line of thinking is lunacy.  As a company grows larger their returns fall, this isn't math, it's common sense.  If a company can grow at 20% forever they will eventually run out of humans to sell things to.  A perfect example is Wells Fargo, which is praised for their high returns on equity.  A few months back I ran a simple simulation and if they can continue to grow at 15% a year in less than 20 years they will be the only bank in the US with 100% marketshare.  It's possibly they can keep up their high returns on equity due to financial engineering, but it's more likely their returns will naturally fall as they grow.  Nothing can grow forever.

What Buffett, Graham, Schloss and others realized was that buying anything for far below what it was worth was a winning proposition.  These famed value investors kept things simple, they purchased obvious values and didn't base their investment on assumptions or approximations of the future.  American Express in the wake of a scandal was a good purchase for Buffett and is a great example.  If one thinks about the salad oil scandal it fits Graham's advice better than the platitude of a great company at a marginal (high?) price.

For those who manage billions of dollars it is difficult to find truly cheap companies.  But for anyone who isn't managing billions I firmly believe the best course of action is to find decent companies selling for absurdly low values.  But like Buffett and Bell Industries I'm also not opposed to buying something below average if the price warrants it and selling when the opportunity arises.

One characterization I hate is that companies that don't earn their cost of capital are worthless.  When I read things like this I have the thought that if this statement were true then American enterprise would cease to exist.  Do you think the company that services your furnace earns their cost of capital?  Or the local grocery store, or your mechanic, or almost any non-Wall Street company?  The large majority of companies in America and around the world provide a service for customers, pay employees an income and provide an owner a modest income with a little bit left over to reinvest in the future.  Without these companies our lives would be much more difficult, imagine fixing your own furnace, car, and growing your own food!  It seems like we would all be a lot poorer if it weren't for low margin companies that don't earn their cost of capital.

Yet in the world of Wall Street and academic finance a family owned grocery store should either close their doors, or engage in financial engineering to artificially boost their financial metrics that pile on risk.  Of course Wall Street is very happy to sell said products that achieve these goals, maybe that's why there's such a push?

This about the absurdity of return on equity for a few moments.  Consider a company that has $100 in capital, and earns $5 a year.  At present they have a paltry 5% return on equity.  If the company were to take on $99 in debt that costs 3% a year their earnings are now reduced to $2 a year.  But that $2 in earnings on $1 in equity is now an astounding 200% return on equity.  My example is clearly simplified, the $99 in debt goes somewhere and doesn't magically make equity disappear.  Of course if a company did want to make that money disappear they'd simply buy back shares.  This example company would be a darling of Wall Street, with high returns on equity and giant per-share figures.  Of course to hit these metrics the company went from being stable to increasingly fragile.  A slight bump in revenue could send the company into bankruptcy court for a default.

I had a conversation with someone recently where they mentioned they considered a 10% return on equity to be the bare minimum a bank should be making, and that banks below that were considered below average.  This investor said they only looked at banks that earned 15% on their equity, a value they considered appropriate for a US bank.  Interesting enough a bank earning 10% on equity or higher isn't just average, they're far above average.  In the most recent quarter the average return on equity for all banks in the US was 7.75%.  Banks earning 15% or more on their equity are in the top 12% of US banks, of which only a handful are traded.  What this person considered average criteria to themselves was actually very stringent criteria for an investment.

Many investors need to stop fooling themselves about what they're doing.  There is nothing special to buying high growth companies, or companies with great brands.  This alone forms the basis for most of the market, the market is obsessed with growth and growing companies.  There's nothing wrong with looking for good companies, or for looking for great brands, but don't make the mistake of paying too much.  There are many wealthy investors who have made fortunes buying stocks of great companies in bear markets from disenfranchised investors whose growth narrative vanished before their eyes.

At the right price many companies are worth a purchase.  But to me the sweet spot is finding a good company at a very low price.  These companies don't always have great ROE's, but at some point 50% of book value and a few times earnings is good enough for me.  Two examples of companies that fit this description are Pardee Resources or Citizens Bancshares that I profiled recently.  My portfolio is filled with companies like this, Installux, PD-Rx, Solitron, Precia Molen, Conduril, Kopp Glass, Conrad Industries and others to name a few.  It's easier to find small companies with average or above average operations at great prices compared to compounders at anything less than nosebleed prices.  Would I ever consider buying a compounding company?  Absolutely, when the price is right.  I purchased some Berkshire in the midst of the financial crisis for example.

If I could encourage value investors, or aspiring value investors to do one thing it would be to use their imagination.  Acquiring companies, private equity firms, and budding managers use their imagination to take many sleepy companies to great companies by thinning the ranks, introducing new products, or selling unprofitable divisions.  Yet many value investors invest as if what is happening now will happen forever.  Just like Wells Fargo won't grow at 15% forever a small company with a profitable niche selling for a few times earnings won't be independent for long, they'll be acquired.  The most dangerous type of thinking of investing is to think about things as if they were linear events.

The whole premise of valuing investing is purchasing something for less than it's worth.  But I feel that value investing has hit it's 1998 moment where we're inventing new metrics like 'eyeballs per click' and other goofy things to justify a new narrative.  If one looks deep enough, or in enough offbeat corners of the market they will always find value.

19 comments:

  1. The issue is the no-growth economy. That's why investors have been paying premiums for growth—of course this is a cyclical phenomenon as well, and in many cases they're exposed to extreme downside.

    It strikes me that in modestly inflationary, growth economies, value investing performs very well. This was the case in the early 2000s: consider deals like Wilbur Ross's steel rollup, the Kmart bankruptcy, and many others. The reason is that the asset values are carried upward—but I'm not sure those deals would work today, in a more deflationary environment.

    Japan was an example where net nets persisted for something like a decade or more. That's what investors are worried about nowadays, and there's a very real "career risk" involved...

    Perhaps two years of lackluster performance is enough to cause a major drawdown in AUM; consider what happened to Bruce Berkowitz, and he's a prominent name with a clearly expressed approach.

    Most "value" managers need to drift into whatever works at the moment, because there's so little truly patient, value-oriented capital.

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    1. I agree that most larger or professional value managers need to drift to what works. But smaller funds and individuals shouldn't waste their time trying to mimic large funds.

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  2. This post is so well-written that it makes me suspicious you got Carol Loomis to proofread and edit it!
    What if your CompleteBankData and other side start-ups start raking in so much cash flow that you can quit your day job? With the size of the float your businesses will generate, soon you will have no choice but to evolve into a Buffett-type compounder investor.

    Wouldn't it be ironic if the writing of this article marks the beginning of the end of your oddball-style investing? Regardless, great job! And thanks for writing!

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    1. Thanks, it'd be nice to be doing this full time...hopefully soon enough.

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  3. This is a great post, particularly the following:
    If I could encourage value investors, or aspiring value investors to do one thing it would be to use their imagination. Acquiring companies, private equity firms, and budding managers use their imagination to take many sleepy companies to great companies by thinning the ranks, introducing new products, or selling unprofitable divisions. Yet many value investors invest as if what is happening now will happen forever.

    By coincidence I've spent the past couple of days looking at Ball (BLL). It's been a great performer over the past fifteen years, rising 1600% since 2000. But in the fifteen years before that the stock price was flat. Ball has always paid a minuscule dividend, so anyone who owned it in the 80s and 90s lost money after inflation. The stock was cheap in 2000, trading at 6x fcf, but no one who'd looked at its history and extrapolated the past forward would have imagined it doing as well as it did.

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    1. Sometimes value is obvious and languishes for years. If you can spot it and are patient enough to wait you will do well.

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  4. Thank you for this great post.
    I have not been able to find your own performance in your blog. Have you published it?
    Thanks again

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    1. I have two thoughts on this. The first is that what someone says or believes should stand alone. That is if what I write has value it shouldn't matter if I've made 2% or 200%.

      Of course in the world of investing only people with good returns are to be believed. Which I think is a mistake.

      I published 2013 returns here: http://www.oddballstocks.com/2013/12/looking-back-at-2013-how-did-my-13.html

      I don't run a fund, I'm investing my own money. So calculating performance isn't something I do often. According to Fidelity at the end of September I was up about 15% YTD. That slightly under-reports my performance because they have some issues tracking how foreign stocks do. In January I'll probably sit down and figure out exactly how well did.

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  5. Nate the reason why some folks focus on high ROIC (leverage neutral) is that's the only way to get wealthy. Flipping cheap average (<10% ROIC) companies will pay the bills and helps you get by, but that's about it.

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    1. I love comments like this. I completely disagree, but do what works I guess.

      If it were only as easy as buying high ROIC companies that wouldn't everyone be rich? And if those of us flipping cheap companies are going to lose out why do I know so many very wealthy individuals who used this method to build their wealth?

      This is completely anecdotal but I meet a lot of people through this blog. I meet a lot of younger investors who are obsessed with high ROIC and high ROE stocks. They're all out to make a name for themselves. I also meet a lot of older wealthy investors, universally they've made their money buying cheap stocks. Read what you want into it.

      I'll be content to pay the bills, no Ferrari for me..

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    2. The way to become rich is by doing hard things. I know a value investing billionaire who made his fortune in a similar way to what you're describing; with difficult-to-stomach companies (also heavy into bankruptcies/restructurings and control positions).

      Conversely, I know another billionaire, in Silicon Valley, who made his fortune by taking extreme risks. While some of it looks smart in hindsight, at the time his positions (particularly the sizing) would've been seen as a huge gamble. But sometimes risk does equal reward—and some people do win lotteries.

      What doesn't make big money are common things. So yes, holding a high ROE stock like, say, IBM will not make you a billionaire. It will simply produce a better return on your savings, or perhaps edge out the S&P by a percent or two.

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  6. I find the very last sentence of the post to be very true. There are some absolutely insane bargains out there. There is probably more junk to sort through than in more typical markets but the rewards are much more outstanding than in typical markets.

    Growth can definitely provide a margin of safety but one has to be extremely sure of the prospects or else is being given the opportunity at a reasonable price. A stock could potentially be a huge bargain if bought at 25x but it's a lot easier to buy something at 10x or less earnings. There are some excellent companies (QVCA or FTD for example) that are trading at 10x or less (after accounting adjustments).

    Aswath Damordaran says, I think rightly so, that there can be ginormous discrepancies between price and value in developing businesses. But it's not an easy game to play.

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  7. Nice post. I'm partial to investing in "good businesses" myself, but the view of high ROE/ROIC investing that you describe is a pet peeve of mine as well. For me, it's not just a problem of the sustainability of high ROE/ROIC (which is a big problem). It's that even if one believes a stock's returns should ultimately converge to the returns of the underlying business (i.e. stock return is approximately ROE in the long run), it takes a hell of a long time for retained earnings to grow large enough to drive the lions share of the returns.

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  8. My comment was deleted and I'm not going to re-type with as much detail but, on Wells Fargo, the payout ratio is what allows Wells Fargo to grow at the rate of the economy/GDP while returning 15% on equity at a reasonable leverage ratio.

    Also, compounders are nice if the company returns 15% on capital then it only needs to sell at the same price multiple as you purchased to realize 15% returns. However, an average company realizing 5% return on capital needs a 10% compounded return on price multiple expansion to realize 15% returns. Although this can be defended as reversion to the mean or something it is ultimately a bit of speculation.

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