The Values Of Value Investing

by: Vitaliy Katsenelson, CFA

This article has been in the works since last November. It started out as a speech I gave to the Swiss CFA Society. To me it is an important framework for understanding value investing. I think the rise of the consulting industry, armed with cheap computing power and an abundance of stock-specific data, has harmed the industry, because according to them, a "value" investor is one who holds statistically cheap stocks and a "growth" investor is one who holds statistically expensive stocks. The truth is somewhere … well, actually it's a lot more complex, and the consulting industry's crude segmentations don't capture it. - Vitaliy

The Values of Value Investing

The problem is that managers now feel that the composition of their portfolios has to fit in a specific "box." I remember talking to a friend who runs a mutual fund that is considered to be a "growth" fund. We'd been discussing a stock, which was actually his idea, and then he said "I think you'll make a lot of money on it… but we can't buy it; it's a value stock."

I organize a conference every summer called VALUEx Vail. Vail is a quaint, beautiful, ritzy ski resort town tucked away in the gorgeous Rocky Mountains, about 100 miles from Denver.

One day I received an e-mail from a reader asking why I - a value investor - would have a conference in an expensive place like Vail. He suggested that as a true value investor I should hold the conference in a hotel somewhere by the airport where prices are much cheaper. His precise comment was, "I thought value investors were supposed to like cheap stuff."

This e-mail challenged my value-investment-hood. It made me question my value investing "values." Was that reader right? Was I straying from value investor traditions? Maybe I should rename the conference VALUEx Motel 6 and hold it at a $36-a-night, remote airport hotel?

I recognized that the notion was slightly silly, but it started me pondering: What are the values of value investing?

Let's think about the bible of value investing - Ben Graham's 1949 The Intelligent Investor. Graham spent a lot of time talking about cheap stocks. He defined them as the ones that trade at single-digit price-earnings multiples, trade at a discount to book value, or trade below their cash value (net-nets).

Graham placed great emphasis on statistical cheapness - his flavor of value investing is tangible, staring you in the face. It requires very little imagination. You just need to close your eyes, plug your nose, take a deep breath and buy whatever you scrape off the bottom of the stock market abyss - what Warren Buffett calls the cigar-butt approach to investing.

But if the only thing you get out of Graham's teachings is to buy statistically cheap stocks, then you are shortchanging yourself. This analysis is one-dimensional and ignores much that is important.

In one of my articles, I called Charlie Munger "Warren Buffett's sidekick." Jeff Matthews, a friend and the author of Pilgrimage to Warren Buffett's Omaha, sent me an impassioned note saying, "Charlie is not a 'sidekick'! Charlie changed Buffett's investment philosophy. Sidekicks don't do that."

He went on: "At Munger's 90th birthday party, Buffett pulled out an old, yellowed letter that Munger had written back in the day where Munger actually told Buffett explicitly that he had to change - that the cigar-butt stuff wouldn't scale, that it was better to buy good businesses even if the price wasn't dirt cheap."

"I thought that was astonishing, maybe the most insightful thing I'd ever heard about Munger. He didn't just talk about it; he actively pushed Buffett to change. Literally, without Munger there's no Berkshire as we know it."

Munger turned Buffett from being a one-dimensional to a three-dimensional investor. The two dimensions he introduced are quality and growth.

A statistical value investor does not even have to be good at math - the counting skills you acquired in kindergarten are enough. As long as the P/E of the stock you want to buy doesn't exceed the number of digits you have on two hands, you are a Ben Graham value investor.

But as Munger pointed out, this one-dimensional strategy is not scalable. You have only a very few opportunities in your lifetime to assemble a portfolio of (in-your-face) statistically cheap stocks that are decent businesses. All other times, you'll end up owning a lot of melting ice cubes.

The quality and growth dimensions may lack in-your-face tangibility - they are often more difficult to quantify - but are very important sources of value.

Let's look at quality. A high-quality, mature company that is barely growing earnings (think Coca-Cola (NYSE:KO)) is like an inflation-protected bond. This company dominates its industry, and its existing (key word) business generates a high return on capital; but it cannot put this capital to work at these high rates because it already has a large market share in an industry with GDP-like growth.

As an investor you'll collect dividends that will grow with inflation. You'll make or lose money on the stock price depending on the pendulum swing of price to earnings around the fair (par) value (which will also appreciate in line with inflation).

From today's perch, in a world where investors are starved for yield, mature high-quality businesses trade like very, very expensive bond substitutes - their P/E pendulum puts their valuation much above par.

Growth is a tricky dimension. On a stand-alone basis it means very little and can often be dangerous. A company that grew earnings at a fast pace in the past but lacked a sustainable competitive advantage (a bedrock of quality) will invite competition that will destroy current and future profitability.

When you combine growth with quality, however, the mixture is magical and will result in a lot of value (think Apple (NASDAQ:AAPL)). This value lies in future earnings. Another way to say the same thing is: A high-quality company with a high return on capital married to a significant growth runway - the ability to reinvest at a high rate in the future - will create significant value, which will not be observable in last year's or even next year's earning power but years from now.

Think about some of Buffett's best investments: American Express (NYSE:AXP) and Geico. Both had significant competitive advantages. In the case of Geico, it sold directly to consumers and thus was a low-cost producer in a commodity industry. American Express simply had an unassailable brand. Both had a huge growth runway ahead when Buffett purchased them.

If Graham's Intelligent Investor is the bible of value investing, then what should we learn from it?

Don't trade stocks like you would trade sardines; view them as partial ownership of businesses. Mr. Market is there to serve you, not the other way around. And of course there is margin of safety - buying stocks at a discount to what they are worth. But a discount to "worth" doesn't equate to statistically cheap.

A $36-a-night room at Motel 6 by the airport, overrun by cockroaches and bedbugs and with questionable plumbing, may be statistically cheap, but it's not a bargain. If I held my investment conference in a hotel like that, it wouldn't be attended by anyone other than the vermin that are already there.