So, you’ve heard it a lot lately. “Value Investing” is dead:
Q2 hedge fund letters, conference, scoops etc
Is value investing dead? It might be and here’s what killed it
Value investing: is the age-old strategy dead?
Just google it and you’ll get pages and pages of articles.
You’ll repeatedly hear that “Buffett’s favorite measure of value, book value is increasingly irrelevant”.
Simply, book value is subtracting the company’s liabilities from its assets and dividing by the number of shares…. you then get “Book Value per share”. The theory then goes if the current share price is near or below the book value per share, the company is a “value stock”. The thought is that even in a worst-case scenario, the company has more assets than liabilities so a total loss on the investment is unlikely. People blindly perform stock scans for this and buy these stocks.
This is where the term “buy $1 for $.50” If you could find a stock trading at 50% of BV, you’d assuredly make money on it and your chances for loss were minimal the theory goes.
But a simple book value approach has some dangerous limits. The most obvious is that the value of the asset base can be overstated. When a company begins to fail, the wholesale dumping of those assets will not be done at the value they are held at, there will be a significant discount to them. Look at any retailer that has flirted with disaster. In order to raise cash, they will have sales of their inventory at 50%, 70% or even 90% off. I can promise is was not being accounted for on the balance sheet at those prices. Additionally, the liabilities tend to grow as the enterprise will attempt to also raise cash via the credit markets. A particular problem here is that debt tends to be very expensive and is then secured by many of the assets that show up in a book value screen. A term loan secured by inventory effectively removes that inventory from the “asset base” for shareholders. This will not be reflected anywhere and can be a very painful lesson for shareholders thinking a company’s inventory is a source of security for them.
So, no… a simple book value screen as a reason for investing is not adequate. The problem with this is many mutual funds or “value” index funds use this painfully simplistic screen as a gauge of value in their selection. Bottom line is it doesn’t work. Value investing has more to do with management and growth, not a basic screen. If one reviews any of Warren’s past writings one undeniable conclusion is that Buffett is more concerned with growth that he is “price to book value”
Here is an applicable relationship:
Value without growth is like sex without orgasm
You really do need both to make it enjoyable….
This is where the classic “value trap” comes from. People buy a cheap stock that isn’t growing or doesn’t have any prospects for growth. In this scenario, you may pay $.50 for a $1 but the problem then comes in that in the future, that dollar you just bought declines in value to $.75… then $.50… then $.25. Now you’re in a losing position.
But let’s look deeper, is book value actually Warren’s favorite measure of value?
From the 1996 Berkshire letter:
I dwell on this rise in per-share book value because it roughly indicates our economic progress during the year. But, as Charlie Munger, Berkshire’s Vice Chairman, and I have repeatedly told you, what counts at Berkshire is intrinsic value, not book value.
When Warren talk’s about buying back Berkshire stock today he does not mention book value at all. What does he say?
Buffett had said in his February (2019) annual letter to shareholders that over time Berkshire would likely be a “significant” buyer of its own stock, when it traded below the Omaha, Nebraska-based company’s estimate of its intrinsic value.
“Intrinsic Value”, NOT “book value”. Intrinsic value cannot be screened for. It takes into account future growth, earnings and cash flow. It’s is left to the practitioner to determine. It is the future value of the business, not the current ratio of its assets to liabilities.
In 1992 Buffet said:
“Most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth.’ … We view that as fuzzy thinking … Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. … In addition, we think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation (which is neither illegal, immoral nor, in our view, financially fattening).”
Buffett added that a low ratio of price to book value, a low price- earnings ratio, or a high dividend yield, “even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.”
The problem is when “value” is measured by the media for its effectiveness, it is measured by those very metrics Buffett says are flawed.
Here are Warren’s 1950’s writing about the “The Security I Like The Best”. Read through these articles and you’ll notice something. He does not mention book value. What does he talk about repeatedly? Growth. He talks about the growth prospects of every company in the articles. He sees the “value” of the stocks currently as the discount of the current share price when compared to the growth he expects from them.
Vvv
Let’s take a look at arguably the greatest investment Buffett ever made, GEICO. In the article above he wrote, he noted the attractiveness of GEICO was Buffett said the stock was trading at just eight times forward earnings at the time, based on 1950 earnings, a “miserable year” for the industry. However, that multiple did not reflect the fact that over the previous 14 years, premiums had increased from $103,000 to $8 million, a compound annual growth rate of 36.5%. Again, Buffett was more concerned the price did not reflect the growth in the company. At no time does he talk about “price to book value”.
In 1976 Buffett wrote the following letter to George Young at National Indemnity Insurance regarding GEICO:
July 22nd, 1976
Mr. George D. Young,
National Indemnity Company,
3024 Harney Street,
Omaha, Nebraska. 68131.
Dear George:
Thanks very much for your memo of July 19th regarding GEICO which I believe summarizes well the problems attendant to the specific property treaty we are discussing, as well as the general problems associated with reinsurance of any type at GEICO. I still am willing to explore further the GEICO property treaty—if they subsequently decide that it fits their needs—and today committed to Jack Byrne that we would take a 1% quota share of their entire book. This increase from .8 of 1% was pursuant to his request in order to help him attain the 25% mark by the shareholders meeting tomorrow.
I consider the overall quota share to be an acceptable—but not exciting—piece of business. Under normal conditions we would take nothing like 1%, obviously, since that makes it by far the largest reinsurance treaty on our books, and involves substantial risks along with a limited prospect of profit. I also do not like the feature that provides for a credit to GEICO for interest earnings on funds held by us. In effect, we are making this contract number one in size for the reinsurance department, whereas the contractual terms make it less attractive than most of our other contracts.
However, I have three reasons for taking this unusually large portion of the quota share arrangement, and these same reasons also apply to my interest in the property treaty.
- I hope it is not a governing factor in any way, but I do have some sentimental reasons for wishing GEICO to survive. GEICO has enumerated all of the hard headed reasons, such as the State Financial Guaranty funds, etc. I just have pulled out of the bottom drawer of my desk a statement of my net worth at the end of 1951 when I was 21 years old. I showed net assets of $19,737, of which $13,125 was in GEICO stock. That was the year when I first started selling securities, and I told everyone who would listen to me that they should put every cent they could scrape together into GEICO. A number of friends and relatives did so, and enjoyed a significant change in their financial fortunes because of this. It provided the first big boost to my own small savings, as well as an even more important boost to my reputation in the Omaha investment community.During those early years, when I followed the company, the people involved couldn’t have been nicer. Leo Goodwin was running things then and was helpful. Even moreso was L. A. Davidson. He was personally encouraging and forthcoming with information regarding the business, which enabled me to develop a depth of conviction which I have felt few times since about any security.
- At that time I felt that GEICO possessed an extraordinary business advantage in a very large industry that was going to continue to grow. Since that time they never have lost that advantage—the ability to give the policyholder back in losses a greater percentage of the premium dollar than any other auto insurance company in the country, while still providing a profit to the company. I always have been attracted to the low cost operator in any business and, when you can find a combination of (i) an extremely large business, (ii) a more or less homogenous product, and (iii) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation. That situation prevailed twenty-five years ago when I first became interested in the company, and it still prevails.The company managed to nullify this advantage—and even more than nullify it—by inadequate recognition of loss costs through poor techniques of loss reserving. This led to improper pricing of product with the result that a product which *could* have been sold at a profit *was* sold at a loss.But the important point to note is that the company had not lost its position as a low cost operator; they merely had mismanaged their loss information which caused the product to be priced inadequately. I believe the advantages of a 13% acquisition cost ratio are as important as ever. I also believe that practically no other companies are going to achieve costs near that figure in the future. Therefore, GEICO, properly managed, should prosper if they can pull themselves back from the financial precipice.I like very much what Jack Byrne says about reducing policies in force. It seems to me that such an approach a rather than an obsession with growth is very likely to reconstruct the situation whereby they can give the policyholder an unusually high percentage of the dollar back in losses and still make good profits for themselves.
- The crucial factor, then, becomes whether they can get past their present financial difficulties. Much of the press –witness Time last week—assumes that they can’t. Until recently, I was unclear myself as to their possibilities in this regard. If they had been at all wishy-washy in obtaining rate increases or biting the bullet generally, I don’t think they would have made it. However, the size of the rate increases they have instituted, along with the underwriting results they have published for April and May, have convinced me that their combined ratio will come down to tolerable limits within a fairly short time.Even this would not have been enough if Mr. Wallach were inclined to put them into receivership because of the unwillingness of the industry to accept his 40% plan. When he did not move to do so after the June 23rd deadline, it convinced me that he was not going to act precipitously to terminate a business that fundamental economic logic still dictated had a bright future ahead of it. When he did not bow his back over the non-subscription to his 40% plan, I believe the company’s future became assured. I decided then to buy stock, which is the most tangible evidence I can give you as to my assessment of the Company’s chances for survival.
Therefore, George, I will take the responsibility for making the decision that GEICO survives as a business entity. You should make any underwriting judgments that you wish, with this as the premise—if I am wrong about their survival, it will be my fault and not yours. I do not want to go overboard because of sentiment, but I certainly want us to make every effort to come up with proposals that make business sense to us and are useful to them. I do not want mare of the overall quota share because I consider the terms too disadvantageous to the reinsurer, all things considered. But, if a property treaty can be put together with a prospect of gain that more than balances the risk of loss, let’s proceed.
Sincerely,
Warren E. Buffett
WEB/glk
Again, notice what he talks about regarding the future business prospects of GEICO. Its cost advantage and growth potential.
In 1995 Buffett bought the remaining 49% of GEICO Berkshire did not own:
The Berkshire Hathaway offer of $70 a share was 26 percent higher than Thursday’s closing price for Geico of $55.75. Geico stock closed yesterday at $68.625.
Buffett on GEICO in the 1995 Berkshire letter:
When I was first introduced to GEICO in January 1951, I was blown away by the huge cost advantage the company enjoyed compared to the expenses borne by the giants of the industry. That operational efficiency continues today and is an all-important asset. No one likes to buy auto insurance. But almost everyone likes to drive. The insurance needed is a major expenditure for most families. Savings matter to them – and only a low-cost operation can deliver these.
GEICO’s cost advantage is the factor that has enabled the company to gobble up market share year after year. Its low costs create a moat – an enduring one – that competitors are unable to cross. Meanwhile, our little gecko continues to tell Americans how GEICO can save them important money. With our latest reduction in operating costs, his story has become even more compelling.
In 1995, we purchased the half of GEICO that we didn’t already own, paying $1.4 billion more than the net tangible assets we acquired. That’s “goodwill,” and it will forever remain unchanged on our books. As GEICO’s business grows, however, so does its true economic goodwill. I believe that figure to be approaching $20 billion
Additionally:
The excess over tangible net worth of the implied value – $2.7 billion – was what we estimated GEICO’s “goodwill” to be worth at that time. That goodwill represented the economic value of the policyholders who were then doing business with GEICO. In 1995, those customers had paid the company $2.8 billion in premiums. Consequently, we were valuing GEICO’s customers at about 97% (2.7/2.8) of what they were annually paying the company. By industry standards, that was a very high price. But GEICO was no ordinary insurer: Because of the company’s low costs, its policyholders were consistently profitable and unusually loyal.
Today, premium volume is $14.3 billion and growing. Yet we carry the goodwill of GEICO on our books at only $1.4 billion, an amount that will remain unchanged no matter how much the value of GEICO increases. (Under accounting rules, you write down the carrying value of goodwill if its economic value decreases, but leave it unchanged if economic value increases.) Using the 97%-of-premium-volume yardstick we applied to our 1996 purchase, the real value today of GEICO’s economic goodwill is about $14 billion. And this value is likely to be much higher ten and twenty years from now. GEICO – off to a strong start in 2011 – is the gift that keeps giving.
The bottom line? Buffett essentially paid 2.4X tangible book value for GEICO in 1995. Why? He felt the market was grossly underestimating both its growth prospects and the MOAT the company enjoyed. The moat was its low-cost advantage unmatched both then, and today in the market. Inept management almost destroyed the company and quality management saved it and made it a gold mine for Buffett.
Buffett doesn’t buy “$1 for $.50” based on the company’s current book value. What he does is buy “$1 for $.50” based on what he expects the company’s future growth to produce. If we go back to the GEICO example one could argue based on book value Warren paid “$2.40 for $1” when he completed the acquisition. Why? He realized that the dollar he was perhaps overpaying a bit more for today, based on the company’s growth expectations and its competitive advantage in the insurance business were going to be worth multiples more than the $2.40 he paid that day.
He was spectacularly right.
This is the thesis behind our latest buy, VPG (up 9% since 6/7). We bought a company trading at 2.4X book value and a PE of 15X earnings. By no measure its this a classic “value stock”. However, they are debt free, produce gobs of cash and are growing those earnings ~100% YOY. Best of all it is a $500M company growing like a weed so I will profit from that growth based on the absurd current valuation to that growth and or by a potential buyout as a larger competitor looks to purchase that growth.
Value investing isn’t dead, far from it. We as humans need to classify everything to bring order to our lives. It doesn’t matter if it is sports, politics or investing. The problem is there is no simple screen that actually encapsulates the necessary exercises needed for the value investor so we get these flawed comparisons.
Additionally, I would even go one step further with this. Isn’t everyone who buys a stock a value investor? Don’t you buy a stock today because you think it eventual value is going to be higher? You are saying that you feel the stock is currently undervalued based on what you think it should be priced at. The only real difference is the way that value is determined and the expected time frame of the investment. Isn’t it?
