Last week I wrote a post on Value vs Growth and some of Buffett’s thoughts on the distinction (or lack thereof) between the two…
Just a few more thoughts on the ever-present debate between these two schools of thought within the value investing community…
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The Value vs. Quality Debate
The big debate is always how much to pay for growth and how to value it. Earnings are often linked to “growth” or “quality”, while net tangible assets are usually linked to “value”. Deep value guys will say that growth can’t be predicted and so you have to buy assets cheap (rely on low valuations or low P/B ratios). But relying solely on this method means that these investors are relying on the market to eventually agree with them. Granted, this usually happens, but it still indirectly a “projection” that the market will revalue the assets at a higher multiple.
Side note: I’ve heard some fellow deep value guys scoff at other investors who use earnings multiple expansion as an input in their value calculations. I share this skepticism… but these same skeptical asset investors often assume asset multiple expansion (higher P/B ratios) when buying stocks at .7 times book.
I’m not sure either approach is philosophically much different. I personally love asset backed investments that are cheap. But I tend to prefer to invest in cheap situations where my returns are predicated on the business results more than the revaluation (earnings or asset multiple) that Mr. Market assigns to my holdings. The latter usually works out when you buy something cheap, but when it doesn’t, it’s nice to know that the business you own is more valuable now than it was when you bought it. A business that is growing its intrinsic value provides an added level of safety to the investment.
Cheapness Plus Compounding Intrinsic Value
In the 1950’s, Buffett invested in the stock of a small bank in New Jersey at a large discount to book value, but that wasn’t the only reason he bought the bank. He invested in that stock because of the combination of cheapness (a P/E of 5 and a discount to book value) and quality. Buffett mentioned that the business was compounding intrinsic value over time. He said that he wasn’t sure when or if the market would revalue the assets to a more fairly valued multiple. But he took much solace in the fact that if the stock continued to be priced at the same multiple for the next decade or so, the investment would still be satisfactory as the intrinsic value would likely double in that amount of time.
In other words, he spent around $50 to buy what he roughly estimated to be $125 of intrinsic value (or “Price to Value” ratio of 0.4—a 40 cent dollar). He felt that the market should eventually price the stock much closer to its true value, but if it didn’t, that value would likely compound from $125 to $250 in 10 years or so. He was confident in this estimation because of the predictability and the stability of both the management and the business. It was a small community bank that does the same thing day after day, year after year. So even if the market continued valuing the business at the same multiple, Buffett would not lose money, and in fact would realize moderate returns. Not bad for a downside scenario.
Another Side note: I plan to have a separate summary post to discuss more about this investment, along with a series of posts on some of Buffett’s early investments which are interesting case studies. In fact, I have some interesting case study files from Buffett, Graham, Lynch, Klarman, and others that I’ll get around to posting over time.
So the point I’m trying to make is that while it’s great to find something cheap, if you can a business that is cheap that also has the ability to compound intrinsic value over time, you significantly increase your margin of safety, not to mention the upside possibility of the investment. More simply, you put time on your side.
Growth Predictions Aren’t Necessary, But Patience Is
Keep in mind, success in investing does not require the ability to have an abnormally high ability to predict business developments or future earnings. But it does require one to think differently and maintain a long term view. The biggest edge an investor can bring to the marketplace is his or her ability to be patient and maintain a long term view.
This is a monumental advantage for individual investors—and one that is rarely taken advantage of. Most professionals don’t or can’t think long term. Personally, I’m fortunate to be able to invest with a 5-10 year plus timeframe and I’m lucky that I have a small, core group of clients who allow me to act and think in this manner. I’ve tried hard to educate them on the merits of this type of thinking, as it is imperative to the achievement of long term outperformance. My client base combined with my investment philosophy and discipline gives me my edge… not any superior ability to predict business cycles, economic outcomes, product evolution, etc… My setup allows me to wait and wait and wait and wait for the right investment. And then wait and wait and wait some more. Patience is a virtue in investing and a tailwind to long term results.
To Sum it Up
So I like both asset-based investments as well as great operating businesses with high earnings yields. I think it’s important to remember that asset/earnings revaluation (the buzz phrase used by most analysts is “multiple expansion”) alone only uses one of the three factors that create shareholder returns. Asset revaluation combined with competent cash allocation by management can create a great result—sort of a Davis Double Play for asset investments.
However, “all intelligent investing is value investing” as Munger said. The idea is that we find an investment that will result in either higher earnings over time, higher multiples over time, or higher dividends/reduced share count over time… preferably a combination of two or three of those factors.
It’s always worth repeating this simple quote from Greenblatt: “Value investing is figuring out what something is worth and paying a lot less for it”.
That’s really all we’re trying to do.