Why do they call it ‘value’, when they mean ‘intelligent’?
Luis García Álvarez, CFA /Portfolio Manager at MAPFRE AM
The expansion of the multiples of many high growth companies in the last few years has been the origin of a quite significant number of articles that discuss whether ‘value investing’ is actually dead and does not make sense anymore. The main problem with the majority of these texts is that, in the financial markets, many people usually tend to confuse ‘value’ as a statistical and accounting factor with ‘value’ as an investment methodology.
Value as a factor has obviously been suffering in the last decade, as many businesses falling in that category have seen their fundamentals deteriorating, while other companies in the ‘growth’ bucket have led the new digital wave. However, value as a methodology refers to a group of principles and a way of working (and even living, I would say) that hasn´t stopped making sense at any point. This set of principles is not exclusive to the investment world and can be applied to many other areas, are they are based on the ability to stay rational when others do not.
The first thing that we need to clarify is that we wrongly tend to assign the origin of the term ‘value investing’ to Benjamin Graham. However, the fact is that he did not refer to his ideas as ‘value investing’, but as ‘intelligent investing’. By that, Graham was not at all linking the word ‘intelligent’ to having a high IQ, as you probably do not need one in order to succeed in investments. He was actually talking about the investor’s ability to learn, understand and take clever decisions in a moving and challenging environment.
The term ‘value investing’ was originated as a methodology built on the interpretation and evolution of Graham’s investment philosophy. Value investors try to buy assets that trade at a price that is well below their intrinsic value. That is, they look for assets that offer a margin of safety. As an investment strategy, I think there is little that could be said against this simple rule. Value investing, properly done, should work by definition. The reason why not everyone is able to commit to this approach has to do with our human nature. We panic, we get greedy, we herd, and the list goes on.
What is value investing then?
It is therefore important to clarify that value investors do not look for stocks that appear to be cheap from a statistical or accounting point of view. They try to find stocks that are really mispriced by the market relative to their intrinsic value. Beginning by sorting the stocks available in the market by some kind of ratio like price-to-earnings or price-to-book-value can be a first step for some value investors, but it is by no way all that they do. Their process goes beyond “naively” investing in low P/E or low P/B stocks.
This group of investors share another set of principles in their life and their work. In my view, those are valid nowadays, as they have always been (and probably will always be). We have already mentioned the margin of safety as the main idea behind ‘value investing’, but we can name other common principles such as the circle of competence (you should only invest in business that you can really understand), the long-term orientation or their definition of what constitutes the risk of an investment.
Maybe we should spot in the latter for a while. One of the main things that clearly distinguish value investors is the way they define risk. While traditional finances associates risk to statistical volatility, value investing runs away from that idea. If you by a stock and lose two percent every day, you will end up with zero volatility, but very little money in your account. Value investors see a friend in volatility, as it creates situations where the probabilities of finding undervalued stocks increases significantly.
What really worries this group of investors is the possibility of a permanent loss in their capital. Because of that, they stay away from companies that have a lot of debt, as they risk going bankrupt. In the current COVID-19 environment, companies that have the right business model, are well managed and show a strong balance sheet should have little to fear. However, at this moment the market is emotionally broken and fails to make the right match between prices and economic fundamentals. Once again, human nature is playing against us, but this will be a huge opportunity for those that remain patient and committed to their strategy.
What is on the value menu?
Once we have a clearer view on what really constitutes ‘value investing’ as a methodology, let’s try to differentiate between the different styles that fall into this umbrella. We are referring mainly to the so-called ‘deep-value’, ‘quality value investing’ and ‘special situations’. Let’s focus on the first two for simplicity.
Deep-value investors are probably the ones closer to the statistical definition of ‘value investing’. They look for stocks that are trading at low multiples. That is, they look for value as a factor. This strategy has suffered during the last decade, but has worked over many periods of time. If we take a deeper look at the numbers, I think it is wrong to assume that deep-value is not set for a comeback.
Let’s look at a longer series of data to try to get to some interesting conclusions that we can apply to the current situation. We will rely on data from my friend professor George Athanassakos, Ben Graham Chair in Value Investing at the Ivey Business School (Western University), and borrow some ideas from one of his most recent articles . The following chart shows the annualized three-year average monthly ‘value premium’ against a measure of expected inflation. The ‘value premium’ is defined here as the difference between the returns of low price-to-book stocks and those of high P/B stocks.
 “Is this the end of value investing or the beginning of a golden period for value stocks?”, published at The Globe in March 2020.
Annualized 3-Year average monthly U.S. value premium to P/B ratio based value and growth strategies.
Source: Meritocracy Capital Partners of Vancouver.
If we were to expand the graph even more, we would see that the so-called value stocks had a golden era from the early 1930s until late 1960s. However, as we can see, at the end of that decade deep-value investing underperformed relative to stocks trading at higher multiples. As professor Athanassakos points out, by that time, many people started to write the obituary of deep-value investing. Probably those articles were quite similar to some of the ones that we can read today.
But in the 70s the announced dead of value as a factor did not arrive. On the contrary, starting in 1975 low-multiple stocks began a new era of outperformance relative to statistically pricy stocks. That period carried until mid-2012, with very small interruptions. Then, from that moment until today, buying low P/B stocks has not worked that well. But, as professor Athanassakos claims, this strategy “seems to have shone after long periods of underperformance. If this is the case, (…), this may mean we may be at the threshold of a golden period for value investing once more”.
The evolution of ‘value investing’
During all these decades, however, the way some value investors have approached the market has also changed to adapt to new circumstances. Factors like the amount of information available to us and the speed at which we can access to it, or like the main drivers of economic progress, are obviously different now to what they were in 1920. Value investors (in the way we define them in this article) have been adapting to that change.
While “early-Buffett” was closer to the deep-value investing strategy, “late-Buffett” is buying companies that would fit more into the quality ‘value investing’ bucket. As he has mentioned several times, his partner Charlie Munger and the ideas of the legendary investor Philip Fisher have helped him in making that turn. Names like Apple or Amazon, which are now part of Berkshire’s portfolio, rarely trade at low multiples compared to the rest of the market. They are probably not value stocks, by almost any statistical or accounting measure, but they are good value investments, from my (and Buffett’s) point of view.
These investments also remind us about Charlie Munger’s quote that said that “all intelligent investment is value investing”. Intelligent investors do not separate between ‘value investing’ and ‘growth investing’, although they can separate between ‘value’ companies and ‘growth’ companies, according to accounting measures. But, by definition, the growth of a company’s profits is something that should be taken into account when you try to estimate its intrinsic value. Growth can even be part of the margin of safety that value investors need to invest in a company.
In our view, this reinforces the idea that ‘value investing’ can take different forms, but always relies on a series of principles that will never die. Investing with common sense is ironically not so common, as human psychology turns us into our own fiercer enemy when it comes to managing money. But the principles that drive intelligent investing, the way Graham defined it in the late-20s and early-30s, have been the most effective way to beat the market over many decades and continue to sound as the best option for investors, even in this turbulent times.