Malcolm Schembri: There's value somewhere in value

Much ink has been spilt on the so-called demise of value investing. Despite overwhelming empirical evidence demonstrating otherwise, many minds are set on the misconception that stock markets are now being driven by the Federal reserve.

Market consensus seems to be that fundamentals no longer matter; value investing is dead; and growth investing is the flavour of the month.

What do we think of value investing?

For many investors, value investing means investing in companies which are trading at low multiples. The infamous price to earnings ratio is one such example, others include the price to book ratio and the price to sales ratio. By buying companies which are lowly rated by the market, many self-proclaimed value investors expect to outperform. Yet, by its very nature, value investing is binary. A company might be trading below its intrinsic value either because the market is overly pessimistic about the fundamentals of the business or is correctly pricing in structural challenges or issues about the business (as is usually the case).

Value stocks or value traps?

Historically, many “value investors” have piled into banks, oil companies and automotive firms. By simply focusing on the price to earnings/book ratios, many value investors have simply bought a stack of value traps given that many businesses within these sectors are structurally challenged. Trapped by their myopic views, many keep missing the wood for the trees and expect (by some divine right) value investing to finally regain its crown.

However, many factors conspire to render such a situation unlikely. Spiraling debt levels, aging populations and the technology boom all lead towards a deflationary environment. ESG investing is gaining traction fast whilst the increasing importance of intangible assets is well documented. Furthermore, rather than suffer from mean reversion due to the laws of diminishing returns, many highly profitable firms benefit from increasing returns which have led to an increasingly winner takes most environment. Finally, we are on the cusp of major disruptive change which will lead to seismic shifts within the markets. Some companies will be major beneficiaries, yet again many of the so-called value stocks will be permanently disrupted. All these factors led us to believe that many so-called value stocks are likely to be value traps.

At the same time many growth investors have been equally foolish. Certain businesses which have benefited from the pandemic have been bid up to stratospheric levels. For example, we struggle to understand how Zoom Video Communications could justify its $140billion market cap. Notwithstanding its stellar results, to us, we simply cannot predict with any degree of certainty that the firm will generate sufficient cashflow to justify its lofty valuation with limited barriers to entry. As can be seen by Nikola Corporation, eager not to miss out, investors bid up shares up to shares up to nearly $94 dollars a share yet in less than 2 months, the shares drifted to below $40 dollars a share. Reality can and will hit hard.

Do Value investors understand value investing?

According to Warren Buffett, the world’s most renowned value investor, many simply do not understand what value investing really is. In Berkshire Hathaway 2000 shareholder letter, he stated:

“Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component – usually a plus, sometimes a minus – in the value equation.”

Paraphrasing Buffett again “Games are won by players who focus on the playing field –- not by those whose eyes are glued to the scoreboard.” Investors are best served by refraining to cut corners, stop focusing on PE ratios and start understanding what is actually going on within the companies they are invested in. The need to take a long-term view, understanding the business model, management and structural changes is paramount.

The notion that value investing is no longer relevant or that fundamentals are no longer relevant is ludicrous. Value investing is timeless and will endure the test of time. Value Investing is what ultimately separates investing from mere speculation. Yet ratios are not valuations, the intrinsic value of a firm is the net present value of the future discounted cashflows the firm will generate in perpetuity.

This article originally appeared in Investment Week on 13 October 2020.