As you know if you’ve been reading this blog for a while, I’m a growth investor. But I started out my career as a value investor and spent over half my working years in shops that had either a value orientation or a substantial value presence. For an outsider, then, I think I have a reasonable grasp of what value investors think and do. I’m also laying the groundwork in this post for writing tomorrow about the titans of the personal computer industry, AAPL, INTC and MSFT.
how all value investors operate
Value investors like to invest in companies whose stocks are trading at very low ratios of price to book value (shareholders’ equity), price to cash flow, price to earnings and/or price to assets. Many times such companies have gotten to low valuations because their managements have made strategic missteps. Sometimes, though, the environment in which they work is highly cyclical and the cycle has turned against them. Or it may just be that the industry in which the company operates is boring and seldom catches investors’ eyes.
In their pursuit of very cheap companies, value investors hold to two ground-level beliefs, namely:
–you can’t fall off the floor, and
–everything reverts to the mean, sooner or later (but mostly sooner).
The first dictum suggests that if a company’s stock is already all beaten up, at some point it just won’t go any lower. So if buyers can locate and act at around this level, they have limited downside risk.
The second idea is that the company will eventually overcome the mistakes it has made–either with present management, new leadership, or as a division of a larger company. In any of these events, the stock will go up …or the business cycle will turn in the company’s favor …or investors may just spontaneously wake up one morning and find the company’s industry much more fascinating (maybe as the first market entrant is taken over).
In any of these cases, the severe negative market emotion that has driven the stock to extremely low levels will dissipate and the stock will return to a more normal valuation–that is, one more in line with its past trading and with what companies with similar financial characteristics in other industries sell at.
All value investors believe this.
What sets them apart from one another?
For one thing, different investors may use somewhat different metrics. One may be deeply convinced that he should only pay attention to price/book. Another may be equally committed to price/cash flow. A third may want to have another company in the same industry that’s very well run, whose (higher) margins may give a strong clue as to how good things might one day get.
In the final analysis, however, I don’t think these differences mean all that much. Where I see the big divide for value practitioners is between those who want to see some catalyst that will encourage/force favorable change in the firm being analyzed before they’ll buy it, and those who don’t.
I understand the argument that the “no catalyst needed” camp makes. They say that when things start to go bad for a company, investors can (and usually do) have a violent negative reaction that far exceeds anything that the (deteriorating) fundamentals justify. The stock gets battered in a way it never will again, once the sellers are able regain a bit of their self-control. Therefore, by buying when the blood is flowing the thickest in the streets, you get by far the best prices. You’re more than compensated for the risk early buying entails.
I understand the argument, but temperamentally I could never just look at the price/book (or whatever other metric) screens and jump in. What if the stock turned out to be GM, or Enron, or Global Crossing? As a result, I’ve never tried to investigate whether the approach works. Unfortunately, I have seen it fail, though.
catalyst required, please
The second camp of value investors are those who insist on being able to see some sign, or catalyst, that convinces them that change for the better is under way. It may not have to be much. The retirement of a CEO and the appointment of a more capable successor might be enough …or an activist investor approaching another laggard in the same industry …or indications that the business cycle is changing in the company’s favor. Although I’m not that interested in a regular diet of value names, I’m much more comfortable with this second approach. But that’s just me.
where does GARP stand?
There is a third style that stands on the border between growth and value. It’s called Growth at a Reasonable Price, or GARP. I’ve often had colleagues describe me as a GARP investor, mostly, I think, because I don’t see a compelling reason to live exclusively on the bleeding edge of growth (with emphasis on bleeding). But I’m not a GARP investor in the way value players would understand it.
As growth, GARP means having a forward PE that’s equal to or lower than the forward growth rate. As value, in contrast, being a GARP investor means that you determine a forward PE level, say, 15x, above which you refuse to make a purchase, no matter what you think the forward growth rate will likely be.
For example, I have no problem paying 22x earnings for a company that will grow earnings at a 28% annual rate for at least the next few years. In fact, I’d consider myself lucky to have discovered the stock before the PE rose further. I’d also be happy to pay 40x for a company that could grow at a 50% rate.
A value-oriented GARP investor, in contrast, would have drawn a line in the sign in the sand, probably between 15x-20x–certainly no higher, and would refuse to buy either.
That’s it for today. Tomorrow, let’s apply this to INTC and MSFT.