value investing, American-style–riskier than it seems

First, my usual caveat when I write on this subject.  I’m a dyed-in-the-wool growth stock investor.  But I my initial training was as a value investor.  And I practiced that craft for my first eight years in the business.  (Then I began to research mid-cap Pacific Basin stocks in earnest.  They had, at the time, a unique combination of extremely low valuations and unusually high growth.  After a couple of years of owning these hybrids I woke up one day and realized I had morphed into a growth stock investor.) Since that time, I’ve worked side by side with value colleagues for most of the rest of my career, though.

Growth investing is all about finding situations where a company is likely to expand its profits much faster than the consensus expects, and/or at an above average rate for much longer than the consensus believes.  It’s about where the company is going, not where it is now.

value investing

Value investing, in contrast, is all about where the company is now.   It’s about finding companies whose equities have been beaten down excessively by overemotional holders who have abandoned ship because of temporary earnings disappointment.  This disappointment can come from any number of causes.  Common ones include:  highly cyclical companies entering the down part of their business cycle, a big misstep by a normally competent management, or flat-out terrible corporate managers.

As an astute former value colleague put it, “There are no bad businesses, only bad managers.”  Put another way, there is enduring worth in a company’s tangible (think:  factories and inventories) and intangible (think: brand names, market positioning) assets that persists despite whatever earnings disappointments the firm may be experiencing at present.

In the first two causes I cite, time will cure the earnings deficiency.  Wayward shareholders will rediscover their zeal for the name and bid the stock price up aggressively.

But what if the management is genuinely awful?  In this case, value investors believe that the incompetents will be shown the door and be replaced by more highly skilled individuals.  The board of directors may do this, because, after all, that’s their job.  Or shareholders may demand a change.  (Fat chance of either of these happening, in my view.)  Or–and this is particularly American–either activist investors or hostile acquirers will swoop in and force a change.

two risks

As far as I can see, this last American idea–that justice will be served and the bad management tossed out–is valid in the US, but almost nowhere else.  Just look at the experience of activist value investors over the past quarter century in Japan or in continental Europe.  Yet, oddly enough, otherwise rational American value investors try the same tactic over and over, each time in the expectation of a different result.

This risk has been around for a long time.  The second hasn’t.

One of the deep underlying assumptions of value investing is that a company’s assets have an enduring economic worth, despite current headwinds.  All we need is some spark, some catalyst that will enable this worth to shine through.  And we can wait, since the value of accumulated assets is unlikely to deteriorate.

This is the sense behind the observation that a stock is trading at a discount to book value–that is, to the total sum of the assets the company owns, after subtracting out anything it owes to the rest of the world.  Calculations of “book” are based on the actual historical cost of acquiring the assets, which very often understates (usually by a lot) what it would cost to replace them.

Two new, still poorly understood, threats to this view:  the internet and Millennials.

Take suburban shopping malls as an example.  Millennials, at least more affluent ones, seem to like to live in cities, not the suburbs.  Internet shopping has reached the point where retailers are openly saying (they’ve probably secretly know this for much longer) that they have too much mall retail space.  Who to sell it to?

In other words, demographic/technological change is accelerating.  This increases the chance that balance sheet assets are writeoffs waiting to happen rather than “straw hats in winter,” needing only a change of season to flower.


2 responses

  1. Very good points regarding the largely false distinction between value and growth investing and the significant impact the Internet is having on a broad range of industries. Thanks for posting this series of comments.

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