A short while ago, I got an email from my friend Matt, with general questions about stock market investing. I figured I’d answer him with a series of posts. This is the first.
To be clear at the outset, I’m a growth stock investor. This is one of the two main schools of thought (the other being value) guiding professional investors in the US. The mindset for me is to be more concerned about possible upside, with less worry about downside protection. In contrast, the more important thing for my value counterparts is protecting the downside. So we tend to work in different parts of the market.
I got my first job, a lucky accident, at Value Line in New York in 1978. The essence of the “value line” on the company’s stock charts (which led to the name of the firm) was the thought, back in 1931, that price/cash flow is a better indicator of a stock’s worth than price/earnings. What brought the company real fame wasn’t this, however, but instead the computer ranking system devised by Sam Eisenstadt in the 1960s. His stock picks trounced the market returns year after year for well over a decade, to the chagrin of academics whose (wacky) efficient market theories maintained this was impossible. Sam’s basic idea was GARP–growth at a reasonable price–with “reasonable” being an amalgam of the relative standing of a given stock’s current earnings vs. its history plus a comparison of where this position stands vs. the positioning of the 1500 or so other stocks in the VL universe. The system gradually lost its edge by the 1980s, though, as (among other things) the price of computing power plunged, spawning a host of imitators.
The people who trained me as an analyst were almost all value investors of one type or another. I spent the six years after I left in 1984 working in Pacific Basin markets, where the cheapest stocks were also the fastest growing. By the time I joined a domestic deep value house in 1990 I realized I was no longer a value/GARP investor. I’d become a growth advocate. Still, I worked with, and learned from, value colleagues for the next ten, very interesting, years. I ended my working career with six years in a heavily tech-oriented growth shop.
All this is to say that while I’m not a value investor, I do know something about value techniques, and have been able to watch, and swap ideas with, value managers of various stripes from the inside for 16+ years..
value investing
The essence of growth investing is to locate companies whose future earnings you think will be higher than the market has factored into today’s price. The best case is when the market also mistakenly judges that any period of superior earnings performance will be much shorter than will end up being the case.
Value investing, as I see it, is about finding companies that are rich in potential but poor in current operating performance. They may, say, be in a growing industry, or have lots of cash, or have brand names, or software, or valuable intellectual property, or prime store locations, or maybe the company HQ is on top of a gigantic soon-to-be-developed gold mine …but are not making anywhere close to the money they should be.
Benjamin Graham, the father of securities analysis as well as of modern value investing, began teaching and writing during the Great Depression of the 1930s. One of his early formulations was to look for firms where, if they were to turn all their working capital into cash and repay all long-term debt, the money that would be left over would be greater than the total market value of the company’s stock. If so, you essentially get the longer-term company operations for free. Maybe business will get better all by itself, but even in the worst situation–where someone new gains control in order to shut down operations and liquidate–anyone who buys stock now should turn a profit. It’s hard to see the stock going down. In addition, the worst may not happen. The business might revive, with or without the help of newcomers, creating a bonanza for current shareholders.
There were a lot of these back then, while the world economy was flat on its back, so there was no reason to take the risk of doing anything else.
Since then, other than for a short time in 1974, or maybe in 2008 (?), you’d be hard-pressed to find anything to buy if you followed this ultra-stringent rule. But if nothing else investors are pragmatists. So that early Graham rule is long since out the window.
Today’s value investors retain the general cheaper-than-dirt Graham attitude of buying assets they perceive as deeply cheap, though, and they tend to fall into two camps:
–investors who won’t buy until they see a catalyst for change in an underperforming company and
–“deep” value investors who are willing to commit before there’s any evidence of change to come.
In the latter case, the value buyer argues that sooner or later change must come to an underperforming firm, so long as it has revenues. Either the board of directors will throw out the old, bungling, management or a third party will launch a hostile takeover and do the work the board should have been doing, heaving them out along with the CEO. This gets you in at an ultra-low price.
Two worries with the before approach: unless your clients understand what you’re doing and have deep faith, you risk being fired yourself before your stocks begin to pay off; and the technique may not travel well outside the US. Two decades+ of heartbreak by foreigners dabbling in Japan is probably the prime instance of this.
example
Singer, the sewing machine people, was one of the first companies I was assigned to cover at Value Line. It was a train wreck. Demand for home sewing machines in the US peaked shortly after Benjamin Graham got out of college and had been in secular decline since. There was reasonable demand in emerging markets, but even there Singer was bleeding market share to more advanced, reliable and less expensive machines made in Asia. The stock price at the time was $7.
Overall, the company was cash flow positive but unprofitable. In the plus side, it had accumulated tax losses worth about $25 a share if they could be used all at once (which they couldn’t). Singer was also the world’s chief maker of aircraft pilot training machines (also used in horrible virtual rollercoaster rides in amusement parks). It made power tools and had an assortment of other manufacturing subs. It owned a lot of real estate, as well. And it had just replaced its CEO.
I was too dumb at the time to realize what was about to happen. But the new CEO began to reorganize, to cut costs–like closing the sewing machine plant in New Jersey and relocating to Southeast Asia–and to sell off businesses that couldn’t scale. Within two years or so the stock was around $50.
If you want a counterexample to the turnaround idea, look at GM. It had something like half the US auto market a generation ago but ended up in bankruptcy in 2008 despite continuous government protection against foreign competition. It trades at about 5x earnings.