Yesterday I wrote about the Indexology observation that value investing hasn’t worked well over the past decade. That’s a long time. Here’s what I think is happening:
Every professional investor, no matter how he describes what he does, looks to buy undervalued securities. That’s not unique to value investors, no matter how academics may insist otherwise. Growth stock investors seek this undervaluation in the market’s underestimation of a company’s future prospects, as measured by how fast earnings are growing, how the trajectory is accelerating and how long super-normal growth may continue. Value investors look for undervaluation in underestimation of the worth of companies’ here-and-now, based on metrics like price to book, price to cash flow and price to earnings.
Most often, value investors are attracted to companies that:
–are suffering from temporary misfortune–the wrong part of the business cycle or a management miscue–that the market mistakenly thinks is a permanent defect, or
–are badly run, but the market doesn’t realize that change is possible, either by action by the board of directors or by third parties forcing change of control.
In either case, the presumption is that cumulative spending on property, physical plant and equipment or on intangibles like brand names, patents, distribution networks or building brand names through advertising and marketing all have an enduring value that will most likely grow with time. In the worst case, the worth of these assets will erode only very slowly.
This assumption is value investing’s chief problem, I think.
–through e-commerce and social media, the internet continues to erode the value of traditional distribution networks and the power of the decades of advertising and marketing spending that have established and (until a decade or so ago) protected them
—generational change. The gradual but steady replacement of the Baby Boom by younger generations who want to distinguish themselves from their parents means not only a change in what categories consumers spend on but a change in tastes, implying traditional firms may not benefit
—the Great Recession. In my experience, big economic downturns most often trigger changes in behavior. They’re the reason for reassessing and changing spending habits. They are also, if nothing else, the excuse for severing traditional relationships. Some of this is economic necessity, some not. Gen-Xers, for example, congregate in cities instead of the suburbs where their parents live. They can’t afford to get sick and miss work, and they can’t afford restaurant meals, so they avoid fast food and make healthy meals at home. They use mass transportation rather than owning a car. Macys and McDonalds are the last places you’ll find them.
These three developments all attack the traditional order, and thereby undermine the assumption of the relative permanence of asset value for many firms. This phenomenon is greatest in consumer-facing enterprises, less so in industrial.
The result is, I think, that value investors have to become more like their growth colleagues in investigating in great depth a firm’s ability to withstand the disruptive forces I’ve just listed. Buying and selling based on screens of low price to book, low price to cash flow and low price to earnings is no longer enough