Value investing is a broad church – so broad, in fact, it now embraces at either end of its spectrum of doctrines two clearly identifiable extremes. The first of these could, for the sake of brevity, be pigeonholed as ‘deep value’ – the classic screen-based approach where investors identify cheap companies and then try to work out where the reasons for this cheapness may be transient.
Then, over on the other side of the congregation, stands what we might call ‘quality value’, where investors seek to identify sustainably high-returning businesses and then buy into them when they are trading at lower valuations. This approach is perhaps best embodied by Warren Buffett while the patron saint of ‘deep value’ is of course Benjamin Graham.
Like all the great religious differences of opinion, these value extremes are characterised as much by what they have in common as by what they do not. Most obviously, both emphasise the importance of company analysis – of working out how good or bad a business is and then trying to understand if this is or is not sustainable.
Here on The Value Perspective, however, we would argue that ‘quality value’ has two important drawbacks from an investment point of view, the first of which is that economic mean reversion will not be working in its favour. Very few businesses enjoy the luxury of a permanent advantage because the attractive nature of superior returns will inevitably promote competition.
So-called ‘barriers to entry’ such as brand, scale and intellectual property may all help incumbent businesses but none is insurmountable. For every Coca Cola, there are many Kodaks and for every Next there are plenty of Blacks. When companies are doing well, a powerful combination of competition, innovation and human nature works to pull down their above-average returns.
As a result, ‘quality value’ investors face enormous pressure to identify businesses that can boast sustainable competitive advantages. Clearly this is not impossible but, given the forces highlighted above – not to mention the extraordinary uncertainty of the future – doing so with any sustainability in their own right is extraordinarily difficult.
The second drawback ‘quality value’ faces is that, irrespective of the quality of a business or how much it returns, the stockmarket’s perception of what it is worth is itself a cyclical and mean-reverting factor. We have touched on this many times on The Value Perspective – tobacco companies were hated then feted; pharmaceuticals were zeroes then heroes; banks were a hit and then … well, you get the idea.
The point is, if you buy a business that the wider market already acknowledges to be quality, then the chances are you will be on the wrong side of this mean-reverting valuation. We are not saying that you will definitely be wrong – only that history definitely suggests you will be putting yourself on the wrong side of the averages.
This is important because some of the most expensive stocks on the market today are what are seen as quality, ‘sleep-easy’ businesses – for example, as we observed in Oh-oh seven, members of the food & drink, tobacco and utilities sectors. According to some prominent investors – including, in the wake of Heinz’s proposed acquisition of Kraft, Warren Buffett himself – they are also value investments.
Now, value may be a broad church but is it really broad enough to embrace stocks that trade on some of the highest valuation to be found in global markets? For those investors who are now arguing it is, the thinking goes that, if you have identified a good business that generates sustainable high returns, then there will be better and worse prices to pay for it but, ultimately, you will prevail.
That is a bit like acknowledging there were better times to buy Amazon than the top of the technology boom in 2000 before going on to argue that, in the end, you would have made money as the business grew into its valuation. Well, perhaps. But we would counter that we are not suggesting that seemingly expensive businesses cannot give great shareholder returns – only that, on average, they do not.
That holds true even in that tech boom example because, for every Amazon that went on to succeed fantastically, there were half a dozen Boo.coms that failed utterly. What did investors need in 2000 in order to correctly identify which companies would go on to be winners? Supreme skill or massive luck? More likely, they would have required a significant amount of both.
Today the world is an uncertain place and, when uncertainty is everywhere, certainty – or, more accurately, the perception of certainty – becomes expensive. This is not just true of the stockmarket but can be seen everywhere – not least among the negative real yields of the fixed income world, at which we marvelled in Bonderland.
This is the nature of markets but the point investors must not lose sight of is that history suggests, as assets grow more expensive, future returns grow worse. Some value investors may try to convince themselves the quality of the businesses they own offsets the increasing valuations. “I am a buy-and-hold investor,” they will assert but, while this may sound laudable, it is also nonsensical.
The only way to avoid falling foul of those averages that say you will lose money buying highly-valued stocks is to correctly identify businesses that can definitely beat the mean-reverting pull of economics and outgrow their valuations over time. The overconfidence necessary to believe this is possible is frightening and, anyway, what could such an approach possibly have to do with value investing?
When all is said and done, it is very hard to convince people that their investment philosophy is not something they think it is. As we say, value investing is a broad church and it is probably to its credit it is able to accommodate so many different interpretations. However, here on The Value Perspective, when it comes to the doctrine of ‘quality value’, the same nagging doubt will not go away.
The essence of a value investment approach is contrarianism. It involves moving away from the crowd – from the comfort blanket of cheery consensus and the reassuring warmth of conventional wisdom – and heading for a colder, bleaker and more lonely world of doing what feels counter-intuitive and just plain difficult.
That being the case, is it really possible such an investment style would truly point its followers towards some of the most consensual, sleep-easy and downright expensive stocks in global markets? If that were so, then The Value Perspective would risk being guilty of heresy – but of course we do not believe it for a second. Here endeth the lesson.