With growth investing absolutely destroying the market lately, people are wondering if value investing is dead. After all, the post-internet economy is much different than the pre-internet, value “hey days”.
Just look at the biggest and most popular stocks—Facebook, Apple, Netflix, Google… and don’t forget Amazon and Microsoft. All of those have several things in common: they are technology companies, they are growing at a blistering pace, and you wouldn’t consider them your typical “value stock”.
Before we write its obituary, how should we define value investing?
At its most base form…
Split the stock market in two. The 50% that is more “expensive” makes up the group of growth stocks, while the less expensive 50% make up value.
But, value can be like beauty, in the eye of the beholder.
The question and answer behind “is value investing dead” might be more about how you define intrinsic value than anything else.
First let’s talk about the two most popular reasons that people argue that value investing as we’ve always known it will never work again.
The Technology Economy
Value investing has traditionally relied on low relative valuation metrics, things like P/E, P/S, and P/B.
Buying stocks with low P/B used to work great because many companies used to need lots of assets in order to generate growth. So, if as a value investor you could buy more assets at a discount (hence low P/B), you could pick up bargains on companies that were temporarily out of favor.
What’s the problem with using P/B now?
Well, if you look at some of the biggest companies today, they don’t need hardly any assets in order to generate growth.
For example, most of the value of Netflix’s, Facebook’s and Google’s business model is not in expensive buildings or tangible assets, but rather their capital light technology platforms and the users which regularly go on their websites/ apps.
A website or app in-and-of itself is not expensive to create. You could probably invest anywhere between $100- $1,000 for one yourself. And even the infrastructure to handle high loads of traffic has gotten incredibly cheap because of the cloud (providers like Amazon’s AWS and Microsoft’s Azure).
If you were to call Facebook’s website its primary asset, which it totally is, then even if we were reflecting that value on the balance sheet it wouldn’t come up as much.
It was not building the website itself which was expensive, and so the “accounting value” is not a high value on paper.
Of course, it wasn’t enough for Facebook to just throw up a website and then have a successful business. They spent many years investing in marketing and R&D in order to build the features and audience which they now have.
Since marketing spend (SG&A) and R&D only is expensed in the Income Statement, it does not make its way to the Balance Sheet (and thus, Assets and Book Value).
So these real capital investments aren’t reflected making these companies’ Price to Book really high.
That means that even if these technology platforms are minting cash and spurning incredible growth (which they have been), they will never show up as cheap in a Price to Book basis no matter how cheap compared to earnings they become, simply because of the reality of how little capital it takes to build technology, and how investments in this technology is accounted for in financials.
The Technology Economy Part 2
Well what about P/S, or Price to Sales? Companies need sales to grow regardless of whether they are a technology company or not, right?
Yes and no.
Part of the low capital requirements that technology (particularly software) has enabled in today’s economy means that not only are the amount of long term investment needed to build and maintain cash flows very minimal today (low capex), but also the Cost of Goods tends to be low.
Cost of Goods represents all of the expenses that go into producing a product or service. Think about a consumer goods manufacturer; they probably need people on the assembly lines to maintain the equipment that produces the product, as well as shipping and logistics costs to move product between distribution facilities.
In the case of capital-light technology platforms like a website or software, the costs to maintain the service that the company provides are so much ridiculously lower than a more traditional, pre-internet business.
What’s great about websites and software is that the extra costs to scale are so minimal; the costs to support 100,000 users can be very similar to the costs to support 1,000.
That makes Cost of Goods (COGs) really low, which makes Gross Profits (Revenues minus COGs) really high, and Gross Margins (Gross Profit per Unit of Revenue) extremely high.
When you have ultra-high Gross Margins, you don’t need as many sales to create great cash flows and growth. So where a traditional company might have needed $1 billion in sales in order to make $100 million in profit, a high Gross Margin tech company could potentially generate $300 million or more from that same $1 billion in sales.
That lower sales requirement means that these technology companies will inherently trade at a higher P/S, because the amount of earnings will be greater than its lower Gross Margin (with the same amount of revenues) peer.
And to make matters “worse”, it’s generally easier for a high Gross Margins business to scale (grow rapidly), because of these exact low capital requirements.
The incredibly high Gross and Operating Margins we see today with so many companies just wasn’t possible before the internet…
And so yes, business has changed in this regard.
If you’re using old value investing metrics like P/S and P/B to determine intrinsic value, you’re using an outdated (pre-internet) model.
Where Business Hasn’t Changed (and Probably Never Will)
All of that said, value investing is not dead if you recognize that while the way intrinsic value is generated has changed, the economy as a whole has not.
Meaning, the stock market is still predominately run by fear and greed.
And the basics of economics, supply and demand, still reign supreme.
One of the great thought leaders in finance, Michael Mauboussin, has made that exact point about economics. While we’ve seen incredible amounts of innovation throughout the economy, and will likely see many more in the future, the ultra-basics of supply and demand HAVE NOT changed.
In other words, competition in a healthy free market still affects supply and demand, which has its impacts on profits, which has its impacts on growth, which has its impact on growth and value stocks.
One thing that I feel gets missed by a lot of growth investors…
Is that if your business has ultra-low capital requirements, then guess what; your competitors will also have ultra-low capital requirements, which can make for intense competition.
When you have intense competition in a marketplace, there will be lots of undercutting of prices, and aggressive expansion which often leads to overinvestment and value destruction.
If the supply of something is so great that consumers have many options—whether you are talking about everyday commodities like milk or a highly technical Software as a Service—then the switching costs for customers are low, and so keeping them as customers will probably be expensive for the business.
What has made Google so great is not just the fact that their website is not expensive to maintain; it’s also that there has been no serious competitor to the specific service the company provides.
People love Google, and Google serves them well, and so they continue to use Google which frees up a lot of capital for Google to invest in their various growth initiatives.
Even better—since Google grows with the economy as it provides a valuable service to businesses (advertising), its main product/service is an ultimate cash cow. They can do the same thing, day-in and day-out, investing little capital for future growth into the cash cow as long as the economy grows and businesses spend more on advertising, and Google can keep users happy.
Facebook operates on a very similar model. And while Netflix has seen a torrential increase in competition in the last few years, their subscriptions have remained pretty sticky, as the user experience that the company has provided has continued to be top-notch and miles ahead of all their competitors.
That’s the thing about today’s crop of growth stocks.
Part of it has been enabled by technology, sure. Part of that has made obvious the flaws in today’s accounting standards and how it hasn’t kept pace with the new ways that companies generate cash flows.
But so much more of the story is about this latest crop of businesses and their moats, which have so cemented a place in the lives of consumers, than it is about the technology that has also made it inexpensive.
You can see this play out live in the mobile games industry.
Almost anyone and their brother can whip together a mobile app, and do so with little capital required. But because almost anyone can, it seems like almost anyone will.
So it’s not the fact that margins of mobile apps are so high that make a business attractive; a business with only $100 in sales is not attractive even if their margins are an obscene 99%.
You need both a huge moat (competitive advantage) as well as huge margins to make investments into high P/S and P/B stocks a reliably profitable investment.
Some stocks, like the FANGs, do have this incredible combination.
But there’s so many other growth stocks out there with zero moat—with flashy new business models, innovations, and technology—that don’t have this competition and will get creamed in the next bear market when their exciting growth fades out.
As long as we have a free market, you can’t get away from the fact that invaders will come and try to steal your profits.
You need a rock solid moat as a company to continue in high growth and margins.
That’s just economics 101.
And just because today’s most popular growth stocks like the FANGs have happened to have moats, doesn’t mean that every single popular growth stock out there today has one too.
As young companies fight to establish a moat in emerging industries, some will fall off while some will prevail.
The ones that fall out will tend to wreak havoc on an investor’s portfolio, especially if purchased at ultra-high valuations. We probably haven’t seen it yet because there hasn’t been a lasting bear market in a while, but like Warren Buffett said,
“Only when the tide goes out do you discover who’s been swimming naked.”
The Interest Rates Impact
Long story short, low interest rates help growth stocks immensely.
This is because the lower that interest rates are, the more valuable future cash flows are. And since growth stocks usually don’t have much cash flow now, they are being bought on the assumption that there will be lots of future free cash flow.
You probably should understand the basics of a DCF valuation model to really understand how interest rates affect valuations, but in a nutshell they impact growth stocks more than value stocks.
This means that you can’t look at value investing’s recent stark underperformance to growth in a vacuum; you have to examine it in the context of the latest interest rate environment and these low, low rates that we haven’t seen in almost a century.
Low interest rates lead to low discount rates, which lead to higher levels of acceptable intrinsic value for a company whose cash flows you are analyzing.
Think of it this way—if interest rates are low, it doesn’t cost you much to invest money into a company. It’s not like you have many other options for your money.
But if interest rates are at 10%, then you better make sure that this company earns at least 10% and ideally a return that’s significantly greater. That’s because parting with money when you could earn 10% interest at a bank is painful, so you demand a better price (higher future returns) for a stock you’d want to buy.
That’s the very basics of how discount rates work in a DCF valuation, and how interest rates help set DCF valuations and influence changes in intrinsic value over time.
Most stocks out there today are based on DCF valuations, and its why some (growth) stocks with little in earnings have commanded such high valuations (leaving value stocks in the dust), because ultra-low discount rates have allowed for high valuations.
The thing about interest rates is…
Guess what… they change!
We could very well see another decade of low interest rates. I wouldn’t see that out of the realm of possibilities especially in the context of history (going back hundreds of years).
But, it’s unlikely that interest rates stay pegged at their exact rate forever. And it’s because of the basics of economics again, this time with interest rates.
We won’t go into a whole macroeconomics debate on interest rates, but I will say that interest rates are not a constant. They always have been fluid, and probably always will be.
Because interest rates are tied to so many parts of the economy; they affect:
- Consumer borrowing
- Business investment and spending
- Stock markets, bond markets, etc
- Government spending
And so much more.
To say that we are in a “new era” of interest rates and economics just because we’ve seen ultra-low rates over the last 10 years or so is naïve and short sighted.
Yes, the Federal Reserve has done some unprecedented things, which have had a huge impact on interest rates.
But the concept of central banks is not new in history; it also goes back hundreds of years.
You CAN’T just say that “things are different this time” with interest rates just because they’ve been in a unique situation over the last 10+ years.
And that means that you can’t confidently proclaim that “value investing is dead” without acknowledging that the situation with interest rates has had a major bearing on that performance gap, and is likely to be fluid rather than constant as time goes by.
At the end of the day, being a good value investor means buying stocks with a margin of safety, emphasis on the safety.
In other words—you have to determine a stock’s intrinsic value and determine to buy that stock when you perceive its price to be trading below (or at) its intrinsic value.
If you look at DCF valuation models and run them with stocks today, you start to understand WHY stocks are trading at the high historical levels that they currently are.
Simply put, interest rates have not been this low in a very long time (if ever), and so it makes sense that valuations have not been this high in a long time too (if ever).
But at the same time, all of these higher valuations have inspired more and more higher valuations throughout the market, causing many mediocre businesses to trade as if they are FANG stocks, when they are so clearly not.
Please, please, please.
Differentiate between “this time is different” and “this time it’s not different”.
In my mind, the basics of economics and markets have NOT changed. The way companies generate cash flows because of technology (and some of the accounting behind it) HAS.
The extent of that difference varies between company to company. It is NOT black-and-white. So don’t invest like it is.