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Well, welcome to the Investing for Beginners podcast. This is episode 171 tonight. Andrew and I will answer a great listener question because it discusses something we’ve wanted to talk a little bit about. So I’m going to go ahead and read the question, so we have a good morning, Andrew. Thanks for the awesome podcast. I am new to investing and wanted your opinion on the price to book. Many of my peers think of the price to book as a ratio of this should only be used by banks. They think to evaluate companies such as Microsoft using the price to book is not appropriate. Can you explain it? Thanks, John. Andrew, what are your thoughts on this?
New Speaker (01:11):
It’s a great question. And I have a lot of thoughts. So we’re going to spend a lot of time on this today. As Dave said, it is a little technical, and so if you’re an absolute beginner, I would recommend going to episode four, the two, and start on the back to the basic series.
Or you can go back to episode 21, where we talk about the Benjamin Graham formula that mentions the price to book ratio a little bit, or you could read the seven steps ebook and that intros that pretty well too, but price. The book is very controversial, and it’s near and dear to my heart because you know, I’m a value investor at heart. When you hear us say invest with a margin of safety, that’s a concept that goes back to Benjamin Graham, Warren Buffett’s mentor. And he was somebody who invented value investing in a sense. And so being somebody who’s a value investor, I’m constantly trying to reduce risk by buying companies that are trading lower than their intrinsic value, lower than what they’re worth. And so as a value investor, price to book is something that is usually associated with value investing.
And it’s something that as time has gone on, my opinions on the price to book have changed. So, you know, in a nutshell, price to book is talking about the relationship between a company’s book value and the price it is in the market. So, you know, price-earnings is PE price. The book PB and book value is a company’s assets minus its liabilities. Then, the idea of buying companies at a low price the book was popularized. I think it started to get popular when Benjamin Graham wrote the Intelligent Investor. And that was his second book. And so, you know, he, he had a couple of formulas in the book that he shared. One of them was the Benjamin Grant formula. And that involved, I think that one involved price to earnings, right? Yes, yes. And then he also had like, a couple of formulas that he recommended.
And so he recommended a low price to book as part of a defensive portfolio. And so I think a lot of people kind of took the take parts of his ideas and, and preach it as gospel. And so, you know, if we look at the reality of how price the book has done, it’s it the metric has changed, and it’s because the business world has changed. So when Benjamin Graham first started and he wrote security analysis, this was his first book, it’s a huge book, seven, 800 pages. And it’s more like a textbook to looking at stocks and then evaluating them. And if you look in his book, he had two great examples of companies type types of companies. He was evaluating. So he looked at utility companies and railroad companies. So back in his day, those were two of the more popular industries and stocks that a lot of investors looked at.
And so if you contrast that to the type of businesses we have today, you have Facebook, Google, Amazon, Netflix. These are businesses that are a lot more, you know they have a lot more advanced tech technology that will always be the case as time goes on, but their strengths come from something a lot less tangible. So for Netflix, it’s not, it’s not even the servers that contain the content. What makes Netflix valuable is the fact that people will click on their app. And they have that access to those people with Facebook. It’s the fact that everybody has a Facebook account with Google. It’s the fact that people know to go on Google. It’s not the fact that Google has nice office buildings or that they have, you know, factories or anything like that. So if you contrast those businesses today and you, and you look at businesses from Benjamin Graham’s time, you know, to build a railroad and to be successful railroad company, you had to lay down a lot of the track.
That was just, that was the rule of the game. You know, you weren’t going to grow that much unless you had these profitable railroad tracks that went through various cities and similar to utilities. If you wanted to create more profits, you needed to build more electric plants and things of that nature. So you have, you know, you have similarities obviously, but you have vast differences in the value of how value is created. And it’s not just the tech companies we see today. It’s also branding, something like a brand like a Nike is, is so valuable. It’s not the shoes that they make or the manufacturer contracts that they have that makes the Nike business so profitable. It’s the fact that people want to buy Nike’s and that, so that’s something that doesn’t show up in the balance sheet. It doesn’t show up as an asset.
And so it doesn’t show up in book value, so the price to book doesn’t include it. And that’s a big reason why, especially as the economy turns more and more towards intangibles and the way from these big, expensive pieces of equipment and machinery that are needed, when you look, you know, from a broad standpoint, they’re there, you just have two different economies. And so the price to book has become less and less useful. And there are several reasons for that. And I think this is a big one that that needs to be looked at first.
Yeah, I would agree with that. And I think things have changed so much since his seminal books came out and the analysis of companies has changed drastically as the, I guess, the notion of how the businesses function and what’s involved in actually operating the businesses have changed so much. And all the examples that you gave or fantastic examples of how much industry has changed, just the intangible nature of it. And just the function of the assets themselves have morphed so much from the top companies that Ben Graham would have been looking at during his time compared to what we’re looking at. Now, the question that was asked about Microsoft, if you compare Microsoft to standard oil, it’s night and day. Then you wouldn’t use a price to book to compare the success or failure of Microsoft, whereas it would be something that you would use to evaluate the success of a standard oil back in the day.
And I just think that having this discussion now is, is a good discussion because I think it, it goes to how value investors look at value companies and just the different metrics that are involved in trying to assess the strength or weakness of a company because there are so many things that have changed intangible versus intangible is very much a big part of, of a lot of what’s going on right now. And whether you think things are overpriced or not, or are underpriced, it comes down to how you value the company and where you think things will go. And even when you look at a company, folks say, for example, somebody like a Walmart, they have quite a bit of inventory. They have many stores and everything, but even with them, you wouldn’t necessarily use something like a price to book to value the company because there’s a lot more intangible involved in Walmart than there is in a bank now. And I think that probably would be a nice place for us to segue into some of the things you wanted to talk about.
Yeah. And the emphasis on that is, you know, how are you valuing it? And so with Benjamin Graham, I think something that stuck out to me when I saw this, it was just, you know, hidden and implanted in his book, but the way Benjamin Graham originally defined intrinsic value, if you look in security analysis, he mentioned, it’s the value, the way you value a company is based on how you expect their future earnings power. That was it. He didn’t have, you know, I don’t think he mentioned price the book until his second book, the intelligent investor and the intelligent investor. They became, you know, a number one smashing hit and the one that we review regularly. But that, that was his definition. And so how that looked for him back then and how that looks for investors like us today is two different things.
And so I think you, you, you throw another wrench into it, and I hope I won’t go too deep into this, but the other fact of the matter is that I like what you said about how, you know, like assets kind of have different types. Like one asset isn’t the same as another asset, you know, and an asset can be more valuable than another. Going back to the example, let’s say you took a Microsoft versus an oil company. You know, if Microsoft can make, let’s say they can make for the dollars on a hundred dollars of new assets. Still, the oil company can only make $6 on a hundred dollars of new assets. Microsoft’s assets are more valuable than the oil company’s assets because they will have higher future earnings power. And so not only can you say that about different assets, but you can also say it about like cash itself.
So if we think about what’s different, what’s changed to give backstory, we have, you have this, this, this continuous struggle between value investing and growth investing. And so over a very long period, like 80 plus years, you’ve had periods where value stocks have done way better than growth stocks, and growth stocks have done way better than value stocks. And so, you know, believe it or not, value stocks have been underperforming since 2007. So that’s the 13 years that gross stocks have done better than value stocks. You can use that as an argument to say, well, you know, values turn must be around the corner, and you could be right, but you also have to consider what else has happened since then? So if you think about interest rates and consider the fact that since 2007 interest rates have been steadily declining.
And if you think about the implications of what low-interest rates mean, so I’ll give you an example of some things we’ve also seen recently when the fed drop interest rates super-low too, to help against the pandemic companies like Apple and Amazon were able to borrow billions of dollars for 1% interest, 2% interest, ridiculously low-interest rates on their debt. And they have access to this huge amounts of capital. It’s huge; it’s a huge competitive advantage compared to other companies who can’t finance like that. And they have to try to compete against that. So what that tells you, when you can borrow at such cheap rates, cash itself becomes less valuable because it’s so easy to get. It’s so easy to borrow. And so if you remember, cash is an asset and asset goes in the balance sheet, and it’s part of the book value.
So now you have another thing that’s getting thrown into the loop whereas interest rates have gone lower, lower, lower assets, cash has become less valuable. So those assets are not as valuable as maybe previous cash assets have been when price, the book has done better, and low-interest rates can, can stay low for a very long time. You know, I always like to think and try to think of the opposite side. I like to take the contrarian approach. And I like to think, well, if, if, if things are this way, it has to rebound eventually, right? But, but when you look at interest rates, they have historically stayed low for long periods. So the last time we had interest rates really low was during the great depression, and interest rates stay low until the middle of the 1940s and back in Great Britain when they were the dominant superpower. The British pound Sterling was the world reserve currency.
They had a couple of decades of low-interest rates, and they called it great prosperity is something like the great prosperous time of easy money. And it was just a huge boom time for them. And then you had the industrial revolution shortly follow in, in the United States. And so a lot of prosperity can come from lunches rates. And so my point is, is that we have, we’ve had declining interest rates since 2007 value is underperformed. And then now that we have the pandemic, not only have rates dropped to ridiculously low numbers, but the fed has come out and said that they’re not planning on raising them for a couple of years. And then you also need to consider that over history rates can stay long for a very long time; just because they are low now doesn’t mean they need to rise tomorrow or next year.
And so I think as investors, we need to consider that not only is the business world changed in the sense that yeah, tangibles intangibles technology, blah, blah, blah, blah, blah. But you also have a very interesting economic shift. That’s fundamentally different that hasn’t been seen since the great depression, which last I checked was 90 years ago. Many old school ideas that weren’t these old school ideas that weren’t formulated during that period might not be applicable today because we might be seeing such a different environment than what we’ve seen in the past 80 years. Yeah. I agree with that. And I guess, so what are your thoughts on comparing, I guess, different businesses now? I mean, how do you think the price to book has any function at all now
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That’s a good question. I, so I know from a lot of your research, and you’re probably the person we should ask about this first because I think the economics of a financial company is so much different than a lot of other businesses and the way that they have these strict, like, especially with the banks, right? They have these strict roles where they need this amount. They need to follow this formula to grow. So maybe you can touch on that. And why, well, how about you? Like where, where would you see the price of books still being applicable?
Well, I think it’s still applicable to companies that are working in the financial realm. I E banks or insurance companies, any sort of brokerages like a Schwab or somebody of that nature, Goldman Sachs, those kinds of companies because of the nature of how their businesses work. They take in deposits, which is money that they use to generate earnings. It’s considered
A liability, but it’s not. It’s, I guess, the raw material that they use to generate money. And they also have loans that they payout, which are assets for them because it also makes money. So they’re different than Microsoft is. Microsoft is; it’s, it’s a different beast. And you can see that very plainly. And, when you look at a balance sheet of Wells Fargo versus Microsoft, and it’s, it’s certainly not apples to apples. And I think when I am looking at comparing a bank or trying to value a bank like JP Morgan or Wells Fargo Bank of America, whoever you want to name, I am going to look at the book value of the company because that is far more relevant to the performance of the company based on how the business is still operating. And the same thing would apply with an insurance company because the majority of their value-wise in the balance sheet, and it’s going to be kind of a comparison between the assets and the liabilities, where when you’re looking at Microsoft, their value is far more intangible than Wells Fargo’s is.
It’s just, it just is. And I don’t think anybody’s going to disagree with that. And I know that recently, Warren buffet garnered a lot of discussions. Shall we say, in a financial world when he announced in his I don’t know, was it the latest one or the previous one, one of the last two annual letters to the shareholders? He announced that he was no longer going to be using a priced a book as a measure of value for Berkshire Hathaway. And before that, that had been all along, had been one of his acknowledged out there in the world value methods for valuing who his own company. And he, a lot of times, talked about that about buying back shares of his own company, that he would only do it once. He felt like the price to book reached a certain level compared to the share price of the company.
And when he announced that, then suddenly, everybody in the financial world started saying, you know, buffet believes that book value is dead. Book value doesn’t have any more value; it’s; it’s dead. It’s gone because of the tech industry. And what he was saying was that his company has changed in the value of the business and how his business is set up. That’s why he changed what he thinks because now a vast majority of his company is based on things that are not as closely related to book value. I E his investments, those do not book value. And those are more of an intangible value because it’s not real until he sells it. And he doesn’t; he’s not making any money until he sells any of those stocks. And the other part of it too, is the other underlying businesses in his business have moved away from some of the more, I guess, old-fashioned style of businesses.
And he’s moved towards more things like investing in Apple and buying other more capital, light type of businesses, which means that the overall structure of Berkshire has changed. And so that’s why he’s moving away from book value. It’s not that he thinks that book value is dead. And if he’s buying, I guarantee you, if he’s buying a bank of America, like he just did recently, he’s using book value to value the company. I guarantee you that. So that’s, to me, where I think book value has relevance still, but if we’re going to compare book values of Intel to AMD, Nah, that’s, that’s, that’s not a thing. I don’t think that’s; I don’t think that’s a worthwhile endeavor at this point.
That’s interesting. I didn’t know he did that.
He did. Okay.
Okay. That makes a lot of sense. Like you said that the underlying businesses in there and the composition of Berkshire itself had seen a transformation over the years.
The last point on this, I know I especially have to say this because I’ve talked about James O’Shaughnessy’s book, what works on wall street, really, a great book that presented a lot of simple evaluation. He did in the book, if you haven’t read it as he took all these different factors, so he went from price to earnings, price, to sales price, to book. Okay. He looked at technicals like relative strength and, you know, a bunch of other stuff. And he, he would, he would Line up these lists of stocks and then rank them. For example, to take the price to book, He took off This universe of stocks, ranked them and sorted them for, let’s say the top 50 top 100 companies in price to book, put them into a portfolio. And then he would see how that would perform against the S and P 500. And so he showed, you know, it’s a great book. I highly recommend it, I’m reading it, but he showed how each factor performed. And obviously, these days
For factors that would have down years, they would have up years to beat the S and, or they lost to the S and P. Overall, he found that price to the book was a pretty good indicator. If you bought at a low price to book, you did pretty well against the S and P., And if you bought low price to sales, you also did pretty well against the S and P. And then he also found that if you combine low price to book and low price to sales, you did well against the S and P 500. So that was something that I learned very, very early in my investing career. And it was something that I took to heart as I was evaluating. A lot of the companies, something we need to circle back on, understand that’s a type of strategy.
I can work. And it’s, it’s a quantitative strategy, but important detail about why that worked. And at least it made a big contributing factor to it because he took this list of 50 or a hundred. I can’t remember the exact number of these, you know, ranked price, the book stocks. And then he was rebalancing every single year. So whatever that list looked like in one year, the next year is going to be completely different. And then the next year is going to be completely different. And so if you’re going to use a strategy like that, where you’re going to rank and buy all the lowest price to book, or all the lowest price to sales, you could probably do pretty well, but you got to remember to rebalance. And I think probably the best example of that would be this year 2020.
We, we had obviously, the huge crash from coronavirus. You had many businesses like restaurants, airlines, every everybody associated with that who saw their share prices crash. And then they got to ridiculously low price to earnings ratios. And so if you’re able to scoop them up at those low price-earnings ratios, then since then, they’ve, they’ve rebounded a lot more than a lot of the other stocks that didn’t take such a hit. We’ll see what happens if you’re to hold onto a stock like that for two, three, four, or five years. But you know, a lot of the gains made by kind of bottom, bottom fishing, you know, Warren buffet calls it like cigarette, cigarette butt investing, where you, you find these little cigar butts, it’s cigar butts, not cigarette butts. You find these little cigar butts that have like one puff left, and you pick it up off the ground, and you puff that last puff.
And that’s you taking the little value that’s left from a company that might struggle over the longterm. And so what you need to keep in mind is when you buy the most beaten-up stocks, number one, you’re going to have to have huge diversification. And number two, a lot of those price pops will happen in the short term. And then you might see those things start to go down again as the years go on. So you have to look at yourself and think, what kind of an investor do I want to be? Am I trying to be somebody who’s going to buy a stock and hold it for ten years? If I can, you know, and that’s the goal, or am I trying to find the cheapest things I can find? Because once the fear leaves, then the price will pop, but it might put me in the business.
You know, you might have this collection of businesses that are subpar because they’re cheap. And, you know, you bought them simply because they were cheap. So I think like you, as you learn more and you grow as an investor, it’s one of those things you have to reevaluate on because the price to earnings, price, the sales price, the book, these are all fantastic ways to jump into the market to start to make sense of the market. If you look at an annual report, it’s hundreds of pages; you look at the financial statements, it’s like 20, 30 lines. There’s no way a beginner can go in there and start to comprehend any of it. But if you have a price-earnings ratio that tells you, look, we find this one line here. We can make a simple calculation, the same as the price of book. There’s one line in the bouncy to look for same with a price to sales and any of those simple price based metrics, fantastic tools for learning fantastic tool for, for finding cheap bargains. But is it in line with your investment philosophy and how you’re trying to compound your money over the long term? It’s, it’s a question you need to ask, and, and those are the important details to consider when you consider, to what extent am I going to use price to book Talked a lot about our thoughts on the price to book and some of the different aspects and the effects that it’s had On growth versus value and how businesses have evolved a little bit since Ben Graham first kind of introduced the formula.
So I think, Well, you’ve had some thoughts on the price to book And how it’s, how your thoughts have changed on that. So I guess, tell me a little bit about how that’s affected the VTI, and the do updates That you just put out.
New Speaker (29:04):
Yeah. Thanks. Thanks for bringing that up. It’s a perfect time to obviously, and as we’ve, we’ve talked about in the show for the past couple of months, this has been such a transition transitionary period with, with the pandemic and a good opportunity to reevaluate your beliefs and, and locked down, double down on the ones you believe in and evaluate the ones that may have weakened. And so, you know, again, when you see interest rates go so low, you see the fed say that they’re going to keep them low. You start to; you need some sort of adjustment to the fact that we’re in a new reality. And if you don’t believe we’re not in the new reality, just step outside for a second and look at how everything has changed, and everybody’s in the mask.
So as a part of that, and, you know, combined with the fact that you know, I’m constantly doing these updates on the value of the strong indicator. A lot of times, they were minor. But then in the, in this particular case, you know, I’ve been breathing about the price of the book thing for years now, and after a lot of research and a lot of personal experience and a lot more of understanding businesses and understanding accounting and everything that’s involved with that. And then having these tools and competing tools and data sets that are available to me now that I didn’t have available years ago, I was able to take a fresh approach and, and, and take the valued strong indicator with a clean slate and run some tests on it. So basically, what I did is I did my backtests, and I wanted to do it in a way that would be relevant for somebody who is a more long-term investor.
So I talked about how many other backtests mentioned filtering and building a portfolio, or they mentioned, you know, rebalancing every year. And I didn’t care too much about that. What I cared about was maintaining the value trap indicator and also figuring out what makes businesses do poorly. So I ran the value Tarpon Nikita through all these backtests, where I was trying to tweak the price to book ratio. I was trying to tweak a lot of the different price ratios. I was trying to tweak signals for this and signals for that. And I, I wasn’t, I was just kind of spinning my wheels and not getting anywhere. And so it was when I finally went back to the basics and broke it down. And I said, okay, forget about all this price book stuff, which makes my head spin.
Let’s just go back to what the value chap would be best applied for? And it would be to indicate value traps. And so I broke it down and then started to break down. What were the things that may companies do poorly? Not, you know, not just this year, but next year and the year after. And so I ran back to us, I ran more backtests, and I finally found something that works and that filters stocks that are more likely to do poorly. And the next one, two, three, even five years out. And so what I did is I took a universe of 4,000 stocks. These are stocks that trade either on the NYC or the NASDAQ, and I ran the VTI through them. And then I compare, I simply compare them to the universe of stocks.
So I wasn’t trying to build a portfolio. I was just trying to see, you know, what’s the difference in return for these stocks that were the VTI versus every stock. And so I compared the stocks that would trigger value, trap indicator, strong sell with all of the, you know, all the stocks in the university’s 4,000 stocks. And I found that at least for one year, two years, three years and even five year periods, the VTI strong sell socks did worse than the universe of stocks. So bottom line, I updated the formula and made it it’s been the biggest overhaul ever since I had created this thing years ago. And obviously, it’s a; it’s a free update for everybody. Who’s already purchased a spreadsheet. But the biggest difference is that partly because of the price to book thing, partly because of the business world-changing, partly because of the economic change. I don’t feel comfortable suggesting that a formula can tell you whether a stock is a strong buyer or not.
And so I’ve changed it to be simply an indicator only for value traps, either a stock either. I will tell you that you should not buy this stock, or it’s a strong sell, or it’s just not going to tell you anything else about the stock. And so I compare this new it’s version seven. I compare that to version six, which had, you know, the strong buy based on the combination of price to book and price to sales. And the version six did a lot worse than the version seven. And even the Virgin six, a lot of times would pick stocks that did better than all, all of the stocks. So what I mean is it would flag a strong sell for version six and have a lot of stocks that would outperform the rest of the stocks. So, you know, that’s not something that you want to see.
And I think a lot of that has to do with this deterioration, the price, the book I looked at the periods from 2003 to 2018, that was as the extensive data sheet available for me. You know, there is always the chance that you know, the value versus growth stocks thing has, has a lot to do with the results. There’s always; there are a million reasons why this, why this result could have come out. But the bottom line is, is I’ve changed it to be this way. I’m continuing to use it moving forward on stocks I’m looking at. So I intentionally left it open-ended where you can see all of the data that, that I spit out in these tables that come with the update, the updated document. And so you can choose whether how, to, what extent you want to apply it.
You know, are you going to apply it for stocks? And Phil’s a strong sell. You’re not going to buy that stock for one year or two years or three years or five years. However, you want to do it. I’ve left that open on purpose. And, and I’m going to be applying that for myself too, and not trying to use it as, okay, this is, this is this definitive formula. And it’s going to give me a perfect result every time rather, you know, I’m going to take every stock on a case by case basis and, and tried to use the value type indicator as a tool, but not as my decision making. And, you know, we talked, I can’t remember if it was last week or two weeks ago about the Hills we’re willing to die on and the Hill, I’m not willing to die on his price to book, particularly because of all of the evidence I’ve seen leading up to today. And so I think this move to update the VTI is just a natural, that’s a natural component of it, too. Yeah, I like that. And I think it’s a,
I think it’s a natural evolution of all the things that we’ve learned over the years as we’ve been doing this. And as you’ve been learning more and growing and learning more about business and accounting and all of the things that you discussed, and it sounds to me like it more is moving towards a tool that you could use to help you prevent losing money. Because I think that is isn’t that rule number one is don’t lose money rule. Number two is don’t forget rule number one. And that, to me, I think that’s kind of what I felt like the value trap indicator was meant to be, was a way for you to avoid companies that are going to go into bankruptcy. Is that correct?
Yeah. And the updates still maintain that and it’s just, it, you know, it’s just more of a focus on that. And it turns out the bottom line of the formula is it’s just checking to see if a business has deteriorated. And it turns out that when it starts to deteriorate, the price generally doesn’t do as well in the years to follow. And so I, I like, I like the results of this backtest of all the other ones I tried because it’s, it’s a lot simpler. And it’s like you said, it’s, it’s trying to prevent losing money. And it’s not a guarantee, you know, we’re playing probabilities here and all the numbers that go along with that, but it makes sense, and it simplifies it. And I think it takes out the possible hiccups that price to book or price the sales, or even price-earnings can bring. And it’s almost like you’re trying to juggle too many things at a time. You don’t want to add too many spices into the mix. Those should be separate ideas, separate tools, separate discussions,
all right, folks, we’ll that is going to wrap up our discussion for this evening. I hope you enjoyed our conversation on the price to book and Andrew’s thoughts on a price to book, and also his update on the BTI. I wanted to thank John for taking the time to write a step. Great question. And we hope we answered your question to your satisfaction. So without any further ado, I’m going to go ahead and sign this off. You guys go out there and invest with a margin of safety emphasis on the safety. Have a great week, and we’ll talk to you all next week.
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