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 \u201chey days\u201d.<\/p>\n\n\n\n
Just look at the biggest and most popular stocks\u2014Facebook, Apple, Netflix, Google\u2026 and don\u2019t 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\u2019t consider them your typical \u201cvalue stock\u201d.<\/p>\n\n\n\n
Before we write its obituary, how should we define value investing?<\/p>\n\n\n\n
At its most base form\u2026<\/p>\n\n\n\n
Split the stock market in two. The 50% that is more \u201cexpensive\u201d makes up the group of growth stocks, while the less expensive 50% make up value.<\/p>\n\n\n\n
But, value can be like beauty, in the eye of the beholder.<\/p>\n\n\n\n
The question and answer behind \u201cis value investing dead\u201d<\/strong> might be more about how you define intrinsic value<\/strong> than anything else.<\/p>\n\n\n\n First let\u2019s talk about the two most popular reasons that people argue that value investing as we\u2019ve always known it will never work again.<\/p>\n\n\n\n Value investing has traditionally relied on low relative valuation metrics, things like P\/E, P\/S, and P\/B.<\/p>\n\n\n\n Buying stocks with low P\/B used to work great because many companies used to need lots of assets<\/strong> 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.<\/p>\n\n\n\n What\u2019s the problem with using P\/B now?<\/p>\n\n\n\n\n\n\n\n Well, if you look at some of the biggest companies today, they don\u2019t need hardly any assets in order to generate growth.<\/p>\n\n\n\n For example, most of the value of Netflix\u2019s, Facebook\u2019s and Google\u2019s 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.<\/p>\n\n\n\n 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\u2019s AWS and Microsoft\u2019s Azure).<\/p>\n\n\n\n If you were to call Facebook\u2019s website its primary asset, which it totally is, then even if we were reflecting that value on the balance sheet it wouldn\u2019t come up as much.<\/p>\n\n\n\n It was not building the website itself which was expensive, and so the \u201caccounting value\u201d is not a high value on paper.<\/p>\n\n\n\n Of course, it wasn\u2019t 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.<\/p>\n\n\n\n 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).<\/p>\n\n\n\n So these real capital investments aren\u2019t reflected making these companies\u2019 Price to Book really high.<\/p>\n\n\n\n That means that even if these technology platforms are minting cash<\/strong> and spurning incredible growth (which they have been), they will never<\/strong> 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<\/strong> in financials.<\/p>\n\n\n\n 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?<\/p>\n\n\n\n Yes and no.<\/p>\n\n\n\n Part of the low capital requirements that technology (particularly software) has enabled in today\u2019s 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.<\/p>\n\n\n\n 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.<\/p>\n\n\n\n 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.<\/p>\n\n\n\n What\u2019s 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.<\/p>\n\n\n\n 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.<\/p>\n\n\n\n When you have ultra-high Gross Margins, you don\u2019t 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.<\/p>\n\n\n\n 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.<\/p>\n\n\n\n And to make matters \u201cworse\u201d, it\u2019s generally easier for a high Gross Margins business to scale (grow rapidly), because of these exact low capital requirements.<\/p>\n\n\n\n The incredibly high Gross and Operating Margins we see today with so many companies just wasn\u2019t possible before the internet\u2026<\/p>\n\n\n\n And so yes, business has changed i<\/strong>n this regard.<\/p>\n\n\n\n If you\u2019re using old value investing metrics like P\/S and P\/B to determine intrinsic value, you\u2019re using an outdated (pre-internet) model.<\/p>\n\n\n\n All of that said, value investing is not<\/strong> dead if you recognize that while the way intrinsic value is generated has changed, the economy<\/strong> as a whole has not<\/strong>.<\/p>\n\n\n\n Meaning, the stock market is still predominately run by fear and greed.<\/p>\n\n\n\n And<\/strong> the basics of economics, supply and demand, still reign supreme.<\/p>\n\n\n\n One of the great thought leaders in finance, Michael Mauboussin, has made that exact point about economics. While we\u2019ve 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<\/strong>.<\/p>\n\n\n\n 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.<\/p>\n\n\n\n One thing that I feel gets missed by a lot of growth investors\u2026<\/p>\n\n\n\n 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.<\/p>\n\n\n\n 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.<\/p>\n\n\n\n If the supply of something is so great that consumers have many options\u2014whether you are talking about everyday commodities like milk or a highly technical Software as a Service\u2014then the switching costs for customers are low, and so keeping them as customers will probably be expensive for the business.<\/p>\n\n\n\n What has made Google so great is not just the fact that their website is not expensive to maintain; it\u2019s also that there has been no serious competitor to the specific service the company provides.<\/p>\n\n\n\n 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.<\/p>\n\n\n\n Even better\u2014since 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.<\/p>\n\n\n\n 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.<\/p>\n\n\n\n That\u2019s the thing about today\u2019s crop of growth stocks.<\/p>\n\n\n\n Part of it has been enabled by technology, sure. Part of that has made obvious the flaws in today\u2019s accounting standards and how it hasn\u2019t kept pace with the new ways that companies generate cash flows.<\/p>\n\n\n\n But so much more<\/strong> 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.<\/p>\n\n\n\n You can see this play out live in the mobile games industry.<\/p>\n\n\n\n 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.<\/p>\n\n\n\n So it\u2019s 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%.<\/p>\n\n\n\nThe Technology Economy<\/h2>\n\n\n\n
The Technology Economy Part 2<\/h2>\n\n\n\n
Where Business Hasn\u2019t Changed (and Probably Never Will)<\/h2>\n\n\n\n