“The death of value investing”

There was a quite provocative article with the same headline “The death of value investing” on Business Insider a few days ago.

Why should one take such a Business Insider article serious at all ?

Well, at first, this was not written by some lowly paid BI staff but from Marc Andreesen and Ben Horowitz, two venture capital legends with currently 3 bn under management. Andreesen by the way was one of the creators of MOsaic, the first web browser and founded Netscape.

Let’s look at their article:

Most of the best investors in the world are considered value investors. Well, times are changing — the destructive power of technology is starting to break down companies faster than ever.
Value investing is an investment philosophy that evolved based on the ideas that Ben Graham and David Dodd started teaching at Columbia Business School in 1928. Since I started my career as an investor, value investing was the holy grail of investing.

Hmm, I am not sure about that one. I always thought that value investing is rather a minority strategy…but ok.

There are many interpretations of what value investing is, but the basic concept is as follows: essentially you want to buy stocks at a discount to their intrinsic value. Intrinsic value is calculated by taking a discount to future cash flows. If the stock price of a company is lower than the intrinsic value by a “margin of safety” (normally ~30% of intrinsic value), then the company is undervalued and worth investing in.

That part is OK although I am not sure where have the 30% “margin of safety”. But then it gets interesting:

Generally, value stocks are companies that are in decline but the market has overreacted to their situation and the stock is trading lower than their intrinsic value.

Hmm, that is in my opinion only true for the original Graham “Cigar Butts”, but lets move on:

The classic case is Research in Motion (RIM). In January 2007, RIM was trading at a high 55x PE multiple. Over in Cupertino, a computer company called Apple had reinvented itself as an MP3 player company and was now unveiling a new phone set to launch in the summer. By the end of December 2009, market share for Apple’s iPhone iOS as a percentage of US smartphone OS was 25% while RIM had increased from 28% to 41% in that same period. Though RIM had grown market share, fears of iOS growth had toppled the PE multiple to ~17x.

Many traditional, value investors sat back and thought, “Well, RIM is holding up pretty well compared to the iPhone, yet their PE multiple is getting destroyed.” It’s trading at near the historical average S&P 500 PE multiple of 15x. Apple hasn’t historically been strong in the enterprise, so maybe iPhone will just be a consumer phenomenon that doesn’t break through to business users. Android is irrelevant with 5% market share. The smartphone market is growing rapidly and RIM is the clear leader. RIM is still growing north of 35% and generating nearly $2.5B in net income. I think RIM looks cheap!
Two years later, RIM was trading at a 3.5x PE multiple and topline growth had screeched to a halt. Market share for RIM had contracted to 16% while iOS and Android combined for 77% market share. In fact, in 2012, RIM posted a net income loss of $847mm. Investors lost a ton of cash and were left scratching their heads.
How did this happen so quickly? Why did net income fall off a cliff? Why now?

They then go on to explain that technology changes faster and faster, mostly because of

1. Technology adoption accelerating
2. Internet way of life
and what they call: 3. Software Eating the World

Their final verdict is clear:

With technology upending markets, remaining a value investor is a death sentence. In the case of RIM, the company thought that their scale was defensible and stopped innovating on the operating system, favoring battery life instead. Apple’s iPhone operating system and associated software was an order of magnitude better than RIM and attracted consumers. Interestingly enough, Apple is dangerously close to losing their own software battle to Google with mobile versions of Google Maps, Gmail and Google voice being far better than their iOS counterparts.

While there may still be opportunities for value investing, you need to be cautious of businesses that appear to be on a slow decline. With the rate of technology adoption accelerating, Internet being a way of life and software consuming the world, businesses who refuse to embrace or adapt don’t just slowly decline; they fall off a cliff and take their cash flows with them.

The final statement in my opinion is both, partly wrong and partly very important for value investors.

What A&H describe is what is known to value investors as a Value Trap. A superficially cheap stock, which however for different reasons is in terminal decline. This is clearly not restricted to technology stocks, although there it is quite obvious.

Even the most famous value investors are not immune against this, as Seth Klarmann’s unsuccessful investment in Hewlett Packard showed.

Interestingly, short seller Jim Chanos (who I consider to be one of the best value investors ever) basically says the same thing:

You have to be very careful, because we looked at our returns over the past 10 years, and, particularly since the advent of the digital age, some of our very best shorts have been so-called value stocks. One of the differences in the value game now versus, say, 15 or 20 years ago, is that declining businesses, while they often throw off cash early in their decline, find that cash flow actually reaches a tipping point and goes negative much faster than it used to.

I think this is a very important point here: Low valuation (low P/E, low P/B) and/or high FCF yields based on past data are by no means a guarantee for superior investment returns. He directly confirms A&H in this paragraph:

The advent of digitization in lots of businesses also means that the timing gets compressed, meaning that you need to move quickly or you are roadkill on the digital highway. That’s true whether you look at companies like Eastman Kodak, or Blockbuster, or the newspapers. Value investors have been drawn to these companies like moths to the flame, only to find out that the business has declined a lot faster than they thought and that the valuation cushion proved to be anything but.

I think this is also one of the reasons, why many of the older “Quantitative Value strategies”, such as Dreman’s or O’Shaugnessey don’t work so well any more.

To summarize it bluntly up to this point: If you think value investing is only about buying low P/E and/or low P/B or low P/FCF stocks, then you will most likely be in for a quite nasty surprise, especially if you invest in anything that is subject to the technological changes as described above. Many of thse companies will drop off much more quickly than in the past and reversion to the mean will not happen.

On the other hand, I don’t think that value investing is dead, but it has rather evolved. If you look at Warren Bufft (and Todd Combs and Ted Weschler of course), Buffet style value investing looks of course very different. He invests at much higher P/Es and P/B, however still with a lot of margin of safety as he is able to factor in the value of potential “moats”.

Other value investors like Seth Klarmann for instance go into other asset classes or “special situation” investing where “margins of safety” are created via forced selling of market participants.

Funnily enough, when I was googling “The death of value investing”, an article with exactly the same title popped up from 2008, written by the quite famous author Edward Chancelor.

He refers to mistakes made by some “value investors” at that time:

The housing bubble, however, changed many facts. But some of the world’s leading investors appeared not to have noticed. First, several prominent names piled into housing stocks when they were selling at around book value. This proved a disastrous move as falling land prices and slowing sales generated massive losses for homebuilders. Then, some of the same investors charged into banks, figuring they were cheap. That also turned out to be a poor idea.

As we know now, Value investing made it at least another 5 years and 2008 and 2009 provided the best opportunities for open minded value investors in a generation.

Summary:

Clearly, Value Investing is not dead. It was not dead in 2008 and it is not dead now. But as the A&H well describe, “simple value” investing, i.e. just buying low P/E and P/B stocks is much more dangerous now that it was in the past.

For the “Normal” value investor, this means to put more effort in to identifying potential value traps. There is strong support to the thesis that declining companies, especially those subject to technological change, will “drop over the cliff” much faster than ever. So buying HP/Apple/ Micrososft/Intel/Solar/Media because it is so cheap at single digit trailing P/E minus cash should not considered to be a value investment unless you are really sure that sales and profits will not drop off similar to Nokia and RIM.

Value investing willneed to further evolve, but buying investments at a discount to a (carefully) determined intrinsic value will always be a good investment startegy.

7 comments

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  • As long as accounting standards don’t reflect the true economic realities, which they never will and can, we value investors will have an edge. Computers can’t read annnual reports yet and the naked numbers are missleading.

    I don’t think technological change has fastened. We have incremental updates more often nowadays and humans underestimate slow and constant change. But real paradigm shifts and transforming innovations are scarce. E.g. inventing new antibiotics ist just a small step compared to discovering the first antibiotic. Electronics companies are focused on downsizing and integrating but no real innovations.

    • “I don’t think technological change has fastened. We have incremental updates more often nowadays and humans underestimate slow and constant change.”

      Important point. Our current technological change is slow in comparison to the real game changers, like electricity or the automobile.

  • Value lies in the eyes of those who watch… if the number of watchers increases, value will manifest in rising prices if a decent return is expected. Sometimes value investors seem to forget about it and think just because their own analysis gives a result, everyone else should share it or is doing the same kind of detailed analysis.

    This is also true regardless if the stock sells with a discount or not – currently or in the future. Especially technology stocks often claim to have “value” or a “story”, which vaporates faster than water (see Blackberry / RIM with their large business consumer base) and I would add, that a lot of mining stocks, which are loved by many value investors have the same problem, because the prices for gold, copper etc. are influenced much stronger by speculation than by any economic background and so margins evaporate here as fast as in technology.

    So I try to stay away from those industries and think the “moat” idea from Buffet is one of the key concepts of value investing – and staying in a small circle of knowledge, which probably are small, classical industrial enterprises.

  • if it has the same impact of the (in)famous article “The death of equities”, let’s hope to see more discussions on the end of value investing…

  • Ich denke “value investing” wie bisher bekannt, ist in der Tat nicht mehr in dem großen Umfang möglich. Man sollte folgendes berücksichtigen:
    – der Zugang zu allen Informationen ist für mehr Menschen zugänglich, wie damals
    – die Bildungsrate ist wesentlich höher als früher
    – zu viele Teilnehmer, die um wenige Schnäppchen streiten
    – das Denken der Teilnehmer, als einziger “contrarian oder Value” Anleger zu agieren

    Vor allem sollte man auch genau definieren od sich selbst eingestehen, was value Investing bedeutet.
    In sehe mich nicht in der Lage, analytische Zahlen derart zu analysieren, dass ich mich als Value Investor bezeichnen würde. Vielmehr sehe ich mich als Value-Spekulant, der einen entscheidenden Vorteil gegenüber anderen großen Teilnehmern hat: ich bin Privatanleger und bewege somit eines sehr kleineres Portfolio ! Ich denke, es gab keine bessere Zeit, als Kleinanleger von diesem Chaos derart zu profitieren, dass man sich finanziell in obere Regionen bewegen kann. Denn die Informationen den der Markt liefert, muss ein Teilnehmer in einem längeren Zeitabschnitt verarbeiten, als ein Kleinanleger. Wenn ein Kleinanleger die Situation einigermaßen richtig einschätzen kann, kann er sich schneller zu Objekt bewegen. Bis der Großanleger die Information komplett abgearbeitet hat, sorgt er durch seine Aktivitäten für steigen Kurse. (Siehe Davita – Berkshire) man könnte sich sozusagen als Kleinanleger ein wenig an Dhando (Pabrai) orientieren.
    Wie gesagt, der erste Schritt überhaupt als Teilnehmer einigermaßen ein bisschen Gewinn zu erzielen, ist es sich einzugestehen, als was man an diesem “Spiel” aktuell teilnimmt und dementsprechende Erwartungshaltung einnimmt.
    Sonst kann es wie bei manchen Singles werden, die sich absolut toll finden und immernoch Single rumlaufen und sich nicht erklären können warum.

  • I totally agree with your reasoning. As long as humans trade prices will be exagerated sooner or later and Value investors can use that. That doesn’t mean that value investing is easy or does not require lots of work and knowledge.

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