July 31, 2020
Did the internet kill value investing?
This article was originally published on The Herald online.
On the back of an unbridled recovery of global tech stocks, is it time to say the value investing style embraced by the legendary Warren Buffett is dead?
Buffet’s classic strategy is picking companies with cheap fundamentals (such as low price-to-book (P/B) or price-to-earnings (P/E) ratios) and investing when they are at a discount to intrinsic value. Conversely, growth investing focuses on finding companies that have high compound growth potential, typically in sectors like technology.
Classic value investors who have built their strategies looking only at these fundamentals, may look with bewilderment at the P/E and P/B ratios of today’s global giants. After all, just about any of them look terrible on these metrics.
But with declining interest rates, and as we embrace the technology generation, the ‘value’ under-performance has happened for good reason.
Modern growth stocks are typically highly scalable, leverage technology, and invest heavily in customer acquisition, on the basis that revenue should multiply over subsequent years.
Investment in future growth isn’t attractive to the value investor looking for low P/E or P/B ratios and focused on the company’s balance sheet. In addition, value stocks often have large capital-intensive fixed asset bases generating single digit growth.
Valuing the future customer
The best example of the difference in these two models is to look at Software-as-a-Service (SaaS) businesses, with Xero as a case in point.
SaaS companies like Xero are among the best stock market performers, delivering what the Americans call a ‘10-bagger’ (1000%+ return). Yet, all the while Xero looked atrocious on paper to the traditional value investor, unable to justify what appear to be consistently high valuations.
With growth companies, the strategy is investing every dollar into winning new customers. These customers might then go on to return that dollar 5x, 10x, or 20x over, driving further investment in customer acquisition and compounding future growth.
However, value investors don’t examine the future value of the customer.
And that’s a major shortcoming, because the market value of these companies is tied to the future revenue growth of their customer base, rather than physical assets.
As an intangible, future customer value is not recorded on the balance sheet where most of the value investor’s attention is focused. That’s why value investors scratch their heads at the continual rise of growth stocks from already high metrics.
Value stocks and recession
The belief that value stocks perform better during a recession may also not hold true.
Value stocks with high fixed asset bases (airlines and industrials) have low margins. Their profits can quickly turn to losses as demand falls, requiring substantial additional capital investment just to keep up. We’ve seen in with a recent number of capital raises as companies look to beef up balance sheets.
At this time, value metrics may look exceptionally appealing, but these companies could be comparatively poor long-term investments (to be clear, this doesn’t mean investment returns will be negative, simply that they may under-perform compared to growth stock.)
As we have seen during COVID-19, no matter whether GDP is rising or falling, growth stocks, particularly tech ones with high margins, continue growing. That’s not to say these stocks won’t fall with the market, just that a year or two later, the businesses will be much larger and stronger than their value counterparts.
At a fundamental level, value investing makes sense. When companies are below their intrinsic value, you are in essence looking to invest when the company or market is on sale.
In all classic academic theory, investing in a market or company with low P/E or P/B values, should intrinsically outperform investing in companies with high metrics. It’s the subject of countless academic papers and behind the success of a generation of investors, including Buffett.
The technology shift
But as much as technology has changed the world in which we live, it has also resulted in a fundamental shift in how investing should be viewed.
Under-performance of value has been compounded by another market dynamic now exacerbated by COVID-19: declining interest rates.
As interest rates fall, the compound potential higher future earnings from growth stocks become more attractive, justifying higher valuations today. It is, in effect, a market dynamic that penalises value stocks.
And in an environment where growth is outperforming value, there is increased difficulty for active fund managers and stock pickers.
As growth stocks rise in value, and large companies becoming significant weightings in proportion to the entire market, it is tempting for active fund managers and stock pickers to trim their holdings in these companies too early, failing to capture the full long-term economic return of these stocks.
As an investor, short term trading, trying to time the market, and attempting to pick between winners and losers, will always increase your odds of under-performing compared to the market as a whole.
By contrast, long term investors compound their wealth by holding well diversified low-cost investment portfolios that give them their fair share of investment in growth stocks.
Meanwhile, value investors hold on with hope, that like it did during the dotcom bubble, value will have its day again. And while value may return for periods, the rise of growth over value is explicable as a result of a world consumed by the technology revolution.
Founder & Chief Executive