Authored By Louis Stevens
While I was writing Shifting Narratives, it occurred to me that I should write a Brief that considers the various shades of value investing.
Before I delve into this topic, I'd like to provide a concise encapsulation of all that we will cover today:
- Risk = return, so, if we are to generate elevated returns, then we must assume elevated risk, or perceived elevated risk.
- There are no free lunches: An investment operation does not generate 20-30% CAGR on a consistent basis without either assuming elevated risk via deep value investing, where earnings yields are high, or via growth investing, where earnings growth is high but prone to volatility. Of course, the goal is to assume elevated perceived risk, such that we're compensated well for high risk that simply wasn't that high to begin with.
- This is why the best investors have been either deep value investors, e.g., Mr. Buffett, or a combination of growth and deep value, e.g., Mr. Lynch.
- In the conclusion of this Brief, I offer that the best approach is a balance between the two, and I provide the underlying math for this proposition.
With all of this in mind, let's explore the topic of the shades of value investing together today.
As I've shared in the past, LAS' methodology is one that heavily centers on the act of "value investing." At least a portion of my readers are almost certainly rolling their eyes at this statement, upon witnessing buy ratings for companies like Adyen (growing 23%), Monday.com (growing 31%), or Hims & Hers Health (growing 46%). These are not your traditional "value investments," but please allow me to shed light on my mindset in selecting these businesses via the sections below.
What Does It Mean To Value Invest?
In Mr. Warren Buffett's Georgia Terry School of Business lecture, he described his evolution as an investor, with some omissions. I'll fill in those omissions for you, then we will focus on the topic at hand: value investing.
While Mr. Buffett did not specifically discuss his teenage years, it's worth adding here that he began his investing career at eleven or so years old, and it started with technical analysis. He related that he did not make money for the first ten years, until he was mentored at Columbia University by the late (and great) Ben Graham, who authored the critically acclaimed book, "Security Analysis."
"I'd been taught by Ben Graham to buy things on a quantitative basis." - Warren Buffett, Georgia Terry School of Business
While at Columbia, Mr. Buffett took an investing course taught by Mr. Graham, who conveyed to Mr. Buffett that good investing was investing that centered on understanding businesses quantitatively.
It was about understanding the financial characteristics of a business, upon which an investing decision would be made, such as its earnings yield, balance sheet health, and future growth prospects.
For most of you, this is obvious: You buy a stock based on its earnings and the potential thereof, and the stock appreciates or declines based on the the trajectory of its earnings over time.
But, even for those that already appreciate this, myself included, it's still a profound statement to make:
We buy businesses based on their quantitative characteristics.
This does not suggest that we must buy a low p/e business. It does not mean we must buy a business trading at book value (which itself can be challenging when assets on a balance sheet are often subject to subjective assessments of value). It does not mean buying low growth or high growth or in between.
It very simply means that we buy businesses with a focus on their economic, quantitative characteristics. Such a focus ensures we avoid buying a Snowflake at $235/share or Crowdstrike at $390/share or Chipotle at $70/share, days, weeks, or months before they experience their inevitable crashes due to their valuations colliding with the concrete, fundamental characteristics of their businesses.
This is the essence of value investing.
A Little Deeper
To make value investing possibly a bit more profound, value investing is also an appreciation for the laws of physics. In the same way you or I cannot materialize money out of thin air due principally to the laws of physics, a business cannot be valued at any random price for a sustained period of time due to the same laws.
Money = energy, and it too must respect the laws of physics.
So we know value investing, in its most essential sense, is a matter of understanding businesses quantitatively, but, to be sure, there is a bit more to it.
There are different shades of tangibly practicing value investing. Let's explore two of those shades next.
Deep Value Investing
Recall the set of bullets that I shared in the introduction of this brief: No matter which route we take, deep value or growth, we're fundamentally assuming more risk, or at least perceived risk (I should say hopefully perceived risk).
Risk = return, so, in order to generate elevated returns, there must be an assumption of greater or "perceived" greater risk. Value investors will be quick to note that their assumption of risk is one that is perceived, and I have already noted that for them, but it's nevertheless a matter of assuming elevated risk.
We'd simply not be afforded exceptional returns without the presence of real or perceived exceptional risk, for which we're compensated via higher returns.
Deep value investing is the style of investing practiced by Mr. Buffett and Mr. Graham.
Deep value investing entails buying businesses trading at 2x to 10x free cash flow (or 2x to 10x p/e), with the expectation that the market will realize that such an appraisal of value is too pessimistic, and the stock's valuation, and correspondingly price, will appreciate upon that realization.
Notably, it bears repeating that there is risk in this style of investing, as I just mentioned a moment ago.
Because risk = return, there is simply only one way to generate excess returns: Assume more risk, and we either accomplish this by buying high growth (growth investing), no growth (deep value investing), or beleaguered growth, but we will discuss this last option in the concluding in a moment.
When a stock trades at 2x p/fcf or 5x p/fcf, this implies that it offers a 50% fcf yield or a 20% fcf yield, and because risk = return, this implies we're buying 20% or 50% of risk.
Recall that the yield on a "risk free" U.S. government bond is currently on average about 4%. That's a risk free yield (return), so a 10%, 20%, or 50% yield would communicate that there is elevated risk for which we must be compensated.
Whether that risk is genuine risk or perceived risk is up to the investor to decide, and over time, it will be revealed whether the return offered was commensurate with the risk or whether it was in excess of the risk or whether it was insufficient for the level of risk assumed.
And, of course, the goal is to buy a risk = return scenario where the risk is, indeed, perceived risk and not real risk, such that we're being compensated for elevated risk that never existed to begin with, which was the case for Mr. Buffett's purchase of Apple in 2016-2018 when it traded at about 10x free cash flow, i.e., offered a 10% cash yield, which was far in excess of the risk free rate at the time of about 2.5%.
Growth Investing
Growth investing is, indeed, value investing, even if the growth investors do not refer to themselves as value investors.
At the end of the day, the laws of physics dictate the pricing of an asset because money = energy, and there are energy laws governing our reality.
A business that offers a 1% free cash flow yield while the risk free rate offers a 10% yield is very unlikely to sustain that yield simply because rational humans will not buy the 1% yield, instead choosing to allocate their money (energy) to the 10% yield.
A surface level explanation of human behavior may leave space for questioning where the laws of physics fit, but these laws are indeed, quietly and subtly, governing human behavior as well, driving capital away from the 1% yield and into the 10% yield.
With less demand for the 1% yield, the price, in accordance with the laws of supply and demand, invariably declines as fewer buyers show up to bid on the stock.
All that said, if the business can demonstrate that it has a high likelihood of growing its 1% yield at 30% for the next 10 years consecutively, buyers may continue to show up to bid on that 1% yield because, by year 10, at a growth of 30%, that yield will have become 13.8%, exceeding the aforementioned 10% risk free yield.
(The reality for this scenario is that the 1% yield would likely still be avoided because the 10% risk free yield is so far in excess of the 1% yield for the majority of the 10 years in question.)
But, if the starting yield were 3%, which then grew at 30% per year consecutively for 10 years, then investors would certainly bid on this business, granted growth sustained at 30%, which is a difficult feat to be sure.
By year 10, for investors who bought the 3% yield growing at 30% instead of the 10% risk free yield, they would find themselves holding an asset with a yield of 41%, far, far in excess of what they could get from a risk free bond.
This is the allure of growth investing, however, 30% annualized growth is brutally difficult to sustain and is reserved for only a very, very small number of companies in the global economy, many of whom, I believe, I discuss with you daily!
The Perfect Balance
To conclude, the perfect balance of these two shades of value investing is to buy the fast growers at something closer to deep value prices.
It is to avoid the 1% yield growing at 30%; instead wait to buy it at 3% yield, via which we, over time, capture the above-illustrated 40% yield.
To be sure, this requires disciplined patience in our capital allocation strategies, but that disciplined patience is the essence of investing broadly! So it makes sense that this is what would be asked of us.
Lastly, the perfect balance will likely not come in moments where there's little to no perceived risk.
A business that has the capacity to grow at 20-30% annualized for ten years straight will almost always been seen as expensive, until it experiences a hiccup in execution or some setback, which serves to elevate perceived or actual risk.
At this point, we have the opportunity to purchase a rapidly growing business at a much more attractive value, i.e., at a 3% yield, as was the case for Adyen in late 2023.
Importantly, there's still risk to this process, so it's important to buy a basket of these unique setups, which, to be sure, especially in our current market environment, do not come around so often!
Disclosures:
L.A. Stevens has rated Adyen, Monday.com, and Hims & Hers Health a "buy."
L.A. Stevens has not rated Crowdstrike, Snowflake, and Chipotle.
