The 4 Dimensions Of Value Investing
Summary Value investing can be much more than just calculating the intrinsic value of a business. The more traditional value investing tends to focus only on quantitative metrics, such as P/E, P/B, EV/EBIT or EV to maintenance cash flow. Buffett and his followers introduced a new value investing approach which is more scalable and in longer term, which I call “quality-value investing”. Besides quantitative metrics and qualitative factors, there is the 3rd dimension: the certainty or the information edge. Finally, the 4th dimension is not about monetary gains, but about the emotional gains in the investment process, as well as an investment in the investor himself/herself. The Two Camps in Value Investing When Benjamin Graham wrote his famous book “The Security Analysis” 82 years ago, he built the foundation of value investing approach. This book became a timeless piece, and is still being followed everyday by many famous value investors. Interestingly, although all the value investors seem to be under the same title of “value investment”, their approaches could be dramatically different. One major and obvious difference is the focus on quality. Graham had his deep belief that any forecast is unreliable, and therefore we should always fallback to the “facts”, which are the numbers we have seen in the past. Apparently, this is a pure quantitative approach. On the other hand, Buffett and his followers started to deviate from Graham’s traditional approach, and started to focus on the quality side of the business. As Buffett said, he would rather invest in a great business at a fair price, than invest in a fair business at a great price. In reality, deep value investors (Graham’s followers) would not only invest in a fair business, but also often invest in a poor business with a poor management. Another difference is on the time horizon. While value investors are usually the long term investors, and have much longer time horizon than the other market participants, Buffett usually has even longer time horizon than the deep value investors. As he said, his favorite holding period is “forever”. However, many famous deep value investors clearly said they would sell when the stock price reaches its intrinsic value. Some of these deep value investors even criticized Buffett’s saying, or at least didn’t really understand the logic behind it. In my understanding, this difference comes from the roots of different focus. Deep value focus on pure quantitative metrics, such as P/B, P/E, EV/FCF, EV to maintenance cash flow, current ratio, debt ratio, growth rates, and dividend yield. There are two benefits of this kind of pure quantitative approaches: 1. It is objective. In investing, one of the biggest enemies of investors is their emotion, or their behavioral bias. Not only we are emotionally influenced by the price actions, the changes of fundamentals and recent events can also have a great influence on the perception of investors. Because of this influence, investors tend to focus more on the recent events, or more on the outlooks, and less on the historical facts. This kind of over-reaction or behavioral bias is often the reason why deep value investing worked. There are numerous research papers which showed that simple quantitative metrics such as P/B or P/E can generate a significant edge for investors. The pure quantitative approach is not limited to Graham’s formulas either. The famous “Magic Formula” only had two quantitative metrics in it: P/E and ROE. 2. It is easy to be well diversified. Since it is a pure quantitative approach, it doesn’t really need to analyze the business or understand the industry. Therefore, it is very easy to pick many different stocks and achieve high diversification. While I acknowledge the merits of deep value investing, it is also my belief that the pure quantitative approaches will be less effective in the future. This is because information is more available today, and there are more quantitative algorithms being created by backtesting the historical data. It is also easier to implement these investment approaches in an automated algorithm, which takes emotions completely out of the game. In other words, the competition on the deep value approach will be more intensive, and any deep value investment opportunity you can find is more likely to be a value trap, especially when that stock is a large cap or mid-cap. That said, Graham’s basic philosophy is still valid today: we have to focus on facts and avoid any over-confidence in our ability to forecast. This fact makes the first dimension (the quantitative metrics) to be the most important and most basic element of value investment. Without these metrics, we should not talk about “value” at all. While the quantitative metrics are important, we should also not underestimate the importance of qualitative factors (the 2nd dimension), such as the competitive advantages, the management’s ability and integrity, the pricing power of a business, and the industry outlooks. Not only these qualitative factors can give us more assurance of the business’ future, it also makes an exit strategy less important. As we all know, it takes a lot of work to understand an industry and a business. If we have to constantly find new opportunities after exiting the previous investment, it could be very tiring and it also increases the risks of misunderstanding the new opportunity. Beyond that, there is also the impact of taxes when you realize the capital gains. That is why Buffett said his favorite holding period is forever. After all, it is very hard to find a really good investment opportunity, and it takes a lot of effort to truly understand it. Plus, if you know you have to find the best exiting point, you will be tempted to sell too soon. When you increase your investment time horizon, it can also help to create a more scalable strategy, since you only need to slowly build the positions, and not worry too much about the need of liquidating the position with the best timing, or responding to any events quickly. The longer time horizon can also make qualitative factors much more important than quantitative factors. For example, if a stock is being traded at P/E 5, a deep value investor might get it and fetch a quick 100% gain within 1-2 years when the sentiment recovers. However, when you have to hold onto a poor business for 10 years, the poor business, even if it is not bleeding (losing money) every year, could be destroying value by reinvesting earnings with very low ROIC. So over a long period of time, any discount can be superficial and eventually get wiped out by the poor economics or poor management of the business. That is why when Buffett said “if you don’t want to hold it for 10 years, you shouldn’t hold it for 10 minutes”, many deep value investors couldn’t agree, simply because that philosophy doesn’t really apply to many deep value cases. On the other hand, for a good business with a good manager, even if you have to pay some premium for it, because of the good ROIC and high growth, your “sin” will often be more than covered by the good economics of the business when you hold it for many years. For example, a lot of investors were hesitating to buy Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ) 20 – 30 years ago, when its P/B was more than 2. But at least in retrospect, that seemingly overpayment would be more than paid off later. The same thing can be said for many great businesses in their early stages, such as Microsoft (NASDAQ: MSFT ), Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ), and Wal-Mart (NYSE: WMT ). Even today, when Berkshire Hathaway is already too big to grow very fast, the smart capital allocation along with many high quality world class businesses in its holdings make it an attractive investment for people who seek stable growth. Therefore, I believe it still deserves some premium in its valuation. For sure, today’s deep value investment can be much more than just a pure quantitative strategy. Deep value investors do often understand the business very well, and they often pay attention to the quality factors as well. However, their primary focus is still on the quantitative metrics, and they don’t require the business being a high quality business and don’t often require the business having a good management. Furthermore, even Buffett himself still invested in some low quality businesses from time to time. For example, after he had remained pessimistic on newspaper industry for many years, he still purchased many small newspaper businesses a couple of years ago, knowing that these businesses would slowly decline and could eventually die. Still, when the valuation was attractive from a discounted cash flow perspective, he felt that was a sensible thing to do. The 3rd Dimension: Certainty and Edge If the quantitative metrics can give us a view of the past, the qualitative factors should give us a “flavor” of the future (of course, investment is all about estimating the future). However, these two views can be totally unreliable if we don’t know enough about the business and the industry, and all our calculations could be based on imagination rather than facts. That is why we need the 3rd dimension: the certainty and the information edge. Every investment thesis is about finding and filling-in the missing pieces of a big puzzle. Investment, like any other business, is also highly competitive. Good businesses are unlikely to be sold cheap, and cheap ones are very likely to be value traps. The key about solving this big puzzle is about collecting as much information as you can. It is also about interpreting the basic information you collected, which requires some insights of the economics and the industry. In order to beat the market, we should also have an information edge, some unique insight or deep understanding that can help us to find the value discrepancy, and help us to maintain the confidence when facing emotional challenges. Buffett likes to call this as “The Circle of Competence”. It is a field where we can have an edge, a field where we can have more certainty than the other investors. After all, the term “uncertainty” is not equivalent to “true randomness”. When you try to guess the color of a ball in a box, that color is not a “true” random variable, since it is already fixed and known to some people, but just not known to you because you don’t have that information. Therefore, “certainty” is directly related to how much information we have. One obvious question following this is: how can we invest if we don’t have any circle of competence? Or what if all the stocks in my circle of competence are too expensive? I think there are several answers to this question: The first and the most important method to tackle this problem is to learn as much as you can. After all, nobody started with a circle of competence. It is all about constant learning over one’s lifetime. Learning has also become increasingly easier in this internet era as more and more information becomes easily available online. If we don’t have time to learn a new field, we could also simply wait until the opportunity shows in our existing circle of competence. Or try to copy a “superinvestor”, but I am not sure if that approach really works or not. Finally, less certainty in an investment means that we need to rely more on diversification, which again falls back to the more quantitative approach I have mentioned above. As I said, this approach may still work, but I would expect its effectiveness gets weaken over time. The 4th Dimension: Emotional Rewards While investors are normally only concerned about the potential monetary rewards in any investment, there is another hidden element in the investment process which is just as important: the emotional rewards. As a human being, the ultimate goal an investor seeks or should seek is always the “happiness”. While the investment profits can help us to get more happiness, we shouldn’t forget that much of our happiness is not related to money at all. Much of our pleasure directly comes from a constructive process. Much like a businessman who enjoys building his/her business, investors like to find the next gold mine or solve the next grand puzzle. It is a game they love. But beyond that, investors are also partners in a business. They are the owners of a business, even if they may only own a small fraction of it, and may not have any control on the business decisions. Nevertheless, just like a fan of a NBA team, the investors can enjoy seeing the business growing, and enjoy seeing the constructive process of building a business. This also makes a “quality-value” approach more attractive than a deep value approach. When you invest in a high quality business with a good manager, you often end up being happier in your investment life. You would worry less about management cheating on you or destroying value. There are less uphill battles against a deteriorating industry trend, or poor economics of the business. There is less energy spent on a proxy fight with a bad management. Besides the emotional rewards, there is another important side effect coming out of happy investing: when you truly like a business or a industry (not just because of the potential profits), you will spend a lot more time to learn about that business and industry. This will boost your edge in the 3rd dimension: your information edge. More importantly, this will become a very rewarding learning process that will be beneficial in the long run. In other words, when you invest on something that is truly interesting to you, you also invest in yourself by increasing your expertise in that industry. This benefit can be as significant as any monetary gains you could get from the investment itself, because just as Buffett said, “the best investment is always investing in yourself, it is the investment in education.” Summary The reason I call these 4 elements as 4 dimensions is that they are mostly uncorrelated factors. As investors are busy hunting their next best opportunity every day, it is also important to sit back and think through the process on a very high level. After all, it is more important to head in the right direction than moving at an amazing speed.