Value Investing isn't dead - the meaning of Value has changed
Why Investor's need to re-evaluate the concept of value in the market
For the past few years, the one line that has shown up again and again in the broader investing community is that “value investing is dead”. There are good reasons for this. Value Investing, which was originally an investing philosophy made popular by Ben Graham and then later championed by Warren Buffett, aims to find companies that are mispriced due to inefficiencies in the market. However, this approach has continuously produced inferior returns in the past 5 years, not only to “growth investing” but also when compared to the overall indexes as a whole.
The data would suggest that value investing is in fact dead. I disagree with this conclusion. Instead, I would argue that value investing isn’t necessarily dead but what has changed is the meaning of value in the market. As a result, the traditional forms of screening for value stocks no longer tend to work. Let’s examine this through a few metrics and ratios that traditional value investors often use:
The Price to Earnings Ratio: When screening for stocks, value investors have a bias for companies with lower P/E ratios. However, this is often a recipe for missing out on fundamentally well run businesses. In the current environment, a lot of companies are starting to follow the Amazon model where they are happy to have lower earnings today so that they can aggressively reinvest back into the company. In fact, the largest companies in the world today all had extremely low or negative earnings in the first 5-10 years of their operations.
The Price to Book Ratio: Similarly, traditional value investing also has a bias towards companies with lower P/B ratios. I would argue that this metric is even more flawed than the P/E ratio. In today’s environment, innovative companies are rewarded for having the least amount of assets. For example, the biggest music streaming service Spotify doesn’t own any music, the biggest sources of news Facebook and Google don’t own any media, and the biggest disruptor of hotels Airbnb don’t own any hotels. Additionally, most of the assets of innovative companies come from network effects, which simply cannot be priced by traditional accounting metrics such as the book value.
The Dividend Yield: Value investors also have a bias towards companies that pay out dividends. Returning cash flows to investors is generally viewed as a positive and it makes valuing the company easier. However, one thing to keep in mind is that paying out dividends also means that the company is not reinvesting that money back into their business. While the dividends are great today, it may hinder the company’s ability to stay at the forefront of innovation and new technology.
So What is the Remedy?
As the business world has become more fast-paced and technology-driven than ever before, it is clear that the traditional understanding of value no longer works. While there are many ideas behind how value can be redefined, I would argue that the following three changes are fundamental and should be taken into account by every investor:
The Earnings Dial: The most successful companies in the world today have an earnings dial that they can move around at any time. For example, I believe that Amazon or Facebook could easily multiply their earnings if they simply focused more on monetizing their platforms. However, they are probably not doing so for the sake of new customer acquisition and satisfaction. As a result, when evaluating a company, investors should ask the question - “Does this company have an earnings dial?” and “how far can this dial be pushed?” Instead of focusing on current earnings, these two questions will reveal much more about the company’s potential earnings, brand, and competitive advantages.
The Network Effects: Network effect is a phenomenon where current users of a product or service tend to receive benefits from new users of the product. For example, as more people buy a Tesla, the company becomes better at collecting data and making their cars more autonomous, which benefits every other user. Similarly, as more people buy the iPhone, developers see an opportunity and release more apps for the iOS App Store, resulting in the product becoming better for every user. When evaluating a company, investors should ask “Do current customers of this company receive any benefits from new customers?”
Cost-Reduction: A lower price has often been associated with inferior products in the past. However, through technology, companies are figuring out ways to deliver better products at a cheaper price than incumbent businesses. Additionally, they are also figuring out ways to reduce the cost of their products throughout the company lifetime. With reduced costs comes mass adoption. For example, while the computer was not accessible to most common people in the 1970s and 1980s, the costs were eventually reduced enough to the point where everyone has a computer or laptop today. Similarly, even if a company has highly-priced products today, investors should ask “can this company continue to reduce price enough to hit mass adoption one day?” For example, one industry that seems ripe for mass adoption in the future is space exploration.
While evaluating metrics and ratios are still important, I believe that these three criteria should be added to screen for value in the modern business environment. Value investing isn’t dead, but the methodology to evaluate value has certainly changed.