Is Value Investing Losing Value?
In this article, we go over the basics of traditional value investing, critique assumptions about value in light of disruption, and offer a holistic new solution to appropriately apply the tenets of value investing to the dynamic tech sector.
THE BASICS
Popularised by Benjamin Graham’s 1949 book The Intelligent Investor, value investing is an investment strategy that buys undervalued stocks for cheap, but focuses on the intrinsic value of a company in the long-term. Undervalued stocks are those that appear to be trading for less than their book value. The strategy derives from the observation that the market can overreact (or underreact) to news and events, causing stock prices to fluctuate in ways that are not representative of a company’s long-term fundamentals. Market fluctuations provide opportunities to buy stocks at discount prices. By bucking herd mentality, bad press, and market conditions and rooting for the seemingly unglamourous and unloved underdogs of the stock market, value investing profits from getting to know potential stocks first.¹
Value investing subscribes to the ‘buy low, sell high’ mantra, but with a bit less tunnel vision by stepping back to garner a holistic representation of the company’s long-term value. This mantra echoes the margin of safety principle, upon which value investing relies. Basically, when you buy stocks for cheap, you can sell for profit when prices rise again, but if the company flops, then there is less of a loss. In theory, it’s a low-risk investment .
In focussing on a company’s intrinsic value, value investing reiterates the quintessential definition of stocks: part ownership of a company. If you want to own a share of a company, you probably want to do some research on the company itself. A consideration of intrinsic value must combine indicators such as financial performance, revenue, cash flow, earnings with fundamentals such as brand, business model, and competitive advantage. Price-to-book and price-to-earnings ratios are traditional metrics to value a company and its stock as they can show if a company’s assets and earnings are not reflected by stock prices.²
If you need a visual, picture value investors as moms with coupon books, poised and ready to get the best deal on known products. So think of Warren Buffett as a couponer for stocks.
DISRUPTION & CHANGING VALUES
Is disruption altering the way value investing works?
With increasing disruption in various sectors, particularly tech, many cheap stocks have stayed cheap, for good reason. Disruption and tech disruptors inherently seek to change ecosystems and alter markets, thus throwing a wrench in value investing’s reliance on reliability and past performance. As tech normalises trends of disruption and changing values, traditional value investing becomes obsolete. Traditional value investing favours conservative, well-established companies with proven track record, but this is wholly incompatible with the modern tech sector. Tech stocks are unpredictable, as we cannot predict what technologies will be developed in five years or how they will change our lives (let alone what the market will be in five years). There are two concerns regarding disruption-affected values: the spatio-temporal considerations of value and the misidentification of value.
Spatio-Temporal Considerations of Value
Value is reflective and dependent on external factors — it is not inherent or intrinsic despite the nebulous term ‘intrinsic value.’ Value is mutable and ever-changing, simultaneously subjective and objective. What may be considered valuable one day could be worthless the next, depending on external conditions and circumstances of time and space.
Image: BlackBerry stocks 2006-2020, displayed on a BlackBerry phone.
Let’s use BlackBerry as an example. BlackBerry was a disruptor, an innovative player changing the consumer market for handheld communication devices. Between 2001-2011, BlackBerry saw sustained growth, solidifying it as a reputable household name. BlackBerry was a quality company with a quality product, highly valued in all regards. Of course, after its user-base peaked in 2011, BlackBerry steadily fell behind competitors. This is the nature of the tech industry. Is BlackBerry undervalued right now? No, because its product is not nearly as good as its competitors Android and Apple. Just because a company has seen prolonged success in the past, it does not necessarily mean this will continue.
The takeaway from BlackBerry: Value is a product of its environment. Accordingly, it is only appropriate that the ‘value’ of ‘value investing’ should change with the environment as well.
Misidentification of Value
Though value is mutable, quintessential notions of value have not necessarily changed dramatically. However, the identification of value alters drastically when reading (or mis-reading) the accounting. Disruption in the market changes the value of things in a convex way, favouring intangible assets over tangible counterparts. Since the late 1990s, rates of intangible investment have overtaken tangible investments, producing entirely new ways to analyse and determine a company’s value. Fittingly, entry into the digital age coincided with increasing intangible investment. Intangibles are dynamic and significantly more resilient than their tangible counterparts. In 2008, while both assets were affected by the recession, intangibles fared exceptionally well in the aftermath. Accordingly, misidentification of value for intangibles can inhibit understanding of a company’s actual valuation.
Source: Unpublished update to Corrado and Hulten (2010) using methods and sources developed in Corrado and Hao (2013) and in Corrado et al (2016) and Corrado et al (2017) for ©INTAN-Invest and the SPINTAN project.
Book value mismeasurement, such as omitting intangible investments, contributes to misidentification of value. This fact is echoed by Baruch Lev and Anup Srivastava in their recent paper discussing the failures of value investing, claiming that there are “accounting deficiencies causing systematic misidentification of value, and particularly of glamour (growth) stocks.”³ Book values can easily portray tangible assets (such as property, equipment, factories, etc.), but accounting for intangibles is a bit more difficult. Intangibles (such as R&D, advertising, and IT) present themselves in book values as understated earnings, resulting in overstated P/E ratios.⁴ With this deficiency, the value investing strategy falls flat, unable to account for changing dynamics and conditions.
ALTIO’S TAKE: WATCH CONTEXT AND SECULAR TRENDS
Tracing secular trends can provide a holistic picture of where to focus your value investing. Ask yourself: What are some undervalued secular trends? What secular trends have value investors overlooked?
Though denounced in theory by value investors, blindly following market trends continues to be a mainstay in their practice. However, the lethargic conditions of the market due to COVID-19 provide the perfect example of the danger of following market trends. Oliver Jarman notes that “we are currently witnessing statistically the longest period of cumulative underperformance since at least the 1950s, with value lagging its growth style counterpart across all regions since the global financial crisis.”⁵ As such, practically everything is undervalued right now (well, maybe not Zoom). In cases such as this, looking to secular trends, rather than market trends, could provide greater returns in the long-run.
Image: Financial Times 2020, Cumulative Long-Short Excess Returns (%)
We propose a new value investing strategy, derived from the original but tweaked to account for disruption and evolution. New approaches to value investing must practice what original strategies preached, conceiving a holistic approach to investing. Original value investing lost sight of this, focusing wholly on ‘good deals’ and not taking changing conditions into consideration. This new take on value investing should capture the importance of secular trends, rather than emphasising cheaply priced assets or companies with little to no chance of competition in the near future. For instance, no one is going to stop online shopping any time soon, so, after completing due diligence of a company’s intangible and tangible fundamentals, investing in an e-commerce stock like Amazon or Alibaba secures your stake in a stable secular trend. The key is finding an undervalued secular trend to capitalise on, then snagging a stock that’s following this trend.
At Altio, we recognise the importance of intangibles in the tech sector, where new ecosystems and economies are continuously emerging. A new value investing strategy would recognise factors and values appropriate for the tech sector (and, by extension, modern markets). In tech, we need to consider factors like the networking effect and infrastructure investment, as these sorts of assets are generally undervalued and unapparent in book value. Thus, this new strategy of value upholds intangibility and market environment as twin pillars, just as original value investing prioritised tangibility and book values. To make value investing viable again, we must turn the page on book-value in favour of more relevant, contextualised values that respond to both current environments and secular trends.