Value Investing Does Not Mean Low-Multiple Investing

June 16, 2020

At the 73rd CFA Annual Conference, Aswath Damodaran, Professor of Finance at New York University’s Stern School of Business was asked for his thoughts on value vs. growth investing. His response:

If by value investing you mean investing in something (where) the price is less than the value, I’ve never understood the divide. After all, growth is part of value. But I think I know what you mean. I think you mean by value investing those people who flock to Omaha every year – that think that every word comes out of Warren Buffett’s mouth is the gospel. And that buy low P/E stocks and high dividend yield stocks somehow entitles them to a return: I don’t have much hope for value investing. It’s become rigid, it’s become ritualistic, it’s become rightist. And for the last decade, not only has it lost to growth investing – I think this crisis has exposed how empty old-time value investing has become.  (1)

The “Dean of Valuation” does not believe in value investing. He has a point. The term “value investing” has become distorted to mean “low-multiple” – whether it is price-to-earnings, enterprise value-to-EBITDA, free cash flow yield, or another metric. The misrepresentation has been exacerbated by quantitative factor strategies which rely solely (or at the very least mainly) on market multiples.

Valuation metrics are an important step in the process of finding underpriced securities. They serve as a useful shorthand for market expectations, allowing analysts and portfolio managers to assess how well the company must perform to meet or beat the market’s targets. But they are not the process. The process includes assessing competitive environments, growth prospects, cash generation, management, and a plethora of other qualitative and quantitative factors. Good fundamental analysts assess whether the price truly translates to the company’s value. That is the spirit of value investing.

Professor Damodaran is probably right: old-time value investing has become empty. We need to understand that the investing environment is constantly evolving. Even Warren Buffett, one of the greatest (perhaps the greatest) investors of all time and the most recognized figure on the “Mount Rushmore of Value” has evolved his approach over the years. In 2002, he famously pronounced (jokingly) “if a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright.” Fifteen years later he bought airline stocks. Berkshire bought Amazon stock throughout 2019 while the price to earnings ratio was in the 60’s. The sixties! Great investors are flexible: adapt or die.

Two companies MAP has recently purchased do not fall into traditional “value” buckets. Electronic Arts (EA) and Facebook (FB) both had valuation multiples that are high by traditional value standards. However, we liked their competitive landscape and intellectual property, and their high cash balances that would allow them to weather any near-term economic pain. Meanwhile, companies like J.C. Penney (JCP) have been bucketed with value for years due to low earnings multiples. The retail industry has been in secular decline and J.C. Penney was among the weakest players. It was going to be difficult for the company to survive, let alone justify an equity investment. This fragility led to the company filing for bankruptcy in May.

MAP still follows the fundamental principle of value investing: buy when the price is below the value of the company. This principle has not changed since Benjamin Graham developed the concept in the 1920s. Companies with higher valuation metrics have higher targets to hit, but many will end up hitting and exceeding those higher targets. Companies with low valuation metrics often have lower targets for good reason: secular decline, management apathy, and intense competition makes many businesses unattractive even at their low multiples.

Due caution is prescribed when investing in high multiple companies. More things must go right for their shares to outperform. Additionally, the consequences of things going wrong (increased competition, poor management decisions, Acts of God) can have a crippling effect on stock prices when multiples are stretched. Downward expectations revisions are amplified when a company’s valuation relies on high earnings and cash flow growth many years into the future. The uncertainty of these cash flows can scare off investors when events in the short-term magnify potential long-term risks.  

During the last few months, prices have swung dramatically and our investment team has been monitoring developing opportunities. MAP will continue to assess companies based on all merits. Valuation multiples will be an important part of that process. Quantitatively, low-multiple stocks do appear to be cheap, having underperformed for most of the last decade – meaning that good opportunities could be found today at the low end of the valuation spectrum. However, MAP focuses on the long term for our portfolios and we continue to see price movements that do not reflect the fundamentals in both high-quality and low-quality companies. We will not invest in companies that we believe have become highly speculative.

Ultimately, the value vs. growth debate will rage on. All else equal, a cheaper stock is more attractive than an expensive stock, but a low market multiple alone does not necessarily make a good investment. MAP’s strategy is to find individual names with attractive risk-reward characteristics, then build a well-diversified portfolio of our best ideas. We assess companies based on their fundamentals, prospects, and valuation. This has not and will not change.

Managed Asset Portfolios Investment Team

Michael Dzialo, Karen Culver, Peter Swan, John Dalton, Zack Fellows

Research and analysis by Dustin Dieckmann

June 2020

[1] 73rd CFA Institute Annual Conference 2020. https://info.cfainstitute.org/73-cfa-institute-annual-virtual-conference.html

The information contained herein does not represent a recommendation by us to buy or sell any security or securities mentioned in this presentation. Certain statements may be forward-looking statements and projections which describe our strategies, goals, outlook, expectations, or projections. These statements are only predictions and involve known and unknown risks, uncertainties, and other factors that may cause actual results to differ materially from those expressed or implied by such forward-looking statements. Past performance is no guarantee of future results.

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