Value Investing
A Brief Introduction to Value Investing
Value investing has its foundation on one thing: buying companies for a substantially less than what a private buyer would pay for them. As an observant of investor’s behavior, I’ve come to realize that a good business is often confused for a good investment. A good business is not the factor which dictates the merits of an investment result, and therefore to generate good investment results one does not need to invest in good businesses. The rationale behind this is that it’s easy to see that some businesses are much better than others, and therefore the price for those good businesses will reflect that (it’ll be high). And this is really what complicates the process of selecting the best investment candidates.
Consider Adobe. Every photography studio uses Adobe’s products. They’re absolutely standard. Adobe incurred the costs to develop apps like Photoshop, Lightroom, etc. – and it only incurred those costs once (albeit there’s naturally incremental updates). However, Adobe can sell Photoshop and Lightroom and infinite amount of times, anywhere in the world, at no further cost. Compare this to a supermarket, which to generate more and more sales must continually buy more and more inventory, and naturally open more and more locations. A supermarket’s costs will grow as revenue grows. Obviously, the economics of Adobe’s business are much, much better.
In 1988 Warren Buffett invested $1.3bn in Coca-Cola. At the time consumption of bottled beverages per capita internationally was miniscule compared to that in the United States. So, the increase in per capita consumption of bottle beverages internationally and Coke’s ability to take advantage of that – led by increased income per capita – had Buffet make 12x his money by 2000. That $1.3bn investment was worth $15bn twelve years later. A return of more than 20% a year for 12 years.
However, in 2000 Coke was selling for 45x earnings and since then its stock has returned a meager 3% a year, and that underpins the difference between a great investment and a great business Coke is a great business, and it’s bigger than before. It sells a lot more syrup to bottlers than 20 years ago. But the starting price was very high, and that created the set up for a bad investment.
The bottom line is price matters.
Mastercard is another example. Mastercard is a $300bn company and it sells for 45x earnings – roughly the same multiple Coke sold for in 2000. Since Mastercard’s 2006 IPO they have compounded at over 37% p.a. – an incredible track record by any standards. But the company is most probably not going to grow at 30% a year in the future. The company makes almost $6bn in free-cash-flow (actual cash available to be used/distributed), and it sells for 50x that. Meaning that if you laid out the $300bn today to buy the company, maintaining everything else constant, you would only get your money back in 50 years. That’s a return of 2% a year.
Furthermore, the current 2% commission it charges could be much less in the future. In China, there is no Mastercard, commissions are much lower - WeChat and AliPay charge a fraction of that. So why are investors willing to underwrite these multiples? Perhaps because it’s considered a safe stock. Even if Mastercard turns out to still be a satisfactory business in 10 years, investors are likely to have an unsatisfactory return. What I’m saying is that even if Mastercard, as a business, does well, it may not do so well as a stock. I would say it’s not a good ‘bet’. At the current price the stock sells you can very well argue more reasons on why the stock will do bad versus well. As an investor, I look for asymmetrical bets, where the price is so low the only way that stock is going is up.
Price not only matters to achieve a satisfactory investment return, but it also serves as a protection against future occurrences. If an investor buys a business for half of what it’s conservatively worth – because a judgement was made that the future of that business is bright – even if it’s no so bright the investor is probably still going to achieve a decent return.
This brings me on to the second most important point in investing. One must seek for durable businesses. Business with durable competitive advantages also serve to the investor as insurance against the change that will inevitably come in the future. Mars is an example of a durable business. Mars, Inc. – a privately-owned family business – owns Mars, Milk Way bars, M&M’s, Snickers, Twix, Skittles and a number of other brands. Snickers has been the best-selling candy bar for the last 50 years, and it’s terribly difficult to take that away from them.
Some companies can be disrupted, whereas it would be very hard to disrupt products of a company like Mars. In 1930 the Mars Company introduced Snickers and whilst at the time it was difficult to replicate the flavor which was the key differentiator between competition – or come close to replicating the flavor – technological advances today and in the future will probably allow you to get pretty close. But by now, the brand and most importantly the distribution system the company has for Snickers is so strong that it’s basically available anywhere, and therefore flavor copying is not an obstacle for Snickers.
People have habits and habits become very ingrained, but you must take care of those habits. You don’t want a Coke drinker to sit at a restaurant and have the waiter tell him they don’t have Coke, because that gives some competitor the chance to get his ‘foot in the door’. Therefore, flavor and distribution are now Coke’s two major competitive advantages, as well as Snicker’s. It would be very hard to replicate that distribution system, not to mention high volumes provides huge advantages in advertising. The company can spend much more money on advertising on an absolute basis, yet spend much less on a relative basis, because it can spread those costs over more product sold (i.e. ad dollars spent per chocolate bar). All of this makes it incredibly hard to replicate their business.
Apple is another example. A few months ago, you could buy Apple for $640bn. The company had $250bn in cash and if you assumed all of the debt was due today, they’d still have around $125bn in cash. You’re basically paying $515bn for a company that produced $64bn in cash. That’s a 12% return for a business that retains over 90% of their customers. When people buy an iPhone and they use it, they don’t go back. They don’t even consider other options. It’s either the big iPhone or the smaller iPhone, but it’s still the iPhone. They don’t shop around. That’s an incredible competitive advantage, it’s very, very hard to take that away from Apple.
Furthermore, Apple’s brand not only has a global footprint it has also shown the ability to leverage its brands to sell a number of other products – like the Apple Watch. As Buffet would put it, the “brand travels”. “I mean, Coca Cola moves it from Coke to Cherry Coke and Coke Zero and so on.”, Coke doesn’t travel much. But supermarkets’ private label brands? Well they’ve gone from product to product – form cereal to olive oil, etc. It doesn’t stop. Apple hasn’t travelled to the extent supermarket’s private label brands have, but it has travelled. But we can see how they’ve used their brand to sell watches because the Swatch Group did $8.5bn in revenues and Apple Watch – which sold around 22M units – assuming an average selling price of $300, did over $6.5bn.
This business certainly won’t grow at the rate it did in the past, but it can still be a good investment at a certain price. Its’ services business will probably do quite well as the iPhone screen is a very valuable real estate. Services is almost a $40bn business.
And the last thing you need is good management. And it’s only last because if you overpay for a business or buy one that is not durable, the odds are against you. Particularly in a non-durable business where even the best management won’t be able to change a poor industry. If you put a wonderful manager in a terrible business, it may be a little less terrible business, but it’s still terrible. I’m ok having mediocre management if the price is low enough.
Why Value Investing Will Continue to Work
Joel Greenblatt usually says:
“let’s take a look at the most followed market in the world, that would be the United States, let’s look at the most followed stocks within the most followed mark in the world, those would be the S&P 500 stocks (…) from 1997 to 2000 the S&P 500 doubled from 2000 to 2002, it halved, from 2002 to 2007 it doubled from 2007 to 2009, it halved, and from 2009 today it’s roughly tripled”
The way to think about market fluctuation is by the Mr. Market analogy that Ben Graham created.
"Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.”
Once upon a time Joel Greenblatt was asked to explain what the stock market and value investing to a 9th grade class.
Having failed at trying to explain it to doctors, he came up with a new approach. He brought a big old jar of jellybeans. He passed both the big jar and three by five cards to everyone kid around the room. He told the kids to count the jellybeans in the jar, doing whatever they had to do, and write down how many they thought were in there.
Then he collected the cards and went one-by-one around the round and told them to tell him how many jellybeans they thought were in the jar. They could keep or change their original guess.
Here are the results: when he averaged the guesses of the three by five cards, the average guess was 1771 jellybeans versus the actual number of 1776 jellybeans in the jar. But when he went around and asked one by one, the average was 850.
He said the stock market was the second guess. “Because everyone knows what they just heard. What they just watched. What they just read. Who they just talked to. They’re influenced by everything around them, and they didn’t make a very good guess.”