The Dogma and Extreme Crowding of Classic Value Investing
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(Note: — This is an excerpt from my 2015 quarterly letter to investors. While I wrote this almost 5 years ago, I find most of this to be true and generally more applicable today than it was then. Classic Value Investing continues to be underperforming relative to expectations, and this thought piece may provide some helpful insights. Ironically, the underperformance in my final 2 years of managing outside money was due to my own, “non-classic” version of a value bias.)
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If past history was all there was to the game, the richest people would be librarians. — Warren Buffett
Facts do not cease to exist because they are ignored. — Aldous Huxley
As our investors know, we are very self-critical, introspective and questioning about aspects of our own process or general approaches that may be flawed or could use improvement. We are always trying to identify and improve upon our own latent biases. We also are not afraid to research, discuss or question the various “sacred cows” of investing or our industry. The following section is a result of many years of introspection, errors within our own research and errors within my own training and hiring processes. This section may be controversial, and if you are not able to be objective about us reflecting upon and questioning elements of what can be described as a sacrosanct religion within investing, please skip this section. STAY OPEN-MINDED!
In the last several years, there have been many notable investors, experiencing multi-year periods of mediocre to poor performance, who have publicly complained that the “market is stupid” because many classic value investing strategies keep underperforming. We too, at times, have complaints about “what’s not working,” but you would never hear us complain if we got it wrong for years. We believe it’s acceptable to be off for many quarters, but not for many years. These investors speak as if it is ordained that “their stocks” and their style should be respected by the masses. They speak as if the laws of physics have been violated when classic value investing is not working.
We believe that there is no style of investing with more dogma, more blind following and more backward-looking analysis than classic value investing. Even the word “value” is a loaded term that is self-evident and its wildly positive connotation seemingly cannot be questioned. What investor in their right mind would ever say they like buying overpriced assets or those that are poor value? Therefore, analysts and investors are inclined to boast, with a sense of honor and pride, that they are “value investors” and only invest when there is value. We, too, always look for mispriced value, but we question below how it is defined and comment on how this style has changed over time.
Value investing originally reached mass popularity with the classic 1949 Benjamin Graham book The Intelligent Investor. This book was essential in the education and success of Warren Buffett and he referred to it as, “By far the best book on investing ever written.” As a byproduct of the pronounced and publicized success of Buffett and many other notable (and visibly rich) investors through the 1960s-1990s, there are now literally thousands of books and educational resources to teach one how to invest in the same manner as the great investors did decades ago. See below from my (8/2015) Amazon query:
In addition to the books, there are dozens of “Value Investing” websites, clubs, congresses and even entire college curricula (Columbia has an excellent program specifically on this topic). As a result of the above, the folklore and legends, and the annual letters and meetings of Berkshire Hathaway, a religion within investing has been created. This religion has also resulted in far more eager participants and collective interest than other popular investing styles:
Based on our introspection and study, we believe the failures of this approach have been due to several important principles:
- What worked when “Intelligent Investor” was published 66 years ago may not be entirely applicable today. Ironically, the pope of this religion (Buffett) penned the above quote about not blindly following what worked in the past. And more ironically, the prolific publishing from the experts and the adoption by tens of thousands of analysts, investors and quants has actually arbitraged away the very strategy they were trying to teach everyone. Anyone who has taken Econ 101 understands that as competition and education rises in a highly profitable field, the opportunity set diminishes and easy profits get arbitraged away. However, we believe there is not nearly enough scrutiny on what worked very well decades ago as it relates to today’s investing environment. While classic value investing seems immutable, there are many old, yet more recent books that most would consider to be laughably outdated without hesitation:
In the last 66 years, all aspects of competition and awareness have dramatically changed — and this competition has corrected most consistent value-based anomalies that used to exist.
a. Informational advantages: information on public companies has become universally available
b. Analytical advantages: Microsoft excel and other forms of modeling and analysis are ubiquitous
c. Quants: It is safe to say that anything that was observable in historical data (such as buying low P/E and high FCF yield stocks at the beginning of the year) has been arbitraged away. We have commented on the rise of quants and smart-beta strategies in past letters — there has been parabolic growth in both number of funds and AUM in long-only “value investing strategy” funds and ETFs:
2. As more and more people practice this religion in a rules-based (using time-proven methods) manner, it makes observable “value stocks” more crowded, more efficient (in a classic finance sense) and hence more susceptible to dramatic downside risk. Why do we use the word dogma? To presume that one can generate consistently abnormal returns when tens of thousands are investing in the same way is to presume that one can defy basic economic principles.
3. Valuation is a subjective, multi-variable concept. Just as home prices can change based on many factors, so too can valuations for securities. What the collective is willing to pay for a future stream of cash flows is not a hard science — it is highly dependent on what someone else is willing to pay for that asset. Of course, there are valuable financial tools and analytical methods such as discounted cash flow analyses (DCF) that help approximate what an asset SHOULD BE worth, but it is rarely that simple.
4. To presume, at this point of the evolution of the capital markets, that the market is highly inefficient in how it prices historical, observable data during regular times is hubris. In normal market environments, anything valuation-related that is observable and measurable in less than 2 minutes should be presumed to be priced in already. (During crises and market liquidations, investing based off historical, observable valuation metrics is actually highly profitable as selling is indiscriminate.)
5. Most importantly, the concept of value is entirely predicated on what happens in the future. The price is what you pay today, but the ultimate value of the asset is what it delivers in FUTURE cash flows. Many popular value strategies look for high historical earnings yield, high EBIT yield and high return on capital (ROC). But what if earnings or EBIT are not stable? For mature, secularly declining or highly-cyclical businesses, the pace of disruption from competitors is faster than at any point since I have been in this business. This means that possible future fundamental variables such as earnings and FCF may be unpredictable and unanalyzable. Ultimately, investing requires some probabilistic approach to prediction.
As a case in point, take a recently popular “classic value stock” such as Micron (MU). Without going into the various cyclical and fundamental reasons for its recent decline, we can highlight a simple fact. In January 2015, MU was trading at an 8x forward P/E multiple which was viewed, by some, as very cheap (relative to the market multiple of ~16x P/E) with a high margin of safety. At that time, consensus earnings estimates were expected to be ~$4.24 per share in 2016. In July 2015, 2015, MU stock price was 43% lower but earnings are now expected ALSO to be 43% lower. This value stock turned out to be far riskier than many “expensive” growth stocks which are rapidly growing earnings and cash flows.
As a corollary to the challenges of secularly declining businesses that appear to be value stocks, there is also a growing frustration and even anger toward stocks with growth that may command higher than market valuations. Valuing higher growth companies with higher sustainable margins, higher returns on invested capital and more stable future cash flows is quite difficult and requires judgment about the future. However, that doesn’t mean all non-cheap growth stocks are bad investments and a DCF-based approach can actually justify significant upside in some cases. In fact, the best companies in the world that are consistently compounding great wealth for shareholders should be expensive. Blue-chip growth companies that have compounded tremendous long-term shareholder value since their IPOs such as Starbucks, Amazon, and Google have never been conventionally cheap on backward-looking metrics.
These companies have shown that they have massive embedded optionality with their ability to grow revenue, cash flows and develop new businesses. Moreover, our research indicates that there have been rapid losses of top talent from the complacent, maladaptive (and often cheap valuation) tech companies and these people have gone to the more innovative, faster-growing public and private companies. This “brain-drain” may permanently impair the prospects of a company and it dramatically increases the optionality of the companies where the best and brightest end up. Two recent examples of rapid, disruptive value creation are:
· Amazon quietly created, out of nowhere, the largest global cloud business called Amazon Web Services (AWS) over the last several years that will do $8 billion in revenue in 2015. We believe that AWS is ultimately worth more than the entire current market cap today and why we mentioned in our last letter that our target price was $800 or higher.
· Airbnb, a private “sharing economy” startup that allows individuals to rent out their homes/apartments and effectively turn them into hotel rooms is creating unprecedented disruption for the hotel industry. Surprisingly, Airbnb already has as many properties as Hilton and Marriott’s global rooms combined, essentially creating a leading hotel company from thin air without any owned property or debt. While we won’t take an opinion on its most recent valuation of $25 billion (higher than any public hotel company other than Hilton), the speed of disruption (and speed of business creation) relative to traditional, capital-heavy and historically stable businesses is shocking. Behold this below chart sourced from BAML where the Airbnb rooms available look like a virus devouring its host (pun intended).
What should an investor pay for embedded options that create enormous long-term shareholder value? To paraphrase Buffett, we would rather pay a fair price for a great business than a great price for a fair business. And we love mispriced optionality.
For the avoidance of doubt, we want to clarify a few points before concluding:
· All else equal, buying great businesses cheaply is far better than the opposite. However, the frequency with which an investor can do this has declined substantially in the last several decades.
· We do not think all value stocks are bad investments, but rather think that much more scrutiny should be placed on easily observable, classic value stocks. Because of crowding and market efficiency, there are many more value traps than ever before WITH more investors and machines trying to play the same game in a highly crowded fashion.
· We do not think all growth stocks or all non-cheap stocks are good investments. In fact, most turn out to be poor investments. There are plenty of absurdly overvalued, problematic businesses out there that will make terrible investments.
· We do not think all of the principles from 1950–1980s value teachings are obsolete, but rather we think they are generally far too crowded, and most low-hanging fruit has been arbitraged away.
· We do not mean to offend anyone who is a strict practitioner of classic value investing; rather we hope that we educate our investors that the game has changed dramatically. Any process in a rapidly evolving field, when practiced in a dogmatic, immutable manner, is ultimately doomed.
In conclusion, we have learned a great deal over the years about how to adapt given the parabolic proliferation and crowding of classic value investing. Our internal findings and adaptations are as follows:
· Question finding gold in the street. If you stumbled upon a bar of gold in the middle of 5th Avenue during a crowded day, would you presume it was real gold? Surely not. When backward-looking, highly observable valuation data is a critical part of the thesis for an investment, we try to be just as skeptical. We assume basic market efficiency and assume that visibly cheap stocks are cheap for a reason.
· Recognize when to use classic value approaches. We have observed that during times of stress, liquidations, recessions and mass panic, that value approaches work very well. When selling is indiscriminate and/or for non-economic reasons, then investors and analysts are NOT looking at or caring about observable, backward looking metrics like earnings yield, FCF yield and return on capital.
· Garbage in, garbage out. The merits of any investment strategy depend entirely on the quality, stability and predictability of the inputs that an analyst is using. If the forward-looking fundamental drivers of value such as FCF, EBITDA or earnings are unstable or could deteriorate, today’s valuation is irrelevant and backward-looking. We work very hard at assessing the probability of outcomes with the key fundamental drivers. If something is too unpredictable and we can’t handicap the outcomes, we avoid investing.
· Expectations gap + cheap valuation = BEST POSSIBLE IRR. When we find a cheap, hated stock with a large misperception (expectation gap), if we can articulate what closes that gap and leads to an improvement in fundamentals, it has generally led to our best IRRs.
· Mean reversion doesn’t always work. This has been our most painful adaptation over the years because I generally believe (as we have written in the past) that mean reversion is one of the most powerful economic forces. It is a natural human bias to bet on reversals, but it can be a psychological trap (witness your own betting tendencies if you are observing a roulette game where black comes up 10 times in a row and then asked to wager on red or black). Related to the comment above about “brain drain” at large, secular-decline companies, there are many economic forces that accelerate and ensure the future gains and losses of respective companies. Blackberry isn’t likely to recover its losses from Apple, nor is RadioShack from Amazon.
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Jason H. Karp is Founder and CEO of HumanCo — a mission-driven, private holding company which invests in and creates companies focused on healthier living. Previously, Jason was the Founder and CEO of Tourbillon Capital Partners, an investment fund that managed over $4 billion, and has over 21 years of investment experience at other multi-billion dollar investment funds. In 2015, Tourbillon won the Institutional Investor award for Emerging Hedge Fund Manager of the year. At the end of 2018, Jason decided to return all investor money, close Tourbillon, and retire from the hedge fund industry to focus his efforts on health and wellness, embracing the belief that improving health is the most effective strategy to increase global prosperity.
Jason’s passion and fanaticism for health and wellness comes from his own health struggles. After being diagnosed with several autoimmune diseases in his twenties and being told he would be blind by the age of 30, he discovered that poor food and poor product choices were the root cause of his diseases. He eventually cured himself and restored his vision by focusing on cleaner living and being fanatical about ingredients. This journey inspired him to co-found Hu Products and Hu Kitchen with his wife and brother-in-law. Hu is one of the fastest growing snacking-companies in the U.S. with a strict focus on transparent, simple ingredients with a focus on helping everyone “Get Back to Human.” Jason has also been an investor in many other companies that have a mission of health and wellness such as Nutranext, Oura ring, Airgraft, Primal Kitchen, Beekeeper’s Naturals and Magic Spoon.
Jason graduated summa cum laude with a B.S. in Economics from the Wharton School of the University of Pennsylvania. He was also Academic All-American and Academic All-Ivy as a Varsity Squash player. He is on the Board of Advisors of the Tufts Friedman School of Nutrition Science and Policy as well as the Tufts Food and Nutrition Innovation Council. His philanthropic interests and family foundation focus on education, prevention and treatment of autoimmune diseases, chronic diseases and childhood obesity.
