Memo Thoughts – Something of Value

Dear Readers,

We are in the last month of what has been a roller-coaster of an year. There is no shortage of negativity in the news with what the whole FTX fiasco and its comparisons to another such famous (or rather infamous) scandal with Enron. You know that not all is well in the world when you have frequent news surrounding layoffs. Almost all of the Big-Tech names are in the process of laying off some of their workforce and looking to tighten their budgets, bracing themselves for the upcoming turbulent times.

There is so much uncertainty and it is hard to stay focused on your goals as a lowly retail investor. In times of uncertainty, I look for voices of reason to streamline my own thought process and not lose sight of the forest for the trees. And one such voice of reason is Howard Marks and his memos. So I wanted to end this year going back through his archived memos and picking a topic that seemed interesting.

So, I picked the memo: Something of Value. Arguably, in Howard Marks’ nearly 30+ writing career, THIS memo is regarded as his most read/ most famous.

Why this memo?

I want to talk a little bit of the significance of this memo and why I chose this memo from 2021 instead of a more recent memo.

We are at an interesting juncture as far as macro-economic conditions. For the large part of late 2020 and most of the year 2021, there was so much euphoria around early stage startups, EV companies, meme stocks, crytocurrency etc. that the aspect of looking at the fundamental intrinsic value of an investment opportunity had been thrown out of the window by a large portion of the investment community. Contrast that with the year 2022, where growth stocks have been crushed, and all ventures surrounding cryptocurrencies have declared bankruptcy and/or are involved in some or the other scandals. Indeed, social media influencers who were promoting these investment vehicles in order to make a quick side-buck in 2021, have since gone silent on these subjects and are suddenly talking about buy-and-hold investing and dividend growth investing now.

The background around the memo is rather interesting: it is supposed to be an outcome of a conversation between Howard and his son, Andrew Marks, also a fund manager, on the evolution of value investing over the last century and how it compares to growth investing. Howard Marks plays the part of discussing the fundamental tenets of value investing, while Andrew Marks is the more modern “growth investor”. I have always been intrigued by how the broader topic of “value vs growth investing” evokes such heated debates in the investment community. It is almost like as an investor you have to plead allegiance to one camp and even a mere mention of the merits of the other camp is considered blasphemous.

While the debate around which investing strategy is better is largely pointless, I think it is important that we understand the salient features behind each school of thought and understand how that will shape our mindsets as dividend growth investors.

Before we go much further ahead, it is important to define what we exactly mean by value investing and growth investing. We will then explore the relevance of both investing schools in today’s world and lastly explore where dividend growth investing fits into this picture.

What is value investing?

Let us hear from the value investing legend, Howard Marks on this topic.

Value investing… consists of quantifying what something is worth intrinsically, based primarily on its fundamental, cash flow-generating capabilities, and buying it if its price represents a meaningful discount from that value. Cash flows are estimated as far into the future as possible and discounted back to their present value using a discount rate made up of the prevailing risk-free rate (usually the yield on U.S. Treasurys) plus a premium to compensate for their uncertain nature. There are a lot of common valuation metrics, like the ratio of price to sales, or to earnings, but they’re largely subsumed by the discounted cash flow, or DCF, method.

Importantly, value investors recognize that the securities they buy are not just pieces of paper, but rather ownership stakes in (or, in the case of credit, claims on) actual businesses. These financial instruments have a fundamental worth, and it can be quite different from the price quoted in the market…

From a definition standpoint, there seems nothing overtly controversial about this description. At the heart of any successful investing strategy, the investor would need to determine the intrinsic or fair value of a business. And if the price offered by the market is at a substantial discount to that of the determined fair value, the intelligent investor would buy knowing very well that he/she is getting a good deal for the dollar spent.

One of the early proponents of value investing, the great Benjamin Graham, practiced and preached a low-valuation style of investing. This strategy, as stated by his disciple and arguably the most successful investor of all time, Warren Buffett, is known as the “cigar butt style” of investing. Howard Marks describes this as follows:

Graham’s style emphasized the search for pedestrian companies whose shares were selling at discounts from liquidation value based on the assets on their balance sheets, which Buffett likened to searching the street for used cigar butts that had one last puff left in them.  It is this style that Graham preached in his Columbia Business School classes and his books, Security Analysis and The Intelligent Investor, which are considered the bibles of value investing.  His investment style relied on fixed formulas to arrive at measures of statistical cheapness. 

There is a key distinction here from the original definition on value investing as stated earlier. Firstly, Graham’s definition solely looks at focusing on companies that are distressed and/or broken for one or more reasons and it talks about an opportunity for an investor to squeeze out every last bit of remaining cash flow out of this business by paying what is a cheap buying price. Secondly, Graham is also in favor of selling out of a business once it has been determined that the business is selling for far above its estimated intrinsic value. This second difference is something that we will discuss a little more later in the post, as it is related to a very important topic: whether one should sell out of a stock that is a winner.

On reading through Buffet’s journey as an investor, it is interesting to note how he first started out in Graham’s footsteps as a “cigar butt” value investor. However, after meeting Charlie Munger, he broadened his definition of “value investing” to instead look for “wonderful companies at fair prices”. This change in mindset and outlook translated into several of his winner bets such as Coca-Cola, See’s Candies, Washington Post, GEICO etc.

What about growth investing?

The growth investing brigade took off during the years of the “Nifty-Fifty stocks” (1960s). As Howard Marks puts it:

This group comprised the fifty companies believed to be the best and fastest-growing in America: companies that were considered so good that “nothing bad could happen to them” and “there was no price too high” for their shares.  Like the objects of most manias, the Nifty Fifty stocks showed phenomenal performance for years as the companies’ earnings grew and their valuations rose to nosebleed levels, before declining precipitously between 1972 and 1974.  Thanks to that crash, they showed negative holding-period returns for many years.  Their dismal performance cost me my job as director of equity research

That said, however, Howard also notes the following:

It’s worth noting, however, that the truly durable growth companies among the Nifty Fifty – about half of them – compiled respectable returns for 25 years, even when measured from their pre-crash highs, suggesting that very high valuations can be fundamentally justified in the long term for the rare breed of company

This is a fairly important point that most growth investors swear by. Their claim is that if they can pick a company that is a “rare winner”, the returns obtained from such a singular investment can easily outpace any gains made by value investors through their investing style.

There is some kernel of truth to this statement. If one were to observe Ben Graham’s investment record, most of his gains were from what is supposedly a “growth stock” called GEICO. Similarly, a large portion of the Warren’s Buffett’s gains are from his investment in Apple, another supposed “growth stock”.

But there is an important distinction in the value and growth schools of investing. The value investor relies heavily on data, he/she wants to look at the existing cash flows, use that to project all possible future cash flows and discount that back to the present value to determine the fair value of a business. The growth investor, on the other hand, typically does not have as much data to play with. He/she is mostly placing a bet on businesses that are currently at a nascent stage and is taking a huge leap of faith in the business model and the viability of it becoming profitable in the distant future.

Are these schools made up or is this distinction even relevant?

As I stated at the start of this post, the debate surrounding which investment strategy is better is largely pointless. In fact, Howard goes on to state that the investing strategies are not mutually exclusive.

Indeed, Buffett states the same point in one of the Berkshire Shareholder meetings:

I think I would agree. Let me give a simple example: Are dividend growth investors, value investors or growth investors? At some level, they are both. Clearly, they are focused on dividend GROWTH and there are popular dividend stocks such as MSFT and AAPL businesses that are still in that phase of their life-cycle where they are still in a rapid phase of growth. These are companies that are spending heavily on R&D and are investing in business segments that are still in their nascent stages. And yet at the same time, dividend growth investors also invest in companies such as PEP or Realty Income, businesses that have been around for a really long time, have stable predictable cash flows. In both cases, dividend growth investors will typically look to buy more heavily when the dividend yield is more favorable. And when is the yield more favorable? When the stock is trading at a reasonable value in comparison to its estimated fair value. That sounds a lot like the value investing definition that was stated previously.

The decision to sell out of winners

An important portion of the memo is around the topic of dealing with winners. As I stated previously in this post, owing to Ben Graham’s “Cigar butt” style of value investing, a lot of investors will sell out of a position when they deem it is overvalued.

Howard writes the following in his memo:

Much of value investing is based on the assumption of “reversion to the mean.”  In other words, “what goes up must come down” (and what comes down must go up).  Value investors often look for bargains among the things that have come down.  Their goal, of course, is to buy underpriced assets and capture the discounts.  But then, by definition, their potential gain is largely limited to the amount of the discount.  Once they’ve benefitted from the closing of the valuation gap, “the juice is out of the orange,” so they should sell and move on to the next situation. 

And this is where, Andrew, is his son, disagrees:

It’s important to understand the paramount importance of compounding, and how rare and special long-term compounders are.  This is antithetical to the “it’s up, so sell” mentality but, in my opinion, critical to long-term investment success.  As Charlie Munger says, “the first rule of compounding is to never interrupt it unnecessarily.”

In other words, if you have a compounding machine with the potential to do so for decades, you basically shouldn’t think about selling it (unless, of course, your thesis becomes less probable).  Compounding at high rates over an investment career is very hard, but doing it by finding something that doubles, then moving on to another thing that doubles, and so on and so on is, in my opinion, nearly impossible.  It requires that you develop correct insights about a large number of investment situations over a long period of time.  It also requires that you execute well on both the buy and the sell each time.  When you multiply together the probabilities of succeeding at a large number of challenging tasks, the probability of doing them all correctly becomes very low.  It’s much more feasible to have great insights about a small number of potentially huge winners, recognize how truly rare such insights and winners are, and not counteract them up by selling prematurely.

This is my perhaps one of my most important takeaways from this memo. And if you look back at this from the perspective of dividend growth investing, Andrew’s assertion to never sell your winners applies here as well. If you sell out of a stock too early thinking that it is overvalued, you have essentially cut the compounding tree at its root. As a dividend growth investor, you miss out on the potential to realize your true yield-on-cost as a result of such an action.

Summary

Howard ends this memo with what are truly some golden words:

The value investor of today should dig in with an open mind and a desire to deeply understand things, knowing that in the world we live in, there’s likely more to the story than what appears on the Bloomberg screen.  The search for value in low-priced securities that are worth much more should be just one of many important tools in a toolbox, not a hammer constantly in search of a nail…. The goal at the end of the day should be to figure out what all kinds of things are worth and buy them when they’re available for a lot less.

The key to understand here is that the fundamental tenets of value investing and the science of estimating the intrinsic value of a business are as relevant in the modern world as they were back in Ben Graham’s day. All intelligent investing needs to rely on this science in one way or the other. But there is also a fine balance and art in determining the quality of business, the effectiveness of its management, the overall quality of the business model and its relevance in the distant future. Successful investors will also need to ponder over these questions before buying a stake in any business.

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