There is far more to value investing than simply analysing ratios, argues Luis García Alvarez.
The growing dominance of high-growth companies over the past three years has led to a significant number of articles suggesting that value investing is dead and does not make sense any more.
The fundamental problem with such articles is that many commentators often tend to regard value investing as a statistical and accounting factor rather than an investment methodology. This is a fundamental misunderstanding of how good value investors go about their work.
We all know that value as a factor has been suffering over the past decade, but I would argue, value as a methodology has not stopped making sense at any point.
Many critics see value investing as the old way of investing and often hark back to the “guru” of value investing, Benjamin Graham. In fact, this is misplaced as he never referred to his ideas as “value investing” but “intelligent investing” - the investor’s ability to learn, understand and make clever decisions. The term “value investing” came about in the interpretation and evolution of Graham’s investment philosophy, whereby value investors try to buy assets that trade at a price that is well below their intrinsic value. In doing so, they look for a “margin of safety” - a simple principle that is difficult to criticise.
Where critics make their biggest mistakes is to suggest that what drives value investors is to look for stocks that appear to be cheap from a statistical or accounting point of view. In other words, suggesting that their main concern is to find stocks that appear mispriced according to a trading multiple such as price to earnings or price to book value. This is incorrect - there is far more to value investing than simply analysing ratios. Rather, there are serious principles which need to be adhered to, of which the “margin of safety is but one”. We are all aware of value investing’s “circle of competence” (you should invest only in businesses that you can really understand), but there are other principles, such as what constitutes risk, which are equally, if not more important.
Traditionally, the financial world associates risk with statistical volatility. This is not the case with value investing, which sees volatility as a friend that creates situations where the probabilities of finding undervalued stock increases significantly.
For example, amid the current Covid-19 pandemic, when stock markets have experienced extreme volatility, rationalism has given way to fear and panic with the consequent loss of ability to identify the right companies with the right business model, and strong balance sheets.
For those who stick to their principles, remain calm, patient, and committed, they continue to make the right match between prices and economic fundamentals. As a result, huge opportunities will inevitably open up to them.
Of course, news of the death of value investing has been promoted a number of times in the past and yet detractors continue to be proved wrong. My friend, George Athanassakos, professor of finance and the Ben Graham chair in value investing at Ivey Business School at Western University, in Canada, recently wrote an article: “Is this the end of value investing or the beginning of a golden period for value stocks?”, in which he demonstrates that value investing “seems to have shone after long periods of underperformance”. Professor Athanassakos goes on to suggest that “we may be at the threshold of a golden period [of] value investing once more”.
Central to understanding why value investing eventually bounces back is that while the principles are written in stone, the strategy is not static and adapts to changed circumstances. Take, for example, Warren Buffett who was very much seen as a deep value investor in his early days, but is now seen as a quality value investor with names such as Apple and Amazon in Berkshire’s portfolio.
The US investor Charlie Munger argued that intelligent investors do not distinguish between value investing and growth investing, and that profit growth is something that should be considered when you try to estimate a company’s intrinsic value. Growth can even be seen as part of the margin of safety that investors need to invest in a company.
So, value investing is not just about analysing companies by looking at their trading multiples, but about adopting and sticking to fundamental principles that drive intelligent investing. These principles, which lead us to find the best companies, have been shown to have stood the test of time and, in my opinion, will once again prove to be the best long-term option for most investors.
Luis García Alvarez is portfolio manager at Mapfre Asset Management.