Value Is Where You Find It
In elementary terms, value investing means investing when you feel the price is below what it should be. This value philosophy has created many successful billionaire investors like Seth Klarman, Warren Buffett and others. It’s an intuitive philosophy. One should always seek to invest at levels consistent with the value concept. The challenge today is many traditional metrics of value no longer apply due to the pace of innovation and an instantaneous global internet. There are new ways to look at our rapidly evolving world. Here’s how we look at quality and value when investing:
The names have been productized
The terms “growth” and “value” are marquee brand names on Wall St. There are hundreds if not thousands of investment products labeled with variations of those two terms. According to the Russell indexes, growth tends to be defined by growing revenues and value, by lower valuations.
These brand names do us all a disservice. Of course, we want to invest in companies with growing revenues. We also want to invest in companies at lower valuations with the hopes those valuations rise in the future to match their peers.
Take a look at what these two categories own. The top holding of the Russell growth fund (IWF) is Apple. The top holding of the Russell value fund is Berkshire Hathaway (BRK.B) run by Warren Buffett, which is over 20% Apple stock. As the title of this article states, value is where you find it. Warren Buffet found value in Apple stock, one of the all-time top growth stocks and a position that has made him nearly $100B in paper gains. It’s the most profitable investment of his career, by far, and it may be the most profitable investment ever by a professional investor.
There are a large number of interacting elements in the financial markets leading to the behavior of stock prices. Social factors, technological advancements, economic progress, political noise, asymmetric or incomplete information, and idiosyncrasies of investors all add to a complex web of market prices. One way to cut through this noise is to use complex systems theory as a framework for markets. Emergence is a key concept of complex systems.
Today we are witnessing the emergence of technology and innovation. This emergence is a trend that will last, not a fad or a temporary shift in popularity. Emergent technology is changing the way investing is done today as the business models today have much higher profit potential than before and the economics of the winners have never been better. Scaling a business has never been faster and competitive advantages have never been stronger.
The growth of many innovative companies today is governed by network effects. Network effects lead to exponential growth, rather than linear growth. Exponential growth can be very difficult to predict and model with real accuracy. The difficulty of modeling the growth of technology has kept many traditional value investors away, which has caused them to miss out on incredible gains. Value-minded investors should consider that the growth of technology businesses comes with an unpredictable upside that can be well worth an increased tolerance for uncertainty.
The focus on the predictability of return can cause one to miss rapid growth. As long as today’s companies can grow at rates exceeding the cost of capital and risk free rates, they can increase in price exponentially.
As we have written before, intangible assets have been rising steadily for decades. A new type of valuation is necessary to understand today’s investments that include conceptual assets. Many of today’s so-called expensive stocks that continue to rise in price tend to have a high degree of intangible assets. Brands, customer networks, engineering talent, quality leadership also first-mover advantages all contribute to large intangible values that tend to convert to economic success. Consider Elon Musk’s fervent fanbase as another form of a non-traditional intangible asset for Tesla and his other companies.
Determining risk tolerance
We still have to withstand bouts of selling, crashes, volatility, panics, fraud, bursting of bubbles, so on. One way to better understand your risk tolerance is to define your essential, important and discretionary expenses. We can use that information to build a protective reserve that will always be there to cover expenses under all scenarios. We call this liability-driven-investing. The rest, the excess resources, can be invested into productive assets with the knowledge that you are protected from various market scenarios.