Value, Growth & Intrinsic Investing
“The “intrinsic value” of a security is the maximum price that an investor would be willing to pay to own the security if she could not ever sell it.” –Philosophical Economics
“Intrinsic: belonging to the essential nature of a thing” –Merriam-Webster Dictionary
The world of investing is traditionally divided into growth and value approaches. Growth investors favor buying stocks of companies that are growing quickly while value investors buy stocks that they believe are cheap. But this is a false dichotomy. All else equal, fast growing companies are more valuable than slow growing companies and so any sensible approach to investing will recognize that growth is a component of value, not the opposite of value.
Because of this, at Ensemble Capital we rarely use the phrase “value investing” to describe our process. Many of our portfolio companies exhibit growth rates that are faster than the market and/or display PE ratios and other simplistic valuation metrics that are above the market average.
Instead, we talk about “intrinsic investing”. Intrinsic investing means approaching the investment process by assessing how much a particular asset is worth to us and then paying less than that amount. These assets may or may not be cheap relative to the market or to peers, but they are inexpensive relative to their intrinsic value.
If you forget about the stock market for a moment and just focus on businesses (after all, stocks are just a fractional share of a business), you’ll see that businesses have value to their owners that is independent of how valuable anyone else thinks they are. Businesses generate a stream of cash profits that have various degrees of volatility and risk. Clearly this cash is valuable to potential owners. But each potential owner will value that cash slightly differently.
In this way, the intrinsic value of a company is the price an investor would pay such that the cash return on their investment is satisfactory to them. That is the cash return generated by the business, not the potential return generated by selling the business at some point in the future. This process does not require the input of any other investor and does not require the existence of a market for the business to be traded in.
Our discipline does require that we be able to reasonably assess the intrinsic value of an investment opportunity. All companies have some degree of intrinsic value in that they all offer some probability of positive cash generation. But in practice, the large majority of companies have an intrinsic value that is too difficult for us to assess with the degree of confidence we require. In our view, many self-identified value investors make the mistake of paying statistically cheap prices for assets that have an unknowable intrinsic value.
The three key drivers of a company’s cash generation ability are the return on capital that they generate from investing in their business, the scale of opportunity they have to reinvest profits in order to grow and the degree to which they are able to sustainably utilize debt to lower their cost of capital. For many companies, the highly competitive nature of capitalism makes projecting the future levels of these three drivers almost impossible.
But there are a special class of companies that offer far more predictable futures. Companies with strong and sustainable competitive advantages that provide them with a defense against competition. These companies have the ability to take advantage of the ups and downs of the competitive cycle rather than have competitors take advantage of them. It is these companies which offer a reasonably predictable degree of intrinsic value in which we seek to invest.
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