Quality Companies vs Cheap Stocks
In our post explaining the concept of intrinsic investing we said that we rarely describe our approach as “value investing” since many of our portfolio holdings trade at valuation multiples that are higher than the market average and exhibit growth rates that are faster than average as well. Yet, we also said that our approach focuses on assessing how much a particular company is worth and then investing only when we can buy the company’s stock at a discount to our estimate of this intrinsic value.
The way to solve this seeming paradox is to realize that much of what people think of when they hear the phrase “value investing” comes from the early texts of Ben Graham and others who helped to define the concept. This early version of value investing was based on the idea that the value of a company was nothing more than the worth of the assets it controlled. What you saw on the financial statements is what you got and therefore, it was foolish to pay a premium for one company’s assets when you could pay a discount for a seemingly similar set of assets controlled by another company. This led to Graham and other early value investors to focus on buying stocks that were cheap relative to their book value (the value of their assets minus their liabilities).
Over the years, as companies began to rely on intangible assets (patents, intellectual property, brands, etc) to drive profits, the definition of a cheap stock evolved to consider other valuation metrics such as price-to-earnings and price-to-sales ratios. But at its core, the concept of value investing remained focused on identifying cheap stocks. This approach to investing primarily defines good investment opportunities based on statistical measures that relate the price of a stock to the financial statements of the company.
But another approach to investing also arose during this time. While Warren Buffett is popularly known as a value investor and is the most famous student of Ben Graham, Buffett was greatly influenced by Phil Fisher (a growth investor) and Charlie Munger (an investor who focuses heavily on the quality of the companies in which he invests). While Buffett evolved under the influence of Fisher-Munger, the truth is that many self-proclaimed value investors, even those who view Buffett as a sort of demi-god, still pursue a Ben Graham “cigar butt” approach to investing (Graham liked to say that even a discarded cigar butt found on the ground still had one good puff in it and since it was free, it was a good bargain compared to buying a new cigar).
To see clearly just how different Charlie Munger’s approach is to Ben Graham, check out this amazing discussion on the excellent 25iq blog authored by Charlie Munger expert Tren Griffin, which includes such Munger comments as:
“I don’t love Ben Graham and his ideas the way Warren does. You have to understand, to Warren — who discovered him at such a young age and then went to work for him — Ben Graham’s insights changed his whole life, and he spent much of his early years worshiping the master at close range. But I have to say, Ben Graham had a lot to learn as an investor… I liked Graham, and he always interested and amused me. But I never had the worship for buying the stocks he did.”
In proclaiming ourselves intrinsic investors, we do not seek to claim that our approach is wholly unique. Many of the great investors long ago left traditional value investing behind to pursue higher quality companies, even while continuing to seek to purchase these stocks at a discount to their intrinsic value (if not a discount to their book value). But with the practice of investing still generally delineated into the false dichotomy of growth vs value investing, we think it is important to explicitly make clear that our approach is not well captured by this outdated framework.
One outstanding investor who we think has done a fantastic job of explaining this distinction is Sanjay Bakshi, a professor at top Indian business school MDI, a successful professional investor, and author of the Fundoo Professor blog. In an interview last month with The Motley Fool, Bakshi laid out how different a “Graham & Dodd” investor (Ben Graham and David Dodd, his co-author of the value investing bible, Security Analysis) is from a Munger/Fisher investor (Charlie Munger and Phil Fisher, referenced above):
“One of the most important pillars of value investing is the idea of margin of safety. But where does margin of safety come from? For a Graham-and-Dodd value investor, it comes from asset value, or from earning power over the purchase price, which is high in relation to a AAA bond yield. There is far less focus on the quality of the business or the management.
For a Charlie Munger/Philip Fisher type of value investor, the margin of safety comes from the ability of a business to deliver high returns on invested capital over time, and that comes from durable competitive advantage usually created by exceptional people. This type of investor does not hesitate in paying up for quality. But, by no means does this have to mean that he or she is overpaying. And the way to figure out whether this type of investor has overpaid or underpaid is not by focusing on P/E multiples based on historical earnings. The way to figure it out is by comparing the price paid by him or her with the earnings delivered by the business many years later. To be sure, paying high multiples of near-term earnings will make sense only if future earnings will be significantly higher than at present. So, the focus should be on long-term earning power and not current or past earnings.
In a sense, the classic Graham-and-Dodd investor believes in mean reversion. For him or her, bad things will happen to good businesses, and good things will happen to bad businesses. For a Charlie Munger/Philip Fisher kind of investor, the kinds of businesses he or she invests into have fundamental momentum — that is, a probabilistic tendency to continue to deliver exceptional performance. In other words, these businesses do not conform to the principle of mean reversion — at least not for a very long time — long enough for them to become great investment candidates at the right price.
Now, momentum is a dirty word in value investing, but it need not be because I am talking about momentum in fundamental performance of businesses and not momentum in stock prices (although the former tends to create the latter). The Charlie Munger/Philip Fisher type of investor does not completely disagree with the idea of mean reversion that Graham-and-Dodd investors cling to. Rather, the Charlie Munger/Philip Fisher type of investor knows that there are some businesses that prove to be truly exceptional, where there is a persistence of high quality for long periods of time. And he or she chooses to focus on those and those alone. And when she finds them, she does not hesitate in paying up a bit for such outstanding businesses.
So, in a sense, among value investors, there is sort of a clash between two different ideologies in value investing — mean reversion and momentum. And both ideologies are correct in my view. For most businesses, mean reversion applies, but for some exceptional ones, it applies after a long long time, and until then, momentum applies.”
In other words, the intrinsic value of most companies is not particularly knowable and most company’s performance will soon revert to the mean. Therefore, investors should be cheap and just look to buy those stocks that trade at a big discount to current company results. But for some exceptional companies — and these are the companies in which we seek to invest — “there is a persistence of high quality for long periods of time” and so investors in these companies should rationally pay a relative premium for these stocks in relation to their current results.
This is why our investment process starts not with looking for cheap stocks, but with looking for companies (like the one we profiled last week) that benefit from entrenched competitive advantages and business models that produce significant and growing volumes of distributable cash flow.
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