Why Value Investing? (4 mins)
QAV is a form of value investing.
Here’s how Tony explained value investing on one of our episodes.
Tony: I think if you take it back to first principles, all investing is value investing. We’re all trying to buy something today which we think is undervalued and will be worth more in the future. But there are different ways of doing that. And then there are people who focus on growth. So, they’re looking for companies which they think will grow quickly. There are people who think that the best way to invest is to buy the quality stocks, and they don’t really care about the price as long as the company is a high-quality company.
And there are people who kind of do a bit of both and they’re called momentum investors. So, they follow the trends in the stock market. But a value investor is looking for things that sell for less than what’s called the intrinsic value. And that’s the kind of rub, as you’ve got to work out what the intrinsic value is. And you’ve got to find the undiscovered companies, so to speak, that are trading below what they really should trade for. That’s what value investing is.
Cameron : So, how does Warren Buffett fit into this, Tony?
Tony : Well, he’s probably the most famous value investor. There are others, but he’s been around for a long time. The guy was born in 1930. He has a partner called Charlie Munger (born 1924), who’s even older, and they’ve been doing it since the fifties and sixties. Buffett learned at Columbia University at the feet of a guy called Ben Graham, who, along with his colleague David Dodd, wrote a book called Securities Analysis. And that led to the concept of intrinsic value and to some of the concepts that Buffett has continued to teach, like the fact that price is what you pay and value is what you get. And in the short term, the market is a voting machine, but in the long-term, it’s a weighing machine.
Cameron : What does that mean? Can you explain that?
Tony : Yeah. So, a stock market is a market, it’s people coming together to buy and sell products. And in this case, the product is a company. And so it’s subject to all the kinds of psychology and whims of human nature that we encounter every day. And that’s why in the short-term, it’s a voting machine. So, shares and their prices will move according to how people vote with their feet in the short-term. But in the long-term, a share price of a company should represent what its intrinsic value is. And we’ll have to talk in detail about what that means, but basically, the weighing machine comes into play in the long-term. So if, for example, BHP is a good company, even though it’s being sold off at the moment (note: this was during the COVID crash of early 2020), eventually the share price will trackback to what it should be to reflect the accurate value of BHP.
Cameron : I remember a quote from Buffett: “If a business does well, the stock usually follows.” That’s basically my understanding of value investing at a very simple level. It is looking for well-performing companies, good quality companies that are well-managed, have a good business, good prospects for the future, they’re making cash, and it looks like they’re going to continue to perform well for the future. Because generally speaking, the shares of those companies will do well. And then the second component of it is buying stocks in those companies when you can get them at a reasonable price. You work out what you think the value of that stock is on any given day and then you try and buy it at a discount to that. And that’s basically it.
Tony : Yeah, that’s right. There’s a lot of things to unpack in those simple statements, but essentially what I do is try and marry some kind of measurement or rating of what the quality of a company is with a rating or analysis of how discounted the share price is to what I think it’s worth. And just more on Buffett, I mean, the guy’s been investing for a long time. So he has gone through a couple of iterations of that whole process. Early on in his career, he was focusing on more of the value side of things and paying less attention to quality. Then he teamed up with Charlie Munger who convinced him to pay more attention to the quality side of things.
We should point out that Munger ran an investment partnership of his own from 1962 to 1975 which generated compound annual returns of 19.8% during the 1962–75 period compared to a 5.0% annual appreciation rate for the Dow.
After Warren teamed up with Charlie, he went from trying to buy things at deep discounts to paying a fair price for a quality company. And now he’s probably more focused on the quality side of things. How can I preserve my capital going forward?
Cameron : Because now he’s spending billions of dollars to buy large chunks or entire chunks of business, he’s not just trading on the market as you or I would.
Tony : Correct.
Cameron : It’s a different kind of game.
Tony : Most of these investments are outside the share market now, even though it’s still a big part of Berkshire Hathaway, which is his company.
Cameron : And one of the things I’ve learned since we’ve been doing this show is that value investing goes through cycles in terms of its popularity in the market. There will be a period of a bull market, a booming market, that typically lasts 5-7 years, during which people aren’t interested in value investing, generally speaking, they think it’s boring, because it looks at boring things like business fundamentals.
They prefer to put all their money in tech stocks, high growth stocks that would never get through your checklist because quite often they’re either losing money or their P/E (price-to-earnings) ratios are too high and a variety of other things. And their future is uncertain, but their share price is going up, up, up. And so people jump on board and they think value investing is boring. Then, eventually, the market crashes. And, if I understand my history, value investing will then become a little bit more valued by the market over the next five years. But eventually the market will get back to an exuberant cycle again, where it’ll hit another boom time and people will be again think value investing is stupid and boring.
But what I’ve learned from you is that, yeah, some people make money during boom times by jumping on bandwagons, but then they tend to lose money more than they make. It’s very difficult to find anyone who isn’t a value investor who has produced consistent roughly 20% returns, year in, year out, over decades, outside of value investors.
Tony : Yeah. I’d agree with that. There probably are exceptions, and obviously, the venture capitalists in Silicon Valley may have had similar results from investing in tech stocks or better results from investing in tech stocks. But mostly the successful long-term investors are value investors.
Cameron : I’m talking about regular people investors.
Tony : Yeah, that’s right, regular people investors. And just to unpack that a bit, I mean, we saw it happening in 2019. This is what happens. Maybe it’s an indicator of the top of a bull market. If you look at when value funds start going down, within about two or three years the market crashes, because of people especially new to the share market who jump on board without knowing what they are doing and all of that money drives the markets higher and higher until it becomes overvalued and crashes. This time it was millennials who were going out saying “20%?! I have a mate who bought into Afterpay at five bucks and he’s made 250% year on year, blah, blah, blah.”
And I could name any of the other tech stocks in the WAAAX in Australia or the FAANG companies in the US and it’s true, but when the cycle turns down, most of them crash worse than the rest of the market. They’re going to be starved for capital going forward and start to eat up all their cash. And that’s when you hang on for the white knuckle ride, and it’s the people who have followed that trend and thought that 20% year on year wasn’t good enough who are probably locked into those stocks. And they may recover, but a lot will go broke.
Cameron : And we should point out that the stock market, like every other market, trades on the fact that there are whole generations of new investors coming in every few years who are greedy and impatient and want to make quick returns. There are a lot of old-timers out there that smell new meat and take advantage of that. And it’s the old dogs like you, the old fuddy-duddies, who just stick to basic time-tested principles that have worked for Warren Buffett and Charlie Munger for 60 years.
Tony : And they’re still around and still going and they’re in their eighties and nineties and incredibly wealthy. And they sleep well at night.