“Of course, the truth of our generalizations is dependent upon the validity of our concepts. An invalid concept is a red light to induction; it stops the discovery process or actively leads to false generalizations.
Recall the concepts of “natural” and “violent” motion in Greek physics. These concepts made a fundamental distinction between motions that are in fact similar; for example, smoke rising in air is regarded as “natural” but wood rising in water is regarded as “violent,” and a ball swung around on the end of a rope is moving “violently” but the moon orbiting Earth is moving “naturally.” On the other hand, they group together motions that are very different; for example, rising smoke and falling rocks are both moving “naturally,” and a ball swung in circles and another ball with constant horizontal velocity are both said to move “violently.”
Such concepts cannot be reduced back to observed similarities and differences. They are juxtapositions rather than valid integrations, and therefore it is impossible to reach true generalizations among their dissimilar referents. When the Greeks tried to generalize, they were led into a series of falsehoods.”
The Logical Leap: Induction in Physics – David Harriman
Like the ancient Greeks, the modern investment industry has a debilitating conceptualization problem stemming from historical accident and perpetuated by confusing terminology.
Last weekend’s WSJ article by Jason Zweig is the latest to bemoan the decade-plus relative underperformance of value stocks relative to growth stocks.
Zweig cites a recent study by Rob Arnott at Research Affiliates. The study’s conclusion focuses on ‘bad luck’ as the cause of the relative underperformance and suggests that the expected returns of value strategies are as close to as attractive as they’ve ever been.
Yet as Warren Buffett has pointed out countless times, growth is part of valuation. From Buffett’s 1992 letter to shareholders: “Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
Growth is not strictly an input into valuation except by the convenience of the valuer. If one knew the future cash flows of a security (as for a fixed income instrument) one would simply input those precise cashflows into the discounted cash flow model. The growth of those cash flows, a relative comparison from one to cashflow to the next, is a descriptive element. It’s only because of convenience that growth is usually chosen as a driver in DCF models. Growth is a component of value like height is a component of a person.
Note Zweig’s implicit perspective on the growth-value issue: “value stocks should eventually outperform simply because their shares are cheaper.”
Just as the Greek’s use of ‘violent’ motion to conceptualize dissimilar phenomenon led them into a series of falsehoods, so the term ‘cheap’ leads many investors into the same trap. The concept ‘cheap’ is an invalid package deal- a misintegration of fundamentally dissimilar items that are grouped together because of an unimportant similarity. Both securities that are priced low relative to their immediate cash flow and securities that are priced low relative to their intrinsic value are subsumed by the concept despite being very different phenomenon.
There is a superficial similarity between the two types of ‘cheap’ in that they both designate that a security is priced low relative to some standard, but those standards are not the same and shouldn’t be equated. Zweig uses one kind of cheap in one context, and the other kind of cheap in a separate context, and then draws a conclusion based on their false equivalency.
The word ‘cheap’ is used both ways in common parlance, but context generally makes clear what the speaker means. When John says that his used jalopy was really cheap, it’s understood that he probably means that its cost was a low absolute dollar amount. When Sally says she got her new Lamborghini for really cheap, she probably means that it was inexpensive relative to the value of the car and not a low absolute dollar amount. This works fine for everyday life, but the investment industry requires more precise concepts than the man on the street. Imagine the state of physical science if it had not moved past the concept of ‘weight’ to the more precise concepts of ‘mass’ and ‘acceleration’.
Unfortunately, the confusion doesn’t stop at ‘cheap’.
Ben Graham’s contributions to the science of investing were indispensable. Intrinsic value, margin of safety, a focus on fundamental analysis, and the Mr. Market metaphor were tremendous contributions to the field. His practice of earning excess returns by purchasing securities below their intrinsic value came to be known as value investing. Graham also identified a repeatable process for identifying such securities. By selecting among low-multiple stocks, investors had a superior chance of finding securities trading below their intrinsic value. The process was so powerful that a generation of investors was able to find great success by implementing a similar process. By selecting low price to book stocks out of Value Line, Walter Schloss beat the market by an astounding 12.9% a year for over 28 years. That was despite owning over 100 positions at any given time.
Certainly, there were some high-multiple stocks that were undervalued in Ben Graham’s time, and in some other universe it could have been that higher multiple stocks was the more lucrative pond to fish in. But for whatever reason (psychology? financial ignorance? institutional imperative? Non-disruptive period in the economy?), it was the low multiple stocks that contained more than their fair share of undervalued securities. Or at least, it was the low multiple stocks that were easier to identify for quantitative reasons. Value Investing developed with a deep connection to low multiple stocks, which became known as “value stocks”. By sharing the word ‘value’, ‘value investing’ and ‘value stocks’ are victims of the same conceptual problem as ‘cheap’. The undervaluation of a security and a low multiple are two different phenomenon that need to be separated to think clearly.
Fama and French argue that the outperformance of the Value Factor (ie. low multiple stocks) is compensation for the higher risk of those stocks. That seems theoretically plausible, yet many in the traditional value camp claim that the lower multiple stocks are actually safer because you are paying less for a piece of the future. Applying the claim to fixed income reveals how little sense this makes. Would anyone claim that high yield bonds are safer than treasuries because the yield is high?
And like treasuries, some common stocks trade at low yields/high multiples for the exact reason that they are less risky. Utilities and consumer staples have often traded at higher multiples despite low growth because their cashflows are predictable. You can characterize low multiple stocks as ‘paying less for a piece of the future’, as Zweig does, but that future may be far worse than you predicted.
While the future for many growth stocks is difficult to predict, there are also growth companies with greater cash flow predictability than some no-growth companies. In other words, there’s nothing intrinsically unpredictable about growth. Macy’s revenue hasn’t changed much over the last five years while Visa’s revenue has almost doubled. Yet it’s far easier to have confidence around Visa’s 3 year forward cash flows than Macy’s 3 year forward cash flows. Companies dependent on a commodity price are also frequently slow growing businesses that are difficult to predict.
The Future of the Value Factor
There are only two reasons that low multiple stocks could have outperformed historically. One is that they outperformed because they deserved to, or in other words, because they were properly valued but riskier. The other is that they outperformed despite not deserving to, or in other words because they were undervalued.
If the former is the case, it seems likely that we will see a return to the long-term outperformance of low multiple stocks as compensation for additional risk.
If the latter is the case, it seems likely that the systematic undervaluation is gone (or leaving) as a durable phenomenon. It’s very hard to imagine that 150 years from now there will be investors buying low multiple stocks and outperforming everyone else with the same or lesser risk.
It feels like inauspicious timing to be making a conceptual case for higher multiple stocks since valuations do appear stretched, particularly in specific corners of the market. It also feels like we’re in a period where an appreciation of risk isn’t being properly compensated for. And none of this is to say that the low multiple stocks won’t outperform higher multiple stocks in the immediate future or even over the long-term, but it is to say that nothing of importance turns on that happening. Buying securities for less than they’re worth will always work eventually.