personal investment blog

Value

Rule 5: Value

The language used by those who offer investment advice frequently assumes that there is a choice between “growth” and “value”. To state it in the most basic way, growth is implied to be smarter and value more cautious. I could make some arguments defending this distinction but I’m not going to bother because ultimately I believe it to be at best pointless and at worst damaging.

Good value is what we want when we look for investments. Growth is sometimes a means to future value, but when the word is applied to an investment opportunity the subtext is usually “this is expensive, but….” Growth is dangerous as an investment aim because it implies that someone has a gift for seeing into the future. If the “XYZ Growth Fund” into which you had just entrusted your pension were renamed the “XYZ Clairvoyant Fund” you might suddenly find yourself feeling nervous.

Of course, something with great growth potential can be excellent value. It depends on the probability of success implied by its price. In the so-called dotcom boom, when, at best, one or two companies in ten were going to be viable (capable of independent sustained life), pretty much every share was priced as if ultimate success was a probability.

For business, there is a real trade-off between present cash flow and future cash flow. A commitment to grow, which usually happens in economic good times, invariably involves investment which either means that shareholders’ dividends are frozen or borrowing is increased. When companies get nervous and stop investing (see 2009 onwards), free cash flow (that which is left over after capital investment) grows, debt falls and the companies look cheaper. Frequently, share prices fall and the cheapness is enhanced.

By cheapness, I mean that you get more (cash flow) for less (lower share price). Nothing is cheap per se. Everything is cheap relative to something else. The simplest “something else” is itself at another time (a comparison naturally much favoured by third rate stock analysts). When the prices of goods are cut, they are cheap compared to how they were before.

When share prices fall, the shares are getting cheaper, all other things being equal, relative to how they were before. This is usually what is happening when stocks markets fall. Occasionally there is some material bad news about a particular company or sector that makes it quite obvious that a share price had been implying prospects that have become unrealistic. In these cases, the price may not fall enough to make the share cheaper.But most stock market sell-offs are effectively crowd behaviour that seems to assume that everyone’s prospects have deteriorated simultaneously and indiscriminately. The probability that this is correct is not zero but it can’t be much better than zero. Substantial downward moves in stock markets are often golden opportunities for serious investors to seek out value. Needless to say, the opposite applies and bull markets produce valuations that look too high and vigilance is recommended.

Warren Buffet says: “Be fearful when others are greedy and greedy when others are fearful”. This is sound advice though it helps to be rich enough to take advantage of low prices induced by the panic and insolvency of others. In the 19th century the phrase was “buy when there’s blood on the streets”. But that came from a Rothschild who, like Buffet, had access capital in fearful times. I would add that optimism and pessimism are attitudes that should be excluded as much as possible from any investor’s decision. Human nature makes this an impossible aspiration but the knowledge that one will never be completely successful is no reason not to try.

When comparing an asset’s value in the simplest possible way i.e. to itself on other days or years, you can use any measure you like. If you feel comfortable and do the work, go for it. Someone might argue, for instance, that the value of a business is higher as the proportion of women on the management board increases. Others might look at the funding of its pension scheme or the number of pages in the annual report. These might be eccentric measures but this is as much an art as a science. Just make sure that if you decide to count the pages, you do it properly.

More commonly, stockbrokers and newspaper use measures of reported earnings like earnings per share (P/E ratio) or adjusted operating profit that treats all the bad stuff as excludable accounting technicalities (EBITDA). The problem with the reported profit and loss accounts is that there are too many legal ways to put a positive bias on them. Research analysts can and do re-adjust them but it is long, difficult and frequently unrewarding work – there are plenty of examples of company executives making life uncomfortable for analysts who publish work considered to be hostile.

Ultimately all that matters to me, the investor, is how, how much and when? 1) How do I get my money out? 2) How much money is mine? 3) When do I get it? Valuations weigh these three factors and no others.

Most of us understand that there is a trade-off between 2) and 3). In bond markets this is known as the “yield curve” and the normal driver of this curve is the idea that investors who lend their money for longer periods earn a better return. This seems fair enough. On the occasions that this “normal” state is reversed and the yield curve is said to be “inverted” – when a better return can be obtained by lending for short periods – it is generally the case that the borrower is experiencing some financial difficulties. Inverted yield curves for government bonds are said by economists to predict recessions – investors see bad economic news ahead and become less inclined to lend in the short term (demanding higher interest rates) but accept that they might have to settle for lower returns in the long term (as the effects of the recession play out). A starker and much nastier example is that of so- called door step lenders (and arguably credit card companies) that penalise people who are in immediate financial distress with interest rates that, when annualised, are nothing but usurious.

In my view, though, equity investors pay far too little attention to: 1) How do I get my money out? That is the subject of the next section, “competing assets”.

Rule 6: Competing for assets