Value investing – stocks on the rocks
Following a recent post on growth stocks, Harold turns his eye to the so-called ‘value’ style of investing. He argues that true value investing is less about specific financial ratios than about the insights to be gleaned through the synthesis of broad context and specific details of companies that have hit hard times.
Recently, I argued that nature held important clues for identifying longer-term ‘growth stock’ winners. An alternative style, so-called ‘value’ investing, can be defined as finding attractively priced stocks based on filters such as low price-to-earnings (P/E) or price-to-book (P/BV) ratios.
That might have been the case decades ago, but today, both earnings and book value can be deceptive for estimating economic value. We need other pointers to help us.
A metaphor to start thinking about this is to imagine a rudderless ship caught in a storm, drifting perilously towards the rocks. If it is not rescued, the ship is doomed to take in water and eventually sink. Our own shorelines testify to many such tragic events.
The corporate seascape is no different, with some companies gradually drowning in the so-called ‘value trap’. Eventually, investors are left to pick up the pieces of these failed wrecks.
So, how can investors assess the likely survivors of corporate ventures in trouble on the high seas? Three signals are crucial: the experience of company management, the nature of the storm, and the underlying ‘cargo’ reflected in a company’s asset base.
“Three signals are crucial: the experience of company management, the nature of the storm, and the underlying ‘cargo’ reflected in a company’s asset base.”
The word ‘expert’ is commonly misused in the English language to imply someone with a high level of abstract knowledge in a specific area. In fact, the word is derived from the Latin expertus, best translated as ‘gained from trusted experience’.
An example of such an expert is a ship’s captain, whose know-how has been accumulated over years on the high seas. These individuals are less likely to panic. They retain the trust of their crews when hurricanes are howling. In a similar vein, companies in trouble need experienced senior managers who know how to keep their businesses afloat.
So, the first rule for the would-be value investor is to know your captain!
From there, perhaps the single most important piece of analysis for the investor is to assess the storm itself, to understand its maximum ferocity and likely duration. In economic terms, this means assessing whether it is cyclical or secular.
“Sometimes, smart investment means doing nothing – there is value in waiting.”
In the former case, for companies with trusted management teams, the investor should sit tight. There is no point in being disturbed by current market doldrums. Sometimes, smart investment means doing nothing – there is value in waiting. Warren Buffett’s mantra, which says that in the short term the market is a voting machine but in the long term it is a weighing machine, is a useful aphorism to keep in mind.
In the latter case, rather a different course of action is required. Again, to paraphrase Buffett, if you find yourself in a chronically leaking boat, the energy expended on changing vessels is likely to be more productive than the energy devoted to patching leaks. So, in this case, it is time to head for the lifeboats.
The key here is to understand the ship in detail – in corporate terms, its so-called ‘assets in the ground’. How are they being used, and which ones might be repurposed, if salvaged? Ditch unneeded load. Companies can sometimes be saved by abandoning the past to enable a new future. Again, experience is key, the arbiter between imagination and delusion in corporate restructurings.
It is true that crises bring investment opportunities. To benefit from the latter requires attention both to broad context and to narrow detail. This is hard work, as often we focus on one without the other. However, it is the synthesis that is the secret, something any experienced seafarer or CEO can appreciate.
Budding investors could do worse than to reflect on Samuel Taylor Coleridge’s Rime of the Ancient Mariner as they learn the ropes, rather than tying themselves in knots with outdated financial ratios.
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