Benjamin Graham is the founder of value investing with his 1949 book The Intelligent Investor. He has famous followers, including Warren Buffett, Seth Klarman, Mohnish Pabrai and Joel Greenblatt. Graham made sure that investing was no longer equated with speculating, but with investing in companies based on their intrinsic value. Henceforth, it looked at the value of a company based on profits, assets, liabilities, cash flows, etc.
Graham argued that all investment decisions should be made on the basis of value and not price. Buffett summed this up with ‘price is what you pay, value is what you get’. Fama and French came up with the value factor in 1992. By buying undervalued shares and holding them until they reached intrinsic value and selling overvalued shares until they too reached their intrinsic value, a positive value premium could be collected.
That worked well, until 2007. Indeed, what was missing from the calculation of the traditional value premium was the growth potential of the underlying company. Buffett - prompted in part by the late Charlie Munger - has long since stopped distinguishing between value and growth. For him, growth is part of the value calculation. Unlike Graham, since his meeting with Munger, Buffett no longer bought mediocre companies at low prices, but only great companies at reasonable prices.
Deep value until 2007
Yet even undervalued mediocre companies outperformed the market average over the long term until 2007. Graham’s formula worked. That was because it was precisely in these underperforming companies that operational improvements had the most effect. Those improvements included the principle of mass production, the Six-Sigma principle that became best known through GE’s Jack Welch, the just-in-time principle, etc.
Japanese had elevated such operational improvements to a true art. They may not have been creative enough to think “outside the box”, but under the banner of Kaizen, they were excellent at perfecting “what’s in the box”. It is not for nothing that traditional value investing in Japan still seems to work more often today outside Japan.
Disruptive innovations
The traditional mediocre value companies, which were so good at benefiting from operational improvements, were sidelined from 2007 by a new phenomenon called disruptive innovation. Now that phenomenon is similar to a much older one called creative destruction from the Austrian school. But it was only with the advent of the internet and the elimination of trade barriers that the strong network effects allowed disruptive innovations to outpace existing companies in a short period of time.
Before then, changes were still slow enough for mediocre companies to catch on, but that was suddenly over. New products and new companies quickly went viral worldwide. Thanks to the internet, there were “no barriers to entry” which allowed disintermediation (internet kills the middle man) to push aside entire industries where “winner takes all” mainly applied. Mediocre value companies were now mainly the victims.
The new value
One drawback of the traditional value concept is that it looks back too much and not forward. A value investor prefers to look at realised gains. This is because it is difficult to properly determine and value future growth, which is more likely to result in unjustified discounts on a company’s intrinsic value. Such a discount or margin of safety is an almost ingrained part of value investing. Disruptive innovations also mean that seemingly out of nowhere, new technologies suddenly take over the market. That future is hard to read from the current valuation for a company.
Twelve years ago, I tried to explain that at 120 times earnings, Amazon was not expensive at all, also because much of the cash flow was reinvested back into the company. Only when the listener understood that most of the investments were going into something called the “cloud” did they drop out. Apparently, imagination and value investing do not mix well. Still, the new value investing will have to adapt by looking more at the soft factors that are indicative of future success. These include intangible assets such as patents. These turn out to be worth much more than obsolete tangible assets.
A company’s human capital is also difficult to value, but the art of attracting and retaining talent is often the starting point of disruptive innovation. So that means companies where you get free caffè lattes, you are given the opportunity to catch Pokemons at work and where you can take your dog to work should suddenly score higher on value lists.
Retargeting with artificial intelligence
Value investors do not invest in the Magnificent Seven, or it should be Meta after the 2022 share price drop, perhaps helped by the fact that Mark Zuckerberg was then the most hated American (after Donald Trump). The Magnificent Seven is all about enabling artificial intelligence. They are the so-called “enablers”, but the big money falls to the adopters after that.
The companies that benefit most from artificial intelligence are, in part, mediocre value companies. Companies with lots of staff doing boring and mind-numbing work are suddenly interesting because of the huge potential for savings. Artificial intelligence is Mass Production, Six-Sigma, Just-in-Time and Kaizen in one, a big operational improvement. Still, a golden future for value.
Han Dieperink is chief investment officer at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co.