The term "value investing" is one of those words where the more you think about it the weirder it becomes. What is value after all? It seems anything can be value investing, because value is in the eye of the beholder.
Security Analysis author Benjamin Graham made the comment in his book Intelligent Investor that
"Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success."
Let's take a step back for a few minutes. One of the most basic rules of business, if not THE most basic rule is you sell your products for more than it costs to create or obtain them. This is simple. If you are going to open a ice cream shop where your cone has $.25 worth of ingredients and $.50 worth of labor and rent in it you need to sell it for $.75 if you want to stay in business. This concept is so simple that even children understand it. Have a child purchase an item for a few dollars and then ask to buy it off of them for less than they paid, they'll protest. It simply makes sense.
Unfortunately this business logic doesn't extend to the stock market. Our fictitious ice cream shop selling cones for $1.00 that cost $.75 would trades for less than the trendy ice cream shop selling the same cones with the same cost structure for $.50. Why is this?
In the stock market there is a second dynamic at work, it's investor psychology. It isn't just what the underlying business is doing, it's what other investors are willing to pay. In our example investors prize trendiness and losses over profits, and so they are willing to pay more for company B. Of course there will be stories explaining why B is better than A. The psychology is that investors feel that since they love company B that everyone loves company B and they will always be able to sell their shares for more than they paid.
Maybe company B will make it up on volume, or they're growing, or they have a visionary ice cream scooper. The reality is unless company B raises their prices, or figures out a way to lower their costs they will eventually end up out of business.
There is no magic to this, it's simple math. And when you argue with math you lose, every, single, time.
Sometimes value investing is described as buying unloved companies. The story goes that the value investor would purchase company A in our example because they aren't as trendy, or as popular. If you extrapolate this idea you end up with the idea that a value investment is just a piece of unpopular garbage, or something no one else likes. I think it's neither.
There is another way to view a value investor, they're an optimist. Someone who looks at the ugly duckling and says "Hmm, they're still a duck, they can still swim, walk, fly, do duck things. If other ducks are valued on duck things the ugly one should be as well. And besides, beauty is fleeting, maybe those beautiful ducks will age out over time.."
Or let's take another analogy, sports. The market values the MVP's (most valuable player) of the team. They are popular, have great stats, and do well every game. How could you not like the MVP? The value investor looks at the teams that are doing poorly and works to determine which underdog has a real chance. They're looking for the upset team, or the breakout star. Sure that underdog might only win a game or two, but if you're gambling on single games picking the underdog will result a bigger jackpot.
The optimist isn't stupid, they don't buy what's unloved just because it's unloved. They buy it because after evaluating the circumstances they've determined that a company has a chance. There's a reason to be optimistic about the future when everyone else is pessimistic.
Value investing is difficult because it's hard to be optimistic when everything looks bleak. It's easy to be a growth investor because everyone is optimistic and you're optimistic along with them.
Unfortunately at this juncture in the market value investing is dead, completely dead. The reason is there is almost nothing that people aren't optimistic about.
My view on this was crystalized when I spoke to a client earlier today who specializes in small rural banks. They said that what they're seeing is unbridled optimism about economic expansion in places that haven't been optimistic since the post World War II boom. When optimism has crept down to the sleepiest of places it has become persuasive.
Of course a retort to this post is that there are still 'cheap' companies. There will always be companies with struggles or issues, and dying industries. But the caveat is sometimes the market's pessimism is justified. Industries die, companies die. Sometimes a dying company is simply a dying company, not a value investment. A value investment is a company that looks like it might be dying but it isn't. Or one that the market has left for dead that is going to survive.
When I look at the market, both the public market and the private business world I see optimism everywhere. That's a good thing, but bad for a value investor. It's bad because there aren't things that look bad to be optimistic about. At this point being optimistic is simply running with the pack, everyone is optimistic. If the future optimism is warranted then everyone will do well. Maybe we'll finally usher in that period where stocks reach the ever illusive permanently high plateau.
Given the current situation an investor has two choices. Cheer for the star players along with everyone else, or sit on your hands and wait. I'm more comfortable with waiting. The good news is this, when opportunity finally arrives it will be here for a while. The last time the market crashed there were still eye-popping bargains four years later. You didn't have to get in right away, you could have sat on your hands for a while and still done well.
If you want to invest with the market buy something, anything really, it will go up. For those who prefer to be optimistic in the face of pessimism there are always a few companies in little nooks and crannies, but not much else. Maybe it's time to take a long vacation..
