Bad strategies die a slow death in the investment world, but they do eventually decay. The idea that book value bargains are a good idea isn’t quite dead yet it seems.
Benjamin Graham is considered to be the father of value investing, a process of looking for bargains with stocks that have fallen out of favor in the hopes that time in itself will correct whatever imbalances that exist that have the market valuing the stock lower compared to other stocks.
Graham’s contribution was to make popular a formula that compares the book value of a company to the market capitalization of its stock, the market value of the company versus the market value of the stock in other words. Graham believed that such a formula provided better opportunities than other ways of measuring the potential growth of a stock, and this was a fairly popular way of investing in a world long ago and far away.
Value investing itself is still alive and kicking, even though it has been falling more and more out of favor with each passing year now, a decay that has been particularly accelerating lately. Many investors still put a lot of stock in the strategy of focusing their attention on out of favor stocks, although hardly anyone pays much heed to Graham’s book value formula, where even the relics see it as a relic for the most part nowadays.
Graham was definitely a pioneer though and his ideas and approaches to investing are still very influential even though this formula of calculating potential for a stock to grow in value has been virtually discarded. Warren Buffet was a big fan and considers Graham’s 1949 book The Intelligent Investor the best book on investing ever written. Whether it is or not is not the point here, but it shows how highly regarded some of Graham’s bury your investments style advice still is.
We speak of all the myths that have persisted in the investment world quite often, and Benjamin Graham could be considered the father of a lot of these myths since he played such a seminal role in the view that we can and must value stocks apart from how the market values them, not that very many people have really understood why this is such a bad approach anyway.
We might think that value investing merely seeks to pursue opportunities where we expect undervalued stocks to appreciate, for the wrongs that we believe have been perpetrated by the market will be righted in time, but this requires that we take a step back from this and examine the justification of such a separation first, showing that the market has been wrong or ever could be wrong before its actions can be genuinely deemed to be wrong.
Stock prices are contingent on something, whatever forces that ends up driving these prices, and the real mistake that value investors make is to make assumptions about this and skip the step of examining the validity of their assumptions, even though they are building their entire world upon these assumptions and the success of their endeavors requires them to be correct.
This is how these views have become so dogmatic, although those who are guided by dogma don’t realize this because this eludes their examination. If you ask an investor who invests based upon company fundamentals, they won’t be ready to explain why this is a good idea, as they really haven’t even considered the matter.
We need to though, and we especially need to when we see our ideas fail time and again. If we get lucky and assume the right thing without questioning it, we’ll at least be on the right track, although when circumstances change, when something that worked before stops working, we’ll very likely just keep doing what we’ve been doing anyway, and wondering what happened.
Eventually though, often after many decades of wondering why what you are doing isn’t working, people eventually come around and turn their focus to something else, usually an idea that is at least similar to what they are doing before and fits their world view better than other strategies.
Value investing has indeed evolved from Graham’s ideas about book value to today’s much more popular earnings disparity calculation, which is just as contrary but at least looks to pay attention to something more connected to business success at least.
Book value multiples do not really speak to the future, and the future is our only concern when we invest, what our investments will be worth at some point down the road when we wish to cash them in. We can destroy this idea in a single stroke, without even delving into all the other things that are wrong with this idea, by just pointing out that a snapshot of book value tells us nothing about the future of a stock, let alone be enough that we want to stake our future on.
Regardless of what we seek to use to measure the potential of a stock growing, we need to view it dynamically to see how this factor may be changing. Perhaps book value is trending up and then all we have to do is show that these upward trends are correlated well enough with price trends, even though we get a perfect correlation if we just look at the price trends themselves.
Doing this would at least have us trying to measure the growth of something at least in our quest to discern growth potential, where just looking at snapshots are like picking a certain point on a chart and trying to base our decisions upon that with no regard to where this value has been or where it may be going.
Earnings valuation commits the very same mistake, and is an idea that is fundamentally flawed as well overall, but book valuations are one more step removed from what is hoped, that the company’s lower book value means that their earnings are hoped to increase relative to its price as this disparity somehow gets equalized and this should drive its stock price upward if that’s the way these things work.
This involves two assumptions that are just accepted as truth rather than the one that earnings valuation uses, that price underperformance relative to earnings gets equalized, without having to make the additional assumption that a company trading with a very low book value to price ratio will see improvements in business conditions and drive earnings up that way, an additional leg of the fanciful journey. One misdirection is too many, using another to work your way up to it is worse.
Low book value is a symptom of illness though, and looking at this with eyes full of promise is not unlike going to the hospital to find candidates for a job, and not even asking what their prognosis is of one day being able to do the job that we are looking to offer them.
While this low book value is an assignment that the market is making, and it doesn’t really matter why the market is valuing a stock so lowly, the market does account for business results in their performance in addition to all the other things that influences them, and low book value in itself does not bode well for the future of a stock.
Many investors either imagine or assume an invisible hand that will somehow cause disparities to reverse and equalize, like a company that is seen to be doing poorly or even doing poorly in an objective manner will see things turn around, where the weak become strong, from out of nowhere apparently. If they don’t wonder about the mechanism by way something is supposed to happen, they won’t notice its absence.
Being a contrarian can be a good thing, depending on what you are contrary to, and being contrary to bad ideas is definitely preferable to going along with them. Being contrary to the stock market guarantees being on the wrong side of things every time, because the market is never wrong and this is not even possible.
Stocks Need to Become More in Favor to Prosper, Without Exception
This is not to say that we cannot profit from investing in stocks that may have been very out of favor, but we will never profit from them if they remain out of favor. It is only when they come back into favor that the opportunity exists to get a good return from investing in them, as their price rises from the revival, but we need the revival first, the coming back into favor that places us on the right side rather than the contrary side.
We can mess this up on the other end of things as well, holding stocks that have been very much in favor but have since fallen out of favor, where our continuing to hold them would be contrarian. Fighting the market is as big of a fool’s game as there is, and we can assure ourselves of doing the right thing just by avoiding anything that would be in any sense contrarian, to follow the market rather than taking other roads that lead away from success.
This is more than enough to drive a stake into the hearts of not only book value investing but any sort of investing that is contrary to the market and contrary to reality in turn, because with investments, the market is the reality. We may expect a stock to do a certain thing, but when the market chooses to do something else, we have been wrong beyond any dispute.
Earnings based investing would at least be more on point if they looked at earnings dynamically rather than statically, not caring about how current earnings measure up but looking at how earnings are trending, if that matters to them so much. At least earnings growth is correlated to stock price growth somewhat, in contrast to either book value or earnings snapshots which are presumably being used to measure the potential for change without even looking at how their inputs in their formulas are changing. These snapshots actually are correlated with stock prices, but inversely.
Looking at book value growth or earnings growth takes us beyond the interests of the value investor though, and into the world of what is called growth investing these days, the style of investing that value investors try so hard to shun and has them stubbornly clutching their broken ideas and hoping someday their ship will finally come in, when reality inverts.
Growth potential is what we seek though so we cannot both pursue growth and ignore it. It’s fine to seek potential for growth with stocks that have shrunk, but we actually need this growth potential to manifest, and the shrinking itself does not portray this at all and portrays the opposite of what we seek in fact.
Value investing perceives the shrinking but is not concerned at all with looking for a reversal, for the growth phase, as it seeks to portray shrinking as a good in itself, the biggest one even, which sums up what is wrong with this strategy perfectly. If a company becomes appealing based upon its being in decline alone, there is something very wrong with your thinking.
There has been a little revival of sorts with book value investing, where the crash in the market that we have seen earlier this year, and still is playing out with many stocks, has unearthed this old worm of Graham’s that has been for the most part below the ground these days.
This fall and subsequent rise this year has provided some great opportunities to capture lost value, but in order to profit from this, we have to understand the difference between this and what the value investors try to do, which is something different entirely.
We can never approach these things in an undifferentiated manner like these value investors do, seeking value but failing to measure it in a meaningful way. The fact that a stock’s price is beat up does not in itself provide any, and in fact it serves as an impediment to it, unless we have a valid reason to believe that its value will increase.
The starting point here is the requirement to distinguish what value even means here, and it cannot be present value because you just need a quote to discover the present value of a stock, the current bid or offer depending on whether you are looking to buy or sell. Any value must therefore be future value, the difference between now and down the road, but you have to look beyond your shoes to determine it.
We’ll use Amazon as an example as this is a clear case where a stock’s present and future value really mattered. On February 19, 2020, Amazon stock was valued at $2170. On March 16, it was valued at $1689.
We need to step back and understand what a stock price really reflects and what it does not. It does not reflect the present value of the company, or not even the future value of it at some point, it just tells us what the last trade was valued at where there has been an exchange of shares between parties.
When we own a stock, or are considering buying it, we need to compare the price we paid for it with the price that we may be able to sell it at some future time. There is no value to a stock apart from the value of the investment itself, how much we may expect to make. We invest, hopefully, with a reasonable expectation of profit from our investment gaining in value over time.
This all has nothing to do with trivia such as what the company may be worth if it liquidated all its assets, or even the value of its present cash flow. Stock prices aren’t about the present at all in fact, they instead show the way that the beliefs about a stock in the future change.
We Need to Look for Change if We Want Change
There are two reasons why a stock goes up and down in price, with only one of them having to do with the stock itself, and we need to distinguish between these forces. One of them is the changing outlook for the stock itself, and the other is driven by the changing outlook for stocks in general, where they move together like they did between this period that we’re looking at Amazon, where the stock declined by 22% in just 4 weeks.
When we ask ourselves why Amazon gave up that much so quickly, the answer is obvious, it was because it got caught up in the panic that brought everything down. Amazon was one of the stocks whose business was greatly helped by COVID, especially when physical stores were virtually shut down, pushing people toward their online kingdom and driving a lot more sales.
This is why it is so important to compare a stock’s performance to market performance, as the market always plays a role in the movement of stocks, and what we are trying to discern is what sort of distribution they are getting, their net change, whether that be getting more if their share on the way up or giving up more than their share on the way down.
Once Amazon bounced, given both its situation and the concurrent market reversal, it took on a huge amount of potential, which it did deliver on. It now sits up 77% from its March low. In just a little over a third of a year, it has earned 5 years’ worth of a 15% annual return that most investors would be delighted with, and about 25 years’ worth of investing in bonds.
This is what you call a real value play, and the value here is the difference between its present value and what may be expected in the future. This value was created by the 22% loss that wasn’t a legitimate drop since it had nothing to do with the company and everything to do with the level of general fear out there in the market, seeing people dump their stocks and drive prices down beneath where a stock would be if not for this market effect.
We see this with every bear market, where we see a market premium added to declines, which is like holding something that is buoyant under water and let it go, where it will bounce back to the surface and even above the water. If a stock had been sinking before the market move, removing the hand of the market that has pushed it down further in the water may have it move to the surface a bit, but not really by that much as it is not that buoyant. It did not have the positive momentum propelling it before and without a good reason to believe that its own issues will reverse, its lesser perceived value by the market providing new and additional buoyancy, this will continue.
We can think of book value as the present value of the company, and can actually use price to book ratio to provide information that is actually useful, but like we need to do with price to present earnings ratios, we need to turn the normal perception on its head.
In of itself, if the market values a company in the future at only half its book value, this is not a good thing. We should want to be in stocks where the future looks bright, as high ratios would reflect, not an outlook so bleak that people will only pay half what the company is worth now because they see things so dim. This is not a prescription for making money, and quite the opposite.
All things being equal, when we look at snapshots of book value, we should look at higher book value ratios as a positive, a reason to buy, and lower book value ratios should be a red flag, and the lower this is, the more scared we should be of it generally.
Looking at this ratio dynamically though at least shows the trend, where it might have been .50 not long ago, and we’ve seen it move up to 0.60 and then to 0.70, showing us that the market is at least changing its mind about it enough to be worth a look. The way people see this instead it is like trying to claim that the buggy pushes the horse, even when the buggy gets detached and it rolls down a hill in the wrong direction.
We can get an even more accurate view of things by just looking at how the market’s grade of the stock is changing, the way its price is moving. However, if we insist on using book value ratio trends, we at least would be driving on the right side of the road with this rather than on the wrong side.
People are salivating about all those low book value ratio stocks there are out there right now, ones that are still down near the bottom of the tank because they did not move up very much after the panic selling ended. No one is panicking about them now, but they haven’t been liking them either, and that is a big red flag in itself unless things change enough.
If and when they do, we will see it, but we do not want to assume that this very low book value will make them especially bullish, more bullish, or even competitively bullish if this happens. We most certainly do not want to be jumping on without a good reason, and a low book value ratio actually counts on the side of reasons not to.
Once Mr. Market stopped pinning down stocks and let them get up on their own if they could, those that did spring up like Amazon and many others are the ones that offer the greatest potential for a value move. Stocks that don’t really get up that quickly might deliver the goods later, but they are inferior for now at least, especially when you get more of the same worry that brought down stocks when COVID-19 first started delivering big punches to stocks.
Stocks that are still in the doldrums are not there by accident, they are not there because everyone has been that excited about them, even though they might still have some buoyancy once the fear that has driven them down, perhaps further than they deserved, subsides enough.
If we are to decide between a stock that is going up over these stocks that are moving sideways or down, only the confused will eschew the good ones. People have sat for months making nothing or losing money in some of these stocks that are supposed to be such a deal, but we rather would put ourselves in a position to make money.
Even if a guy with crazy hair pulls up in a DeLorean and tells us he came back from the future and Carnival is back up to $50 a share where it was earlier in the year, we still should not want to just jump on this, because we still don’t know the path there. It could sit at $14 for a couple of years while Amazon doubles in price, and then start moving up in a way that should interest us, but we’d rather double our money first and when its time comes it will show itself and we will be ready.
None of this has anything to do with book value, which the market does not even care about, and has no effect on anything. Even if a company does need to be liquidated that you own stock in, you won’t see any of this, as bondholders will get this money, and you should have run for your life long before this anyway.
Having value investors move their focus from the original sin of value investing, valuing stocks based upon book value, to a different view, today’s current earnings to price ratios, has just substituted one stupid idea with another. The dirt that people have thrown on book value needs to be dumped on the present earnings ratio view as well, as it is just as misaligned, and for basically the same reasons.
It’s fine to look at a stock that has declined a lot and ask whether or not the selling was deserved or whether it was overdone, but if we get excited about stocks getting pounded when there’s no other good reason to like them other than we love the sight of blood, we better love the sight of our own as well.