What is value investing? It is to buy a business for less than what it’s worth. We can break this into three parts.
Buy a business
Buying a stock is the same as owning a fraction of the underlying business. If you buy a share of Apple (AAPL), you own the business that produces things from iPhone, iPad, Macintosh, macOS to Apple Watch, app store, Apple TV+ and etc.
What it’s worth
A company is worth the present value of its future cash flow. That is true for Apple as it is for Starbucks, a farm, or the gas station in your neighborhood.
For less than
Since the future is never certain, determining the future cash flow of a company involves a degree of uncertainty. We need a margin of safety to protect ourselves from any potential downside.
Once we understand the first principle of value investing, we can look at two widely held assumptions.
Opposite of growth investing
The first widely held assumption is that value investing is the opposite of growth investing. To find out if that is true we need to be clear what growth investing is. Growth investing focuses on stocks that have an above-average growth rate compared to their industry or peers. And these stocks typically trade at a P/E multiples ranging from 30-100x due to their growth potentials.
If value investing is the opposite of growth investing, that means value investors prefer stocks with little to no growth. But why would a person invest in a stock with little growth when one that grows faster is more desirable? A common explanation is that growth stocks are riskier than value stocks. High risk high return. But how can growth stocks be risky if they can deliver above-average returns? On the other hand, isn’t it just as risky to own value stocks that fail to deliver a satisfactory return?
There’s nothing in the philosophy of value investing that restricts one from buying stocks based on certain growth rates or P/E multiples. Buying a stock that grows 50% with 100x P/E is as value investing as buying one that grows 3% with 5x P/E if the thought process is sound. A stock that makes $10 million with a market value of a billion dollars (100x P/E) can be an attractive investment if all of its future cash flows are worth more than a billion dollars. On the other hand, a stock that earns $100 million with a market value of $500 million (5x P/E) can be a poor investment if the present value of all of its future cash flows is worth less than that. Therefore, growth rate or P/E multiples are irrelevant. What matters in value investing, or what concerns a businessman, is how he manages his risk. How does one manage risk? Good judgment. How do you do that? The first principle has already told us: buy a business for less than what it’s worth.
The risk lies in paying too much for a stock. One can overpay for a growth stock that fails to maintain its growth rate as it is to overpay for a value stock that has a deteriorating prospect in spite of its low P/E, the so-called value trap. And the consequence of overpaying is a permanent loss of capital.
The key thing to remember is that investing in high growth stocks doesn’t make investing riskier than investing in value stocks makes investing safe. What is considered ‘safe’ or ‘risky’ comes down to the price you pay relative to what the stock is worth.
Another widely held assumption is that investing in stocks that are not making money is not value investing but speculation. Value investors should only invest in profitable stocks with a good track record. Again, we can use the first principle to work out if this is true.
When you invest in a stock, you’re buying all of its future cash flow. Therefore, all the past cash flows only matter as much as whether they are a reliable indicator of what the future cash flows are likely to be.
While a stock with a strong track record of positive earnings is expected to continue the same trajectory for the foreseeable future, there is always a risk that it might fail to do so. A company has to reinvest more of its earnings into the business to maintain its position if its competitive advantage gets weakened by technological disruption, changes in consumer preference, or simply more competition. As a result, the business’s near to mid-term cash flow will be less because of those extra investments. That is if it manages to maintain its current position. What if those extra investments aren’t enough to prevent the business from losing market share? It will have to spend even more to cut costs, change business strategy, roll out new products, and acquire the resources and know-how to compete effectively. All of these introduce more uncertainty as to what the future cash flow might be.
Contrast this with a stock that has lost money for the past 10 years. This might seem like a risky investment. But the reason the company hasn’t been profitable is that they have spent all of their earnings to improve their market-leading product. The management understands that if they can make their products 10x better than their next competitor through these investments, it would secure their dominant position in this winner-takes-all market. Once they corner the market, they’ll be able to reduce investment and produce positive cash flows. And since most of their customers are sticky because their product is 10x better than anything else available on the market, they can raise prices year after year without any negative impact on volume growth. Further putting their cash flows on exponential growth.
These examples illustrate that value investing is never about buying a stock based on its past cash flow. Owning a stock that has not made a dollar over the past 10 years doesn’t necessarily make it a riskier investment than owning a stock that has produced tons of cash in the past. The track record of a business is certainly important, but what’s more important is your judgment as to what the future cash flow of the company is likely to be.
Value investing is not an investment style. To call something a ‘style’ is to define what it isn’t. If you practice Taekwondo, you learn movements that reflect Taekwondo, which is different from movements you learn in Jiu-Jitsu, Krav Maga, or Wing Chun. As far as the rules of the game define what you can or cannot do in a competition, you have to follow the rules to score points and win. If you participate in a Wing Chun competition, you get disqualified if you attack your opponent who is on the ground, for example. But what are the rules in the stock market? There are no rules. The stock market is like a street brawling. The long-term winners are those who make money or don’t lose money. So why would you have an investment style that handicapped yourself against the market?
Value investing is a philosophy instead of rules on how to approach investing. Attributes like P/E ratio, growth rate, or past cash flows do not define what value investing is or isn’t. Rather, it is what you do and don’t do. And value investing is a philosophical approach to what to do and what not to do through sound judgment, margin of safety, and circle of competence. If you think well, make rational decisions, avoid doing stupid things, focus on not losing money, and constantly killing your old ideas, you’re practicing value investing. Whether you call yourself a value investor or other names is irrelevant. What matters is how you manage your risk because the long-term winners are those who make money or don’t lose money. And how do you manage risk? Buy a business for less than what it’s worth. That’s what value investing is all about.