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The Question of Value

The doctrine of Value Investing was first proposed by Benjamin Graham, which posits a scientific approach of evaluating a firm’s balance sheets and identifying mispriced securities. The idea revolves around the fact that market participants overreact to positive or negative news, resulting in stock-price movements that do not correspond with a company’s long-term value. This opens a window of opportunity to buy stocks at a discounted price and book profits in the long term.

Value investors are of the view that share prices do not reflect the long-term fundamentals of the company because such prices are considerably dependent on market behaviour. They take a conservative view of firms, placing more weight on their assets, cashflows and record, and less on their investment plans or trajectory, thus placing more weight on intrinsic value rather than their price.

Various metrics are used by investors in an attempt to determine the intrinsic value of a stock. Rigorous financial analysis including studying the financial performance, revenue, earnings, cash flow, profit as well as fundamental factors like the company’s brand, business model, target market and competitive advantages are taken into account. Price-to-book or book value, which measures the value of a company’s assets and compares them to the stock price, is one such important metric. Provided that the company is not experiencing financial hardships, a lower stock price relative to the company’s asset signifies an undervalued stock.

Price-to-earnings is another parameter that is used to judge whether the stock price is reflecting the earnings of a company. Another parameter that is used to determine the liquidity of a company is free cash flow. Free cash flow refers to the amount of cash remaining after expenses have been paid, including operating expenses and large purchases called capital expenditures, which is the purchase of assets like equipment or upgrading a manufacturing plant. If a company is generating free cash flow, it’ll have cash in hand to invest money in the future of the business, pay dividends or rewards to shareholders, clear off its debts and issue share buybacks.

Value investors require a ‘margin of safety’, based on their tolerance for risk and room for error in estimation. The ‘margin of safety’ credo, one of the factors of successful value investing, is based on the proposition that buying stocks at a bargain price gives one a better chance of earning profits later on when one chooses to sell. The ‘margin of safety’ also protects from downside risks in case the stock does not perform well.

The problem is that value investing has led to disappointing results. For instance, if you had bought value shares worth $1 a decade ago, they would fetch $2.50 today, compared with $3.45 for the stock market as a whole and around $4.65 for the market excluding value stocks. Despite its efforts to modernise and adapt, value investing has often produced backwards-looking portfolios and as a result, has largely missed the rise of technology. The asset-management industry’s business model is under strain, with one of its most long-standing philosophies losing its charm.

Value investors might insist that they are the victims of a stock market bubble and thus, they will be proven right eventually. Historically, value strategies have performed poorly from 1998 to 2000, before the dot-com crash. Today, the stock markets do indeed look pricey. But alongside this are two deeper structural changes in the economy that the value framework is still finding difficult to cope with.

The first is the rise of intangible assets, which now constitute a third of business investment- think of data, research and development. Businesses treat these costs as an expense, rather than an investment leading to the creation of an asset. Some sophisticated institutional investors try to adjust for this but it is still easy to misjudge how much businesses are reinvesting and their ability to do it at high rates of return is pivotal for their long-term performance. For instance, traditionally, U.S.A.’s top ten listed firms have invested $700 billion since 2010 while on a broader definition, the figure is $1.5 trillion or more. Intangible businesses can also usually scale up fast and exploit network effects to sustain high profits.

The second change is the rising importance of externalities, costs that firms are accountable for but circumvent paying. Today, the value principle suggests you should load up on car firms and oil producers. But these businesses’ prospects depend on the potential liability from their carbon footprint, the cost of which may increase as emissions rules tighten and carbon taxes become more widespread.

Value investing’s rigour and cynicism are as relevant as ever- especially given how frothy markets look. But many investors are still just beginning to understand how to assess firms’ intangible assets and externalities. It is an arduous task, but getting it correct could give asset management a new lease of life and help ensure that capital is allocated efficiently.

In the 1930s and 1940s, Benjamin Graham described how the old investing framework had become obsolete. Maybe it’s time for another upgrade.


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