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The evolution of ‘value’

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03 December 2020

GAM Investments’ Ali Miremadi discusses the terms quality and value and how the definition of the latter has evolved over the years.

The counterculture classic novel Zen and the Art of Motorcycle Maintenance has a philosopher as its central character who drives himself to distraction (and beyond) by trying to define quality. It is indeed a complex term. As fund managers and company analysts, we spend much of our time trying to identify quality businesses. In our view, quality is a necessary, but not sufficient criterion. We seek quality businesses trading at substantial discounts to our estimates of long-term intrinsic value. We regard our investments as both quality and value – quality because we have no interest in risking client capital in poor businesses, and value because it is incumbent upon us to make investments which can appreciate by an above average quantum.

Our definition of value has evolved over the years. As The Economist1 magazine noted in a recent issue, value investing has for many decades been associated with the tenets laid out in Benjamin Graham and David Dodd’s Security Analysis2 , a book which we have returned to many times over the past twenty five years or so. In this book, Graham and Dodd use traditional accounting to effectively screen for companies trading at fractions of their asset value. As long ago as the 1980s, after buying a large stake in Coca-Cola, Warren Buffett wrote about the importance of intangible assets, such as brands, which was his justification for becoming prepared to pay more than his teacher Benjamin Graham would have done for such a business3. Buffett wrote in 1992: “Growth is always a component in the calculation of value…we think the term value investing is redundant. What is investing if not the act of seeking value at least sufficient to justify the price paid?”

The Economist article of November 2020 expands on this to make the powerful argument that the increasingly digital and service-driven economy of today is even more driven by intangible assets. Beyond brands, we now have to think about how to quantify intangibles such as software, drug patents, customer relationships or corporate culture. This is in itself a considerable analytical challenge. However, there is an equally important financial point about quality business. For this purpose, let us define a quality business as one which generates an economic return above its cost of capital over a protracted period. A quality company generates most of its value over time through the capital allocation decisions around retained earnings. The nature of compounding means that those companies who do this successfully over time will grow faster the further into the future an analyst is prepared to look. Conversely, companies who invest at sub-standard rates will not. This presents a challenge to stock analysts comparing two such businesses today. It is likely that current multiples, such as price-to-earnings, price-to-sales, price-to-book or enterprise value / EBITDA will all be higher for the former business compared to the latter. But what if over three years or so the benefits of higher reinvestment rates which accrue to the former business mean that its growth is above expectations, while the latter business continues to languish? This is to us the best means to try to avoid the dreaded ‘value traps’. A value trap is a company which while on optically low multiples fails to reinvest adequately and hence never justifies a higher multiple. It can be ruinously expensive to invest in a struggling business even at a very low initial valuation, while paying too high a price for a business which turns out not to have the qualities expected carries its own penalties.

We believe in a philosophy of identifying businesses which do have strong quality characteristics and are trading below our estimates of long-term intrinsic value, supported by a solid scenario analysis process.

1https://www.economist.com/briefing/2020/11/14/value-investing-is-struggling-to-remain-relevant
2Security Analysis” by Benjamin Graham and David Dodd 1934
3Buffett has written about this on several occasions. We would suggest his 1992 Berkshire Hathaway letter as a good summary: https://www.berkshirehathaway.com/letters/1992.html.

 

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