I wrote a few posts on “quality” recently, which has sparked a few emails, comments and questions on the overall investment philosophy.
I got to thinking about the interplay between quality and valuation, and thought of Buffett’s shareholder letter in the early 1990s where he said “value and growth are joined at the hip.” Essentially, value is determined by what you return on your initial investment. This is fairly obvious, but I thought I’d point this out. This “investor return” (the total profit we make on our investment) comes from three possible sources (or ideally a combination of the three):
1. The first source of investor returns come from a higher valuation of assets or earnings.
For example, the market “assigns” a higher P/B ratio or a higher P/E ratio to the stock. Deep value investors often buy asset based investments at low price to book ratios expecting at some point the market will revalue those assets to a higher level, which is often the case as Ben Graham and Walter Schloss proved over the course of decades.
2. A second source of possible investor returns comes from the internal results of the business itself.
For example, the market may continually value a business at a P/E of 15, but the business is generating consistently higher earnings per share each year (possibly through either accretive acquisitions or through internal growth). In this case, the stock price increases even with no change in earnings multiples.
3. The last main source of investor returns comes from capital allocation decisions made by management.
In this case, it’s possible to make a positive return on an investment even with no change in valuation and no improvement in the underlying business performance. This pleasant result comes from management improving shareholder value by either returning cash (paying dividends) or reducing the shares outstanding via buybacks.
In the best investment case, a combination of all three of these factors creates a compounding effect that can create significant shareholder value.
The Classic Davis Double Play
Shelby Davis was a famous insurance investor who took a small grubstake of around $50,000 and turned it into a massive family fortune of close to a billion dollars through investing in primarily insurance stocks. Davis called the combination of the first two factors (earnings and multiple expansion) the “Davis Double Play.”
He liked to use the example of being able to make 4 times his money when he bought a stock at a P/E of 10, and then it doubled its earnings over a period of years and the market revalued the business at a P/E of 20, thus creating a 4x return for Davis as an investor.
Value Investing Is Redudant
So it’s a somewhat obvious (but also a sometimes misconstrued) conclusion that Buffett makes when he said in his 1992 Shareholder Letter that value and growth are both inherently a part of determining what a business is worth:
But how, you will ask, does one decide what’s “attractive?” In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.
We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
Buffett is simply saying that valuation and growth are two inputs that determine value. Think of it as a “value” equation. Including management, we’d have:
- Valuation + Growth + Capital Allocation = Value.
This simple equation shows how negative growth (a shrinking business) can destroy value, even if the multiple is quite low — hence the dreaded “value-traps.” It also shows that a “negative number” in capital allocation (i.e. poor management decisions) can also destroy value. And of course, overpaying for any business (i.e. too high a valuation) is never a good thing.
But all of these are crucial components of value that we potentially get from each investment we make.
Buffett went on to say that the term “value investing” is redundant. Everyone is trying to invest in something that is worth more than they are paying.
Greenblatt sums it up best when he says: “Value investing is simply figuring out what something’s worth and paying a lot less for it.”
That’s really all we’re trying to do…