The definition of value
In my opinion, one of the reasons why value has underperformed growth in recent years is that the definition of value has changed from what it used to be.
Value has become a byword for buying cheap stocks. Just because a stock looks cheap does not necessarily mean that it is, and nowadays moreso than in the past, these businesses are struggling to grow and are thus cheap because they deserve to be.
On the other hand, companies dropped into the "growth" bucket tend to look expensive at first compared to old valuation metrics, but these businesses have much more predictable and growing cash flow streams. If you can buy these companies at a discount to your estimate of intrinsic value, that that would qualify as value investing.
Warren Buffett (Trades, Portfolio) talked about this very same topic at the 2019 Berkshire Hathaway annual meeting of shareholders, when one investor asked the Oracle of Omaha about the group's position in Amazon.com (AMZN, Financial).
Amazon as a value stock
Amazon appeared in Berkshire's portfolio in the first quarter of 2019. The position, which is around $1 billion in value, is relatively small (it's just 0.4% of the equity portfolio today), but it still attracted plenty of attention.
Buffett has since said that it was one of Berkshire's portfolio managers that initiated this position, so he's been unable to give a full explanation as to why it was acquired. However, at the 2019 annual meeting, he was asked if this acquisition meant that Berkshire was no longer focused on value investing.
Here's how Buffett replied:
"Yeah. It's interesting that the term "value investing" came up. Because I can assure you that both managers who — and one of them bought some Amazon stock in the last quarter, which will get reported in another week or ten days — he is a value investor. The idea that value is somehow connected to book value or low price/earnings ratios or anything — as Charlie has said, all investing is value investing. I mean, you're putting out some money now to get more later on. And you're making a calculation as to the probabilities of getting that money and when you'll get it and what interest rates will be in between."
This calculation applies to any business, Buffett continued, whether you're buying a stock at 70% of book value or Amazon at "some very high multiple of reported earnings."
There are many ways to value a security, but as Buffett explained last year, the most important thing investors need to consider is how much cash the business will produce between now and "judgment day." If you can estimate this figure with a reasonably high level of confidence, you can place a value on the security. If you can buy at a discount to that value, then that is value investing:
"In the end, it all goes back to Aesop... a bird in the hand is worth two in the bush...
And when we buy Amazon, we try and figure out... whether there's three or four or five in the bush and how long it'll take to get to the bush, how certain he is that he's going to get to the bush, you know, and then who else is going to come and try and take the bush away...the basic equation is that of Aesop. And your success in investing depends on how well you were able to figure out how certain that bush is, how far away it is, and what the worst case is, instead of two birds being there, and only one being there, and the possibilities of four or five or ten or 20 being there."
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Will Berkshire Hathaway Buy Back More Stock in 2020?
- Some Thoughts on Why Value Investing is Underperforming in 2020
- That Time Warren Buffett Bought a Share of a Duck Club
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