I was recently asked this question by a fellow value investor: As a value investor, how would you justify buying stocks at high multiples? This is my first attempt to address this question.
Value investing, though practiced in many styles, boils down to one central principle – margin of safety. At its core, value investing means buying a security at a significant discount to the conservatively estimated intrinsic value.
There are many styles of value investing but for the sake of today's discussion, we will categorize value investing into two groups – classic value investing (or static value investing) and dynamic value investing.
Value investing, in the most commonly understood form, is the classic value investing approach developed by Benjamin Graham. Classic value investing is practiced by many renowned value investors and Ben Graham disciples and involves buying stocks of public companies that trade at discounts to book value or tangible book value, have high dividend yields, have low price-sales multiples or have low price-earnings multiples. It is also preferred that these companies have conservative balance sheets as well as the demonstrated track record of the ability to survive cyclical troughs.
In classic value investing, intrinsic value camouflages itself as readily quantifiable numbers such as book value, or the product of earnings and a predefined P/E ratio such as 10 or 15. If a stock trades at a low P/E multiple or below book value, the stock is considered to be cheap, especially if compared on a historic multiple basis. Of less focus are earnings power and sustainable competitive advantage of the underlying business. Advantageous to this approach is the readily identifiable proxy to intrinsic value as well as the discernible value signs (low multiples).
Apogee Enterprise (APOG, Financial) in many ways is a perfect classic value investment example. Revenue per share bobs around between $20 per share and $32 per share consistently during this 20-year period. The P/S ratio and Apogee’s stock price also demonstrated remarkable consistency with seemingly readily identifiable value bands.
Classic value investing is often static because the earnings power and intrinsic value of businesses that fit into this approach are essentially static over a very long period of time. In Apogee’s case, the business generated revenue per share of $25 in 2013, almost exactly the same as it did two cycles ago in 1994. It is no coincident that the company’s intrinsic value has also stayed the same as it was two decades ago. Even though there is no growth in intrinsic value, Apogee’s stock could be a great investment if bought at cycle low and sold at cycle high.
In reality, very few stocks have a perfect pattern like Apogee. Therefore, classic value investing is by no means a cinch. However, practiced with discipline and patience, classic value investing has outperformed the market.
In contrast to classic value investing is dynamic value investing. We call it dynamic because both the earnings power and intrinsic value of the companies that fit into this style are dynamic and more specifically, compounding above an average rate over time. In this approach, value and growth are joined at the hip. Value, as defined by the classic value investing approach, is less recognizable because the multiples are often expensive by classic value definition. Also key to this approach is the ability to peel the onion in order to assess the true earnings power as opposed to the GAAP reported earnings (or losses), which in many cases vastly underestimated the true earnings power of the business.
In Amazon’s (AMZN, Financial) case, the stock looked expensive almost throughout the preceding 11 years on an EV/revenue basis. We can see that Amazon traded between 1x EV/sales and 3x EV/sales during this period, so it would appear expensive in late 2005 at 3x EV/sales. However, had an investor bought one share of Amazon at 3x EV/sales in 2005, he would have made more than 10 times his investment by the end of 2015.
To explain this using the dynamic (static) value investing framework, if we define 2005 revenue per share of $19.93 as the static metric and the 2015 revenue per share of $224.33 as the dynamic metric, then in late 2005, while Amazon trades at 3x EV/sales on a static basis, it only traded at a ridiculously low 0.18x EV/sales basis on a 10-year forward dynamic basis.
A similar pattern can be observed with Intuitive Surgical (ISRG, Financial). A classic value investor would have avoided the stock in 2006 because it was trading at a static EV/sales ratio of 20x, whereas a dynamic value investor could have paid 20x static EV/sales for Intuitive in 2006 and had his investment quintupled in 10 years. Why? Because in 2006, the 10-year dynamic forward EV/sales ratio is merely 1.25 times for a business that has a net profit margin of more than 25%.
We can apply this dynamic thinking model with many other companies such as Google (GOOG, Financial), Priceline (PCLN, Financial), MasterCard (MA) and Alibaba (BABA, Financial).
A key element in the dynamic value investing model is the rapid revenue and earnings power growth in the decade ahead of the projection date. Without rapid revenue growth, dynamic becomes anemic and without any revenue growth, anemic becomes static, which will require us to reverse to the classic value investing mindset.
How can a value investor apply the “margin of safety” mindset within the dynamic value investing framework? The answer can be found from the redundancy concept in engineering. We want multiple growth drivers along with the gradual and distinguishable widening of moat. We also need to use a conservative growth rate projection even though, in reality, the business can grow much faster. In most cases, we also need a visionary and extraordinary leader. Without Jeff Bezos at Amazon, Larry Page and Sergin Brin at Google, or Jack Ma at Alibaba, those companies would not have come this far.
Disclosure: No position in any of the stocks mentioned in the article.
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