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Grahamites
Grahamites
Articles (361) 

Classic Value Investing vs. Dynamic Value Investing

Discussing the differences between classic and dynamic value investing

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 (NASDAQ:APOG) 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 Apogees 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 Apogees 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 companys intrinsic value has also stayed the same as it was two decades ago. Even though there is no growth in intrinsic value, Apogees 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 Amazons (NASDAQ:AMZN) 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/salesduring this period, so it would appear expensive in late 2005 at 3xEV/sales. However, had an investor bought one share of Amazon at 3xEV/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 3xEV/saleson 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 (NASDAQ:ISRG). 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/salesfor 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 (NASDAQ:GOOG), Priceline(PCLN), MasterCard (MA) and Alibaba (NYSE:BABA).

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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About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 4.9/5 (10 votes)

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Comments

Thomas Macpherson
Thomas Macpherson premium member - 3 years ago

A perfect description of the dichotomy between my investing style versus my co-worker John Dorfman. The methods are co-joined by margin of safety. Great article Grahamites. BTW - The Nintai Trust holds ISRG and the Trust and Dorfman Value own MA.

jtdaniel
Jtdaniel premium member - 3 years ago

Hi Grahamites,

I really enjoyed your fine article, particularly the emphasis on top-line growth. Most how-to books on value investing focus on earnings and free cash flow, but Philip Fisher's writings also gave heavy weight to sales/revenue growth in the search for the best businesses. My initial approach in conducting due diligence is to examine the 5 and 10-year trends in all three. A significant lack of consistency (i.e. IBM's revenue) usually prompts me to look elsewhere.

Both value-investing approaches have proven successful, so from my perspective it makes sense to remain open to and alert for opportunities of either type. I think that investors specializing in the dynamic style should keep a significant cash position at most times. Stocks like Starbucks or Chipotle, although increasing their intrinsic value, could experience greater falls in a crash or bear market than the low- P/E value stocks.Buying into Starbucks at 30X earnings looks risky, but by committing to a long-term hold and to averaging-down in falling markets an investor could do well over time. The catch is that Starbucks has to maintain solid growth well out into the future, which I think is a good bet. Best, dj

Grahamites
Grahamites - 3 years ago    Report SPAM

Tom - I face the same dichotomy at work too. I don't think one style should preclude the other but I've found in practice it does. Interesting that Dorfman Value owns MA, not that easy to justify on a classic value basis but very easy to justify on a dynamic basis.

Grahamites
Grahamites - 3 years ago    Report SPAM

dj - You are absolutely right in saying that it makes sense to remain open to both styles. As I commented above, in reality though, I've observed that most value investors are pretty sticky to one style, especially the classic value investors and the dynamic style value investors can be more open in investing in the classic value stocks. I think the hardest thing is to have confidence in your projected future growth rate and that takes a lot of work and deep thinking. Why can Amazon and Google can still grow revenue at 15%+ at their size? It's not that easy to answer. Maybe that's why most value investors are more comfortable with the classic approcah because it's more quantifiable.

snowballbuilder
Snowballbuilder - 3 years ago    Report SPAM

Hi grahamites interesting article

Generally speaking I m probably on the dinamic side ( or value growth side )

As dj as point out great company tend to growth (and growth sales) at good clip

Of course growing sales are not sufficent but probably necessary for a 5 - 10 bagger wannabe

Looking at my portfolio the companies that have performance the best in the long run are the one that have grow significantly sales per share , ebit per share and bvps.

Just some thoughts best snow

Grahamites
Grahamites - 3 years ago    Report SPAM

Snow - Thanks for commenting. Agreed growing sales is absolutely ncessary for a multi-bagger in most cases. Looks like you own a bunch of them:)

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