At the end of June, Inigo Fraser-Jenkins, head of global quantitative and European equity strategy at Sanford C. Bernstein & Co., published a research report on value investing, which contains some interesting revelations.
The mean reversion principle
As any value investor who has followed the teachings of Benjamin Graham and early life of Warren Buffett (Trades, Portfolio) will know, these great value investors started their investment careers buying securities trading at a deep discount to book value, which they used as a shortcut for calculating intrinsic value.
According to Fraser-Jenkins' research, however, this metric may no longer have any validity when calculating value.
One of the primary pillars of Graham's work (and indeed, that of every other successful investor) is mean reversion or, to put it another way, the belief that over time stock valuations and returns adjust to long-term averages. So if a stock has traded at a price-book value of around one for the past 10 years, but has recently fallen to approximately 50% of its book value, if mean reversion holds, it should trade up to 100% of book value in the medium term. For much of the 1930s, '40s, '50s, '60s and '80s, this principle held true.
But there have been patches when mean reversion hasn't worked, and that has been the case for the past 10 years. Indeed, according to the Sanford Bernstein analyst's calculations, since the financial crisis, cheap stocks have tended to remain cheap and expensive stocks have tended to get even more costly, making it extremely difficult for value investors to make money.
Multiple factors behind the change
Fraser-Jenkins believes quantitative easing by central banks is the main factor behind this change in mean reversion. Low interest rates mean low discount rates for projected earnings and cash flows, which boosts the valuation of companies that are expected to deliver robust growth far into the future, such as high-growth tech stocks.
But there are many other factors at work here as well. For example, as the Bernstein team notes, many of the world's most successful companies today have much of the value in the form of intangible assets, which are difficult to measure.
Take McDonald's MCD, for example. Some estimates put the value of the McDonald's brand alone at around $125 billion compared to the company's current market capitalization of $162 billion. Should we include this figure in our calculation of book value?
And what about companies like Alphabet's Google GOOGGOOGL, which has a tremendous amount of value in both the brand and data. Google's brand is so powerful it has actually made its way into the dictionary, trying to place a value on that is almost impossible.
Changing with the times
I think it is interesting to note the way the world is going. Investors must adapt and change with the times, which means moving on from book value as the primary indicator of value. Even Warren Buffett (Trades, Portfolio) himself has only recently abandoned this key metric.
Earlier this year, for the first time since he took over Berkshire Hathaway BRK.A BRK.B, Buffett announced he was abandoning book value as the primary method for measuring the conglomerate's growth. Specifically, he wrote in his year-end 2018 letter:
"Longtime readers of our annual reports will have spotted the different way in which I opened this letter. For almost three decades, the initial paragraph featured the percentage change in Berkshire's per-share book value. It's now time to abandon that practice.
The fact is that the annual change in Berkshire's book value — which makes its farewell appearance on page 2 — is a metric that has lost the relevance it once had. Three circumstances have made that so. First, Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses. Charlie and I expect that reshaping to continue in an irregular manner. Second, while our equity holdings are valued at market prices, accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years. Third, it is likely that — over time — Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value. The math of such purchases is simple: Each transaction makes per-share intrinsic value go up, while per-share book value goes down. That combination causes the book-value scorecard to become increasingly out of touch with economic reality."
This change, combined with the work of Fraser-Jenkins, is undoubtedly something to think about as we build and develop our own investment strategies.
Disclosure: The author owns shares of Berkshire Hathaway.
Read more here:
- Warren Buffett's Approach to Valuing Berkshire Hathaway
- 3 Stocks Trading at a Negative Enterprise Value
- 3 Cheap, Benjamin Graham-Type Stocks to Consider Today
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