The Price is Wrong: Reflections on Value and Value Investing – Q3 2019

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” – Benjamin Graham

Benjamin Graham brought to the investing public the concept of fundamental analysis in his famous 1949 book, The Intelligent Investor (a great marketing tactic – implying that other types of investing are not intelligent.) Graham wrote about how stocks could be overvalued or undervalued based on their price relative to their underlying financials. In essence, he was arguing for a rigorous analysis of all the assets embedded in a corporation, and investors’ ability to determine an intrinsic value based on the numbers.

In Graham’s era, this was commonly referred to as book  value, which helped shed some light on how much one could recover when selling all the assets of a company. If the price of a stock was far above the book value of the business, it was considered overvalued: You should avoid it – or better yet, short it. If the price was low relative to the book value, that was an indication to buy the stock.

Graham posited that stocks have an inherent “intrinsic” or “true” value, if you will, which the price fluctuates around. This reflects what’s called in value theory the Intrinsic Theory of Value, meaning that what something is worth can be estimated using objective measures. This kind of stock analysis was made possible only in the prior decade by the creation of the Securities Exchange Commission (SEC) in 1934 and the American Institute of Certified Public Accountants (AICPA), which created the Committee on Accounting Procedure in 1939. Prior to standardization, financial statement analysis was like reading tea leaves.

These institutions standardized financial reporting for the first time in the U.S. and laid the foundation for financial statement analysis. Financial analysis dominated the investment world for subsequent generations. Unfortunately, in the modern era, the usefulness of book value is not cut and dried. For example, Services surpassed Manufacturing in the mid-1980s by percent contribution to U.S. GDP; service businesses currently contribute about twice as much. For service businesses, book value’s relevance as a true measure of intrinsic value has waned.

Beyond Tangible Assets: Measuring the Value of Intangibles like Creative Genius

Consider the lofty price-to-book (P/B) of tech heavyweights like Uber (P/B 3.1), Google (P/B 4.3), Facebook (P/B 5.7), or Amazon (P/B 15.9). True, these businesses are replete with tangible assets like real estate, computers/servers, and cash. But ultimately, their value is a function of the creative genius embedded in their business operations. How much, for example, is Uber’s driver/rider-matching algorithm worth?

When these companies went public, the market assigned a value based on aspirational growth – investors were willing to pay for the future, significantly overpaying relative to the present. This behavior is less reflective of the intrinsic theory of value, and sheds more light on the Subjective Theory of Value, where essentially, the value of anything is simply what someone else is willing to pay for it.

This tension between the two perspectives has been the subject of many philosophical debates and has been distilled into what is called the diamond-water paradox. In essence: Why are tiny, mostly useless, clear rocks so much more expensive than water – which is the source and sustainer of all life as we know it?

The value of a diamond can only partly be explained by its scarcity. Sure, the limited supply of Pappy Van Winkle’s Family Reserve bourbon adds to its allure, but there’s utility in that whiskey! The value of a diamond, unless you’re in the concrete cutting business, is ultimately in the eye of the beholder: its value is in confidence that someone else will give it the same, or greater, value in the future.

Currencies Weigh In

This concept isn’t unusual. Fiat currencies, for example, are those that are not backed by another unit of value, such as gold. The U.S. dollar has been completely fiat since 1976. The value of the U.S. dollar is nearly completely contingent upon everyone agreeing that it will continue to have value in the future. Keep in mind, however, that this is based on the world’s largest economy and a ‘functioning’ government. There are many advantages to having a fiat currency. In fact, the gold standard is arguably one of the key elements that exacerbated the Great Depression, because the Federal Reserve didn’t have the tools to expand credit at a fast enough rate to offset deflationary forces.

Cryptocurrencies add even more fuel to this age-old debate on value. They truly have no fundamental or industrial value; they are only worth what other people are willing to pay for them. Nevertheless, millions of people globally and collectively agree (for the time being anyway) that they do indeed have value.

The concept of cryptocurrencies may be more difficult for Americans to comprehend because we have a well-functioning banking system. But for Venezuelans, the volatility in the value of Bitcoin, for example, is much easier to stomach since its volatility goes both up and down. The volatility of the Bolivar has been painfully one directional; they’re in a currency crisis with inflation exceeding 1,000,000% in 2019 alone. When the government issued its newest and largest bill ever in June 2019, the 50,000 Bolivar bill, it was worth about $8. Now, only a few months later, it is only worth $0.20.

This currency crisis is stoking a massive humanitarian tragedy. One study found that the average Venezuelan lost more than 24 pounds over the last year. Simply put, no one trusts the Bolivar enough to exchange it for food. This is a compelling, real-life case for a decentralized digital currency – not to mention a legitimate, functioning government.

In another part of the world, the Micronesian island of Yap is known for its donut-shaped stone currency, known as Rai; some are as big as 12 feet in diameter. Because some are so difficult to move, ownership is not physical: It is based on an oral history. When one changes hands, that exchange is told to the whole group. This is exactly how cryptocurrencies operate. Ownership is also based on a public ledger. While the real-word names of the owners may remain anonymous with a cryptocurrency, the ledger shows who owns what at all times.

Value vs Growth: A Time-Honored Match-Up – And Our Current Tilt Towards Value

Circling back to what the term value means from an investment perspective, some have chosen to define it in other ways besides the price-to-book ratio (or often, the book- to-price ratio because
the math is easier). Regardless, we believe that investing in value companies, those essentially cheap relative to their peers, is a good idea: If you buy companies at a discount, you’re more likely
to be able to sell them later at a profit. A primary way to reduce risk in an investment is to make sure you’re not overpaying in the first place.

Value investing has its ups and downs, however. You’re taking the risk that the price will never recover, or takes so long to recover that you lose faith in the strategy. Growth has outperformed value for the last 10 years – and to extremes not seen since the late 1930s. We have a value tilt in our portfolios at HH. Not a massive one, but a tilt nonetheless. There are data surrounding growth and value that hold us fast to our conviction, and we think our investors should know our positioning and our reasoning.

First, prior to this 10-year run, value had outperformed growth 20 of the prior 30 years; now they’re even at 20 and 20. Second, though frequency is important, so is magnitude: When value outperforms growth, it typically does so with a greater magnitude. Think of two baseball players with the same batting average, but one player hits more doubles, triples, and home runs than the other. That’s magnitude. Third point, value tends to weather the storm better in down markets. In the five worst years since 1979 (1981, 2000, 2001, 2002, and 2008), value has done far better than growth.

We can’t suggest that the prices paid for growth companies are purely subjective; there are legitimate businesses in that space with legitimate prospects that will redefine our future. The challenge is that heady growth markets are laser focused on the future and highly influenced by investor optimism. When confidence is strong, the future looks bright and the prospective sales, profits, and ingenuity look realistic. When confidence turns, and people get less focused on the future and more on the present, the question becomes: What is this business really worth if the future isn’t quite so rosy?

In the longer term, there is a balance between growth and value that is mean reverting. Themes come in and out of favor with investors. We believe there will come a time when the wax wings will melt from some of the benefactors of this growth rally, and people will return to fundamentals. There was something of a regime change following the financial crisis, given the advent of the smartphone. We’re not predicting anything dramatic besides a bit of a return to normalcy.

The stock portion of portfolios here at HH favor what are called fundamental index funds. We believe that owning an index is far safer than being too concentrated in just a few stocks. Furthermore, we tilt towards factors that should outperform the broad index over time like value, momentum, quality, and low volatility. Stocks are still where a large portion of future growth is going to come from in clients’ portfolios, and when incorporated with other non-correlated assets, their volatility can be mitigated.

Ultimately, value encompasses anticipated outcomes. When we say the price is wrong, what we really mean is that we can’t possibly say for certain that the price is absolutely right. As always, a critical part of our role at Halbert Hargrove is weighing a multiplicity of tangibles and intangibles in terms of the rewards and risks most suited to your needs.

For more information or questions, please contact Halbert Hargrove at hhteam@halberthargrove.com.

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