Value Investing Meets 1999, 2015

On January 10, 2000, Merrill Lynch’s Henry Blodget made the following statement: “Valuation is often not a helpful tool in determining when to sell hypergrowth stocks.” Shortly thereafter, the valuation of tech stocks trading on the NASDAQ exchange crumbled. On July 13, 2015, Paul Sweeney, an analyst at Bloomberg, offered this: “When you see stocks with these high multiples, it shows you the market’s comfort in the longer-term growth story.” Every generation, a rationalization for paying prices disconnected from business fundamentals seems to arrive. People can’t help themselves; it plays out over and over again.

The likelihood of falling for this kind of stuff does seem to be more nature than nurture. When Warren Buffett explained value investing to students at Columbia University in 1981, he mentioned that people instinctively are attracted to the concept of buying “dollar bills for fifty cents” or they immediately have no interest in it. Certain people receive an intellectual high from receiving things at a discount, and can’t be seduced into bubble investing because they feel no temptation to invest in something trading at 80x earnings. It holds no interest to them.

If you want to know what calm self-assurance looks like in the face of bubble pricing, check out 1999 annual report filed by Tweedy, Browne for the Tweedy, Browne Global Value Fund.

I’ve reprinted my favorite extended passage in full because I consider it one of the most rational real-time analyses of general stock market conditions that I have ever encountered:

“It was a very strange year in that the stocks that did well were few in number. And those that did well, by and large, did very well. Internet stocks and technology stocks, which we do not own, did extremely well, appearing to defy all forms of fundamental financial gravity, while large value stocks and most mid-cap and small-cap stocks did poorly…

Internet stock valuations are particularly difficult for us to comprehend. In our opinion, these issues are truly the cork on the champagne bottle. As a group they have little or no earnings and no near term prospects for earnings that could justify their sky high stock prices. We feel as though we are sitting on the sidelines watching a wild party going on and wondering if we are missing out on all the fun. However, we remember that, at best, these parties end with a hangover or are brought to an abrupt end when the police show up and cart everyone off to jail. These parties have occurred in the past. We remember the great personal computer party of the early 1980s.

The industry leaders in those days were Atari, Commodore and Tandy, names that are barely remembered today. The same happened with biotechnology companies in 1991. True financial history buffs can recall the tulip mania of the 17th Century, the railroad mania of the late 19th Century, and the birth of the automobile industry in the first part of this century.  Railroads, autos and personal computers all grew to be large, important industries. However, the stocks one could buy to participate in these great growth industries for the most part were bad investments.

A friend of ours who also manages money told us of a report he read which showed that if you had invested an equal amount of money in every personal computer manufacturer in 1980, your annually compounded rate of return over the next 18 years would have been a disappointing 4%. Great growth industries often have the common characteristic of ease of entry with low capital requirements. Despite the fact that the auto industry today is a highly capital-intensive business, the opposite was the case in the early part of this century. The same may be said for the Internet. Add to this the fact that the pace of technological change today is so rapid, what is cutting edge technology one day can be passé the next. Ease of entry and low capital requirements draw competition and while competition is good for consumers, it is bad for profits.

Most Internet companies do not have any profits other than the profits reaped by selling stock to the public. Brand recognition is also important for companies selling products to the consumer. To some extent, has brand recognition. However, when it only takes a point and a click to compare prices at Borders or Barnes & Noble, the only reason to buy from one versus the others is price. The book is the same; price is the only difference and the price will be set by the company that is willing to accept the lowest profit margin. Companies will therefore compete on price for more customers hoping that a significant market share will ultimately lead to profits. Unless one of the competitors has a sustainable cost advantage over the others, this is not the formula for a good business.”

Not only did Tweedy, Browne accurately predict the price collapse of 1990s internet stocks, but the investment firm also predicted Amazon’s business model that continues to this day (i.e. growing revenues at a rapid pace without using profit margins as a primary basis for making investment decisions.) It is an excellent legacy that the company, which rose to prominence as Benjamin Graham’s stockbroker, refused to participate in speculative bubbles and instead does things like buy large blocks of Nestle stock for the Global Value Fund and never sell it.

This is one of the primary benefits of value investing. If you always focus on fundamentals and keep your eye on the relationship between current profits, expected profits over a 5+ year time horizon, and the current price of the stock, you will avoid finding your net worth fall by 60% in a justified way that will guarantee permanent capital impairment. The application of an absolute rule like “I will never pay over 20x earnings for a large-cap stock with normalized profits in a noncyclical industry” will weed out most of the disasters associated with overpaying, though I would treat it more like a presumption so you can go after companies like Visa or Starbucks trading at 21x profits.

The principal risk, and cause of disappointment, with value investing is that you will often be early to the party. There are really no value investing principles that can be consistently applied to tell you when a stock will hit an all-time low because prices are based on what real investors and computers, acting in real time, are willing to pay for an ownership position and this element of discretion elides absolute formulas.

But value investing principles can give you an idea when a price offers you a good deal. Most value investing principles that take into account historical dividend yields or cyclically adjusted earnings would tell you that it makes sense to purchase Chevron at $110, and it can fairly be classified as attractive once it hits $100.

The catch? There is nothing stopping it from falling below that. Chevron going from $100 to $90 can be classified as the stock becoming more attractive based on price, but there is not much you can do to determine the low ahead of time.

There are usually two responses to this tendency.

One ignores the likelihood of a price going lower and just enjoys the opportunity to reinvest at lower prices and benefit from stock buybacks, if any, that the company conducts. If you go through life creating a surplus, and buying high-quality assets at decent prices, things will work out in your favor even if you don’t get the best deal possible.

The other approach actually pursues mitigation. The Tweedy Browne approach to value investing historically recommended buying stocks in three increments. If you have $30,000 to invest, you might set aside $10,000 to purchase Chevron at $110, another $10,000 at $100, and the final $10,000 at $90. It sets aside capital available to take advantage of the lower prices.

The obvious drawback of this approach is that the price immediately available to you might be the most attractive. Coming out of the recession, Johnson & Johnson spent a lot of time trading around $60 per share. If you had money to invest, you should have bought as much Johnson & Johnson as you could at the time. If you set aside pools of capital to purchase at $50, $45, or something like that, you never would have gotten your investment to engage in mitigation through a lower cost basis. And, of course, this mitigation technique can itself be mitigated by just moving onto a different stock with investment funds that never reach the target price with a particular stock.

The hazards of arriving too early with value investing will lead to more preferential outcomes over time because, eventually, earnings growth will support the higher, earlier price you might pay for a stock. Someone paying $110 for Chevron will get bailed out through dividend reinvestment and long-term earnings growth in a way that someone paying 80x earnings for Facebook stock will not. The eventual reversion to 20x earnings with a tech stock like Facebook is such a substantial shift in valuation that it can easily take a decade of strong earnings growth to get fundamentals and valuation in sync.

Source: Tweedy Browne Global Value & American Value Fund