If you pursue the value investing framework, one of the key decisions you have to make is whether you want to be a, what I call, classic value investor; or a Buffett-Prime investor. In my mind, a classic value investor largely follows an asset-oriented strategy influenced by Benjamin Graham; whereas a Buffett-Prime-type investor follows an earnings-power-oriented strategy, influenced by Charlie Munger, Philip Fisher, and Warren Buffett of the 1970's.
Some might say Buffett-Prime-type investing is the same as growth investing but I don't like to call it growth investing. The reason is because there is a whole genre of investing called growth investing that appears to be not based on any value investing principles. There are many growth investors, including some successful ones, who don't pay much attention to financial statements (some may call them medium-term traders). For instance, there are many who will form a bullish or bearish opinion of, say, a stock like Google (GOOG) without even looking at the financial statements or having any idea of its financial metrics. In my mind, value investing, which can also be called fundamental investing, must focus on financial statements. That's why I don't like to use the notion of growth investing on this blog.
Of course, I'm painting with a broad brush here and as Buffett and others have said in the past, growth investing and value investing are joined at the hip. Nevertheless, I like to separate them out.
Most of you, especially the newbies, should probably focus on one approach. I am trying to target more of a Buffett-Prime approach but one isn't necessarily better than the other. If you are really good, you can probably pursue both approaches but, otherwise, the skillsets for the approaches are very different.
So what are some key differences between the two styles?
Looking Through the Net-Net Glass
Over the last few weeks, Geoff Gannon wrote some excellent articles on net-net stocks at GuruFocus, and I think these articles shed light on the different types of investing styles. I highly recommend the following three articles by Gannon:
How Many Net-Nets Are There?
Risk in Net-Nets
When Is a Bad Business a Good Net-Net?
The "Risk in Net-Nets" article is probably the best article on investing I have read this year! So do check it out even if you have no interest in net-nets.
I'll be quoting from the last two articles above to highlight some points (hope it's ok to quote so much). Geoff Gannon may not agree with my opinion on the differences between classic value investing and Buffett-Prime investing so do not construe his articles as being supportive of my opinion. I'm pulling some points he made to illustrate something unrelated to his original purpose.
For those unfamiliar with value investing, net-net stocks are a type of stock. Geoff Gannon uses the following definition for net-nets:
A net-net is a stock with a market capitalization (last traded share price times number of shares outstanding) that is less than the company’s cash, receivables, inventory and prepaid expenses minus all of its liabilities.There are some other slightly differing definitions but it doesn't matter for our discussion here.
(On a side note, if you are newbie or considering trying a new investing style, I recommend that you try classic value investing and focus on net-net stocks. I'm not cut out for it but these stocks provide several big advantages for small investors. Of note, net-nets tend to be smallcap or microcap stocks and large, professional, investors can't invest in them. So a small investor has far less competition and can capitalize on opportunities.)
Net-net stocks are good example of the type of stocks that only classic value investors would buy. These stocks tend to have poor business characteristics, questionable corporate governance, declining long-term prospects, and so forth. Therefore, growth-oriented Buffett-Prime-type investors would not favour them (as usual, there are some exceptions and some stocks may fall into both categories). As Gannon remarks in one of his articles, "Net-nets are asset value bargains – not earning power bargains." This is sort of what distinguishes the two approaches.
I am not a classic value investor, and am not trying to be, so I have little interest in net-nets (only exception is with special situation investing such as liquidations). Most long-time readers probably follow similar investing strategies and tactics as me, since I don't really write about classic value investing. So why am I talking about net-nets all of a sudden?
Geoff Gannon is such a good writer that, even if you have no interest in his core investing tactics, you can learn a lot about general investing concepts. Such is the case with his recent writing on net-nets. In particular, I wanted to highlight his writing that distinguishes the characteristics of net-net versus richly-valued stocks.
Impact of Mean Reversion
At the top end of companies in terms of stock prices versus asset values, the big concern is return on assets and equity. Companies that trade at 3, 4 or 9 times tangible book value need to earn very high returns on their tangible equity to justify these high price-to-asset value ratios.What is said above is kind of obvious but there is a subtle point here. I haven't seen too many people comment on it before.
At the bottom end of companies in terms of stock prices versus asset values, the big concern is safety. The reason for this is simple. Say you get it wrong when it comes to a company trading at a high P/B value like Microsoft (MSFT). You believed the company could continue to earn high returns on tangible book value. It turns out you were wrong. What happens? The company’s return on its assets drifts towards the central tendency of returns on assets at U.S. companies. Returns on assets mean revert. And the stock price falls.
If the same thing were to happen with a low price to asset value stock – you misjudged the company’s future in terms of returns on assets – the most likely outcome is a drift toward this same central tendency. If the company does things you don’t expect with its assets it’s likely to end up earning returns on those assets close to the average of American business. But in the case of net-nets, such mean reversion would cause the stock price to rise.
Investors focus heavily on ROE (or ROA or ROIC) for companies that have high price-to-book ratios. I would say most Buffett-Prime-type stocks fall into this category—particularly because they tend to have low physical assets and high intangle assets. For these stocks, if return on assets mean-revert, the stock will fall. The reason is because these stocks have very high ROA (or ROE or ROIC) whereas the overall market's ROA (or ROE or ROIC) is far lower. The US market has a long-term average ROE of around 12%, whereas most high P/B stocks have ROEs way above that. So if they revert to the mean, it will be a deterioration in their values.
In contrast, for net-nets, mean reversion will result in their ROE (or ROA or ROIC) improving towards the overall average. Needless to say, this will result in their stock prices rising.
In some sense, the point being made is blatantly obvious; on the other hand, it may not be.
I wanted to highlight the differing outcomes because it shows why you need to think differently depending on your investing approach!!! Reversion to the mean is a total disaster in one scenario and pretty good in another. This is one reason I think classic value investing and Buffett-Prime investing require different skills and it's probably best if one doesn't mix up the stock picks.
Earning Power vs Asset Values
Growth-oriented investors care about earnings but classic value investors, especially those buying net-net stocks, care about asset values. Gannon explains this point:
Microsoft has a high P/B ratio. But it has a low P/E ratio. Investors are optimistic about Microsoft’s ability to earn a good return on its assets. However, they are pessimistic about Microsoft’s ability to earn as much in the future as it has in the past.There may be some rare stocks with high ROE that are cheap on both P/B and P/E but that is rare (ignoring cyclical stocks whose P/E behaves differently). Most of the time, if you look at growth-oriented stocks with high ROE, you will end up with very high P/B. The only "cheapness" you will encounter is with a low P/E; you just won't see them trading below book value (unless they were severely distressed).
If you are considering buying shares of Microsoft, the question you need to ask is whether investors are right or wrong about that second part. The question at Microsoft is future earnings relative to past earnings. That’s because Microsoft is only cheap relative to its past earnings. The company is not cheap relative to its present book value.
And that’s totally different from a net-net. A net-net may be cheap or expensive relative to its past earnings. I prefer that the stocks I pick for GuruFocus’s Net-Net Newsletter are cheap relative to their past earnings. But that’s not always the case. Usually, they are – at a minimum – cheap on an enterprise value to EBIT basis. But not always.
Past earnings would be our main concern if the company [not quoted here] was selling at a low price relative to earnings – like Microsoft – but it wasn’t. It was a net-net. So our top concern was the company’s assets and the reliability of those assets. In that extreme case, the company actually had an investment portfolio worth more than its stock price. So, the two questions were how reliable is the value in that investment portfolio and then what was the chance the operating business would destroy value over time instead of just breaking even. The question of the company’s operating business adding value was treated as nothing but a kicker. It might add value. So the stock came with what I hoped was a business that would likely break even and might possible have some positive value. That’s all you need in a net cash bargain.
The point of this article is that you don’t analyze net-nets from the same perspective you analyze Microsoft. You don’t start with earning power. You start with asset values.
That makes safety paramount. At Microsoft, future earnings relative to past earnings will be critical in deciding whether or not you make money in that stock. This is not true of a net-net. Past earnings may be lousy. And future earnings may turn out to be wonderful. It’s very hard to predict this sort of thing. I don’t try.
Given how the high ROE stocks will generally trade way above book value, the investor's success is based on whether the future earnings generate sufficient returns. Asset values generally mean nothing since the stock price is way above those asset values.
In contrast, the success of net-net stocks and other low P/B stocks mostly come down to the asset values. Small changes in asset values can make huge difference to the outcome.
Challenges of Owning High-P/B Stocks
Most Buffett-Prime-type investors pursue companies with moats—as opposed to classic value investors who are willing to invest in trashy businesses—so what are the issues one needs to think about? In "When is a good business a good net-net?" Gannon describes the sorts of questions investors in net-nets vs richly-valued stocks need to ponder:
I’d rather own the wide-moat stock. But it’s not that easy to know what a wide moat is. And it’s even harder to know if it’ll be around in the future.The points made here get to the heart of Buffett-Prime investing. Gannon identifies the challenges with such a technique. For instance, a lot of people throw around the word 'moat' but very few have any idea how strong a moat is.
The problem there [with richly-valued, wide, moat stocks like Apple] is the future. A wonderful recent past combined with bright future prospects will lead to more competition for a company like Apple. So you have to look at the organization. You have to believe in the people there. And the culture. And their ability to innovate. And to preserve a brand. To cultivate an image. And to hype things worldwide.
There is nothing wrong with making that kind of bet. But it’s hard to make on the past numbers alone. Because you know there will be factors – like competition and new product launches – that will transform the company. Will this tend to push the company’s return on equity toward the kind of ROE the average American company earns? Maybe. At a certain size, the push toward mediocrity will be pretty strong.
I’m not saying Apple is worse than a net-net. I’m just saying there are really three different types of stocks. You can – in my view – buy Dun & Bradstreet for its competitive position, you can buy Apple for its organization, and you can buy a net-net for its liquid assets. All are legitimate investments. All require different analysis. The P/E ratio is most applicable to Dun & Bradstreet. I think Apple’s P/E ratio has less meaning. And a net-net’s P/E ratio has even less meaning.
But, like I said in last week’s net-net article, the push toward mediocrity at a net-net will tend to raise the stock price rather than lower it. Any movement towards mediocrity at D&B or Apple will devastate the stock price. Both companies have stock prices that are not backed by tangible assets. Therefore, they need to maintain ultra valuable intangible assets or their stock prices will collapse. Net-nets are different. They are backed by tangible assets.
Furthermore, the difficulty is determing how the future will unfold. If ROE starts approaching the long-run, national, average, it'll all downhill for these stocks that trade at high P/B.
Although what is discussed in this post involves generalizations and there are many exceptions, it is useful to think about what type of investor you are, how that differs from other approaches. Hopefully this post illustrated how low P/B (or net-nets in this case) and high P/B stocks differ. Just to wrap up this post, I wanted to illustrate a sample of three stocks (two mentioned by Geoff Gannon in his articles, and the other, P&G, picked randomly by me). The following graphic shows some key metrics from Morningstar.com for Tuesday Morning (TUES), a net-net, Microsoft (MSFT), and P&G (PG) (as usual, click on image for a larger one):
Tuesday Morning has high P/E but that may be temporary since the forward P/E (not shown) is around 11. In any case, you can see how Tuesday Morning is trading at a P/B of 0.6, and according to Geoff Gannon, is apparently a net-net. Microsoft is trading way above book value, at a value of 3.7. Whereas my other high P/B pick, P&G, is trading at a high P/B of 2.9. The ROEs are almost completely opposite, with Microsoft having a very high ROE of 44.2% and Tuesday Morning with a very low 2.6%.
Classic value investors will favour stocks that resemble Tuesday Morning, whereas Buffett-Prime investors would favour companies that resemble Microsoft or P&G (there are exceptions of course).
Microsoft has very high ROE because it doesn't have much assets. It generates wealth from intangible assets and very little of them. As Geoff Gannon alluded to, if earnings decline materially, there won't be enough assets to protect shareholders.
In contrast, Tuesday Morning is a net-net and what happens to its asset value significantly impacts the shareholder. If earnings change much, it really won't have much impact on Tuesday Morning shareholders because the ROE is so low.
Although I didn't highlight it above, you can get a feel for why Tuesday Morning may be a net-net by looking at its revenue and earnings (EPS) growth over the last 3 years. Tuesday Morning has been posting negative growth for 3 years and it may be a declining business. Its revenue fell at a compounded rate of -2.5% over the last 3 years, while earnings fell -14.3% per year over the three years. In fact, revenue and earnings peaked out back in 2004/2005 (not shown above). So, there is a reason the market has marked down Tuesday Morning shares down to a P/B of 0.6 and P/Sales of 0.2.
In contrast, although Microsoft shareholders have been heading for the exits, and marked down its P/E below 10, its revenue and EPS have grown 3.1% and 5% over the last 3 years, respectively.
Just by looking at the metrics above, you can tell that anyone buying Tuesday Morning must pursue a different strategy from one buying Microsoft. This, in my mind, is illustrative of a classic value investor versus a Buffett-Prime-type investor. Tags: Geoff Gannon, insightful