Earnings Worse Than You Think

Just like the hit series “House Of Cards,” Wall Street earnings season has become rife with manipulation, deceit and obfuscation that could rival the dark corners of Washington, D.C.

What is most fascinating is that so many individuals invest hard earned capital based on these manipulated numbers. The failure to understand the “quality” of earnings, rather than the “quantity,” has always led to disappointing outcomes at some point in the future. 

As Drew Bernstein recently penned for CFO.com:

“Non-GAAP financials are not audited and are most often disclosed through earnings press releases and investor presentations, rather than in the company’s annual report filed with the Securities and Exchange Commission.

Once upon a time, non-GAAP financials were used to isolate the impact of significant one-time events like a major restructuring or sizable acquisition. In recent years, they have become increasingly prevalent and prominent, used by both the shiniest new-economy IPO companies and the old-economy stalwarts.”

Back in the 80’s and early 90’s companies used to report GAAP earnings in their quarterly releases. If an investor dug through the report they would find “adjusted” and “proforma” earnings buried in the back.

Today, it is GAAP earnings which are buried in the back hoping investors will miss the ugly truth.

These “adjusted or Pro-forma earnings” exclude items that a company deems “special, one-time or extraordinary.” The problem is that these “special, one-time” items appear “every” quarter leaving investors with a muddier picture of what companies are really making.

An in-depth study by Audit Analytics revealed that 97% of companies in the S&P 500 used non-GAAP financials in 2017, up from 59% in 1996, while the average number of different non-GAAP metrics used per filing rose from 2.35 to 7.45 over two decades.

This growing divergence between the earnings calculated according to accepted accounting principles, and the “earnings” touted in press releases and analyst research reports, has put investors at a disadvantage of understanding exactly what they are paying for.

As BofAML stated:

“We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of less earnings power. 

Consider that when US GDP growth was averaging 3% (the 5 quarters September 2013 through September 2014) on average 80% of US HY companies reported earnings on an adjusted basis. Since September 2014, however, with US GDP averaging just 1.9%, over 87% of companies have reported on an adjusted basis. Perhaps even more telling, between the end of 2010 and 2013, the percentage of companies reporting adjusted EBITDA was relatively constant, and since 2013, the number has been on a steady rise.

So, why do companies regularly report these Non-GAAP earnings? Drew has the answer:

“When management is asked why they resort to non-GAAP reporting, the most common response is that these measures are requested by the analysts and are commonly used in earnings models employed to value the company. Indeed, sell-side analysts and funds with a long position in the stock may have incentives to encourage a more favorable alternative presentation of earnings results.”

If non-GAAP reporting is used as a supplemental means to help investors identify underlying trends in the business, one might reasonably expect that both favorable and unfavorable events would be “adjusted” in equal measure.

However, research presented by the American Accounting Association suggests that companies engage in “asymmetric” non-GAAP exclusions of mostly unfavorable items as a tool to “beat” analyst earnings estimates.

How The Beat Earnings & Get Paid For It

Why has there been such a rise is Non-GAAP reporting?

Money, of course.

“A recent study from MIT has found that when companies make large positive adjustments to non-GAAP earnings, their CEOs make 23 percent more than their expected annual compensation would be if GAAP numbers were used. This is despite such firms having weak contemporaneous and future operating performance relative to other firms.” – Financial Executives International.

The researchers at MIT combed through the annual earnings press releases of S&P 500 firms for fiscal years 2010 through 2015 and recorded GAAP net income and non-GAAP net income when the firms disclosed it. About 67 percent of the firms in the sample disclose non-GAAP net income.

The researchers then obtained CEO compensation, accounting, and return data for the sample firms and found that “firms making the largest positive non-GAAP adjustments… exhibit the worst GAAP performance.”

The CEOs of these firms, meanwhile, earned about 23 percent more than would be predicted using a compensation model; in terms of raw dollars. In other words, they made about $2.7 million more than the approximately $12 million of an average CEO.

It should not be surprising that anytime you compensate individuals based on some level of performance, they are going to figure out ways to improve performance, legal or not. Examples run rampant through sports from Barry Bonds to Lance Armstrong, as well as in business from Enron to WorldCom.

This was detailed in a WSJ article:

“One out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings.”

This rather “open secret” of companies manipulating bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to flatter earnings is not new.

“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.“

Manipulating earnings may work in the short-term, eventually, cost cutting, wage suppression, earnings adjustments, share-buybacks, etc. reach an effective limit. When that limit is reached, companies can no longer hide the weakness in their actual operating revenues.

There’s a big difference between companies’ advertised performance, and how they actually did. We discussed this recently by looking at the growing deviation between corporate earnings and corporate profits. There has only been one other point where earnings, and stock market prices, were surging while corporate profits were flat. Shortly thereafter, we found out the “truth” about WorldCom, Enron, and Global Crossing.

The American Accounting Association found that over the past decade or so, more companies have shifted to emphasizing adjusted earnings. But those same companies’ results under generally accepted accounting principles, or GAAP, often only match or slightly exceed analysts’ predictions.

“There are those who might claim that so far this century the U.S. economy has experienced such an unusual period of economic growth that it has taken analysts and investors by surprise each quarter … for almost two decades. This view strains credulity.” – Paul Griffin, University of California & David Lont, University of Otago

After reviewing hundreds of thousands of quarterly earnings forecasts and reports of 4,700 companies over 17 years, Griffin and Lont believe companies shoot well above analysts’ targets because consistently beating earnings per share by only a penny or two became a red flag.

“If they pull out all the accounting tricks to get their earnings much higher than expected, then they are less likely to be accused of manipulation.” 

The truth is that stocks go up when companies beat their numbers, and analysts are generally biased toward wanting the stock they cover to go up. As we discussed in “Chasing The Market”, it behooves analysts to consistently lower their estimates so companies can beat them, and adjusted earnings are making it easier for them to do it.

For investors, the impact from these distortions will only be realized during the next bear market. For now, there is little help for investors as the Securities and Exchange Commission has blessed the use of adjusted results as long as companies disclose how they are calculated. The disclosures are minimal, and are easy to get around when it comes to forecasts. Worse, adjusted earnings are used to determine executive bonuses and whether companies are meeting their loan covenants. No wonder CEO pay, and leverage, just goes up.

Conclusion & Why EBITDA Is BullS***

Wall Street is an insider system where legally manipulating earnings to create the best possible outcome, and increase executive compensation has run amok,. The adults in the room, a.k.a. the Securities & Exchange Commission, have “left the children in charge,” but will most assuredly leap into action to pass new regulations to rectify reckless misbehavior AFTER the next crash.

For fundamental investors, the manipulation of earnings not only skews valuation analysis, but specifically impacts any analysis involving earnings such as P/E’s, EV/EBITDA, PEG, etc.

Ramy Elitzur, via The Account Art Of War, expounded on the problems of using EBITDA.

“One of the things that I thought that I knew well was the importance of income-based metrics such as EBITDA, and that cash flow information is not as important. It turned out that common garden variety metrics, such as EBITDA, could be hazardous to your health.”

The article is worth reading and chocked full of good information, however, here are the four-crucial points:

1. EBITDA is not a good surrogate for cash flow analysis because it assumes that all revenues are collected immediately and all expenses are paid immediately, leading to a false sense of liquidity.
2. Superficial common garden-variety accounting ratios will fail to detect signs of liquidity problems.
3. Direct cash flow statements provide a much deeper insight than the indirect cash flow statements as to what happened in operating cash flows. Note that the vast majority (well over 90%) of public companies use the indirect format.
4. EBITDA, just like net income is very sensitive to accounting manipulations.

The last point is the most critical. As Charlie Munger recently stated:

“I think there are lots of troubles coming. There’s too much wretched excess.

I don’t like when investment bankers talk about EBITDA, which I call bulls— earnings.

It’s ridiculous. EBITDA does not accurately reflect how much money a company makes, unlike traditional earnings. Think of the basic intellectual dishonesty that comes when you start talking about adjusted EBITDA. You’re almost announcing you’re a flake.”

In a world of adjusted earnings, where every company is way above average, every quarter, investors quickly lose sight of what matters most in investing.

“This unfortunate cycle will only be broken when the end-users of financial reporting — institutional investors, analysts, lenders, and the media — agree that we are on the verge of systemic failure in financial reporting. In the history of financial markets, such moments of mental clarity most often occur following the loss of vast sums of capital.” – American Accounting Association

Imaginary worlds are nice, it’s just impossible to live there.

“Oh, a storm is threat’ning my very life today
If I don’t get some shelter oh yeah I’m gonna fade away” – Rolling Stones

The graph below plots 15 years’ worth of quarterly earnings per share for a large, well known publicly traded company. Within the graph’s time horizon is the 2008 financial crisis and recession. Can you spot where it occurred? Hint- it is not the big dip on the right side of the graph or the outsized increase in the middle.

The purpose of asking the question is to point out that this company has very steady earnings growth with few instances of marked variation. The recession of 2008 had no discernable effect on their earnings. It is not a stretch to say the company’s earnings are recession-proof.

The company was formed in 1886 and is the parent of an iconic name brand known around the world. The company has matured into a very predictable company, as defined by steady earnings growth.

Fundamentally, this company has all the trappings of a safe and conservative investment the likes of which are frequently classified as defensive value stocks. These kinds of companies traditionally provide a degree of safety to investors during market drawdowns. Today, however, this company and many other “shelter stocks” are trading at valuations that suggest otherwise.

The following article was posted for RIA Pro subscribers last week.

For more research like this as well as daily commentary, investment ideas, portfolios, scanning and analysis tools, and our new 401K manager sign up today at RIA Pro and test drive our site for 30 days before being charged.

What is Value?

Determining the intrinsic value for an investment is a crucial baseline metric that investors must calculate if they want to properly determine whether the share price of a company is rich, cheap, or fair.

Investors use a myriad of computations, forecasts, and assumptions to calculate intrinsic value. As such, the intrinsic value for a company can vary widely based on numerous factors. 

We broadly define intrinsic value as the price that a rational investor would pay for the discounted cash flows, after expenses, of a company. More simply, what is the future stream of net income worth to you? As value investors, we prefer to invest in companies where the market value is below the intrinsic value. Doing so provides a margin of safety.

Jim Rogers, the former partner of George Soros, put it this way: “If you buy value, you won’t lose much even if you’re wrong.”

Calculating the intrinsic value with a high level of confidence is difficult, if not impossible, for some companies. For instance, many smaller biotech companies are formed to find a cure or treatment for one or two medical ailments. These firms typically lose money and burn through funding during the research and development (R&D) stage. If they successfully find a treatment or cure and financially survive the long FDA approval process, the shareholders are likely to receive hefty returns. The outcome may also be positive if they have a promising medication and a suitor with deep pockets buys the company. Because the outcome is uncertain, many biotech companies fail to maintain enough funding through the R&D stage.

Calculating an intrinsic value for a small biotech company can be like trying to estimate what you may win or lose at a roulette table. The number of potential outcomes is immense and highly dependent on your assumptions. 

Coca-Cola

At the other end of the spectrum, there are mature companies with very predictable cash flows, making intrinsic value calculations somewhat simple, as we will show.

Coca Cola (KO) is the company we referenced in the opening section. KO is one of the most well-known companies in the world, with an array of products sold in almost every country. KO is mature in its lifecycle with very dependable sales and earnings growth. The question we raise in this analysis is not whether or not KO is a good company, but whether or not its stock is worth buying.  To answer this question, we will determine its intrinsic value and compare it to the current value of the company.

The textbook way to calculate intrinsic value is to discount the future cash flows of the company. The calculation entails projecting net income for the next 30 years, discounting those annual income figures at an appropriate rate, and summing up the discounted cash flows. The answer is the present value of the total earnings stream based on an assumed earnings growth rate.

In our intrinsic value model for KO, we assumed an earnings growth rate of 4.5%, derived from its 20 year annualized earnings growth rate of 5.4% and it’s more recent ten year annualized growth rate of 2.9%. Recent trends argue that using 5.4% is aggressive. We used a discounting factor of 7% representing the historical return on equities. The model discounted 30 years of estimated future earnings.

The model, with the assumptions above, yields an intrinsic value of $157 billion. The current market cap, or value, of KO is $235 billion, meaning the stock is about 51% overvalued. Even if we assume the longer-term 20-year growth rate (5.4%), the stock is still 35% overvalued.

To confirm the analysis and illustrate it in a different format, we calculated what the stock price would be on a rolling basis had it grown in line with the prior rate of ten years of earnings growth. As shown in the graph and table below, the market value is currently 55% above the model’s valuation for KO.  The green and red areas highlight how much the stock was overvalued and undervalued.

To check our analysis, we enlisted our friend David Robertson from Arete Asset Management and asked him what intrinsic value his cash flow based model assigned to KO. The following is from David:

In looking at the valuation of KO, I see a couple of familiar patterns. The most obvious one is that the warranted value, based on a long-term model that discounts expected cash flows, is substantially below the current market value. Specifically, the warranted value per share is about $21, and nowhere near the mid-50s current market price. The biggest reason for this is that the discounted value of future investments has declined the last few years substantially due to lower economic returns and lower sustainable growth rates. In other words, as the company’s ability to generate future returns has diminished, its stock price has completely failed to capture the change.

The chart below from David compares his model’s current and future intrinsic value (Arete target) with the annual high, low, and closing price for KO.  David’s graph is very similar to what we highlighted above; KO has been trading at a steep premium to its intrinsic value for the last few years.

Lastly, we share a few more facts about KO’s valuations.

• Revenues (sales) have been in decline since 2012
• Price to Sales (6.99) is at a 20 year high and three times greater than the faster growing S&P 500
• Price to Earnings (25.83 –trailing 12 mos.) is at a 17 year high
• Price to Book (11.24) is at an 18 year high
• Enterprise Value to EBITDA is at an eight-year high
• Capital Expenditures are at a 15 year low and have declined rapidly over the last eight years
• Book Value is at a ten year low
• Debt has tripled over the last ten years while revenues and earnings have grown at about 15-20% over the same period

When Value Becomes Growth

In 2018 we wrote a six-part RIA Pro series called Value Your Wealth. Part of the series was devoted to the current divergence between value and growth stocks and the potential for outsized returns for value investors when the market reverts to the mean. In the article, we explored mutual funds and S&P sectors to show how value can be defined, but also how the title “value” is being mischaracterized.

One of the key takeaway from the series is that finding value is not always as easy as buying an ETF or fund with the word “value” in it. Nor, as we show with KO, can you rely on traditional individual stock mainstays to provide true value. Today’s value hunters must work harder than in years past.

Based on our model, KO traded below the model’s intrinsic value from 2003 through 2013 and likely in the years prior. As noted, its average discount to intrinsic value during this period was 41%. Since 2014 KO has traded well above its intrinsic value.

In 2014 passive investing strategies started to gain popularity. As this occurred, many companies’ share prices rose faster than their earnings growth. These stocks became connected to popular indexes and disconnected from their fundamentals. The larger the company and the more indexes they are in, the more that the wave of passive investing helped the share price. KO meets all of those qualifications. As the old saying goes, if you buy enough of them, the price will go up.

Summary

Buying “Value” is not as easy as buying shares in well-known companies with great brand names, proven track records, and relative earnings stability. As we exemplified with KO, great companies do not necessarily make great investments.

The bull market starting in 2009 is unique in many aspects. One facet that we have written extensively on is how so many companies have become overpriced due to indiscriminate buying from passive investment strategies. This has big implications for the next equity market drawdown as companies like KO may go down every bit as much or even more than the broader market.

Be careful where you seek shelter in managing your portfolio of stocks; it may not be the safe bunker that you think it is.  

In a follow-up article for RIA Pro, we will present similar analysis and expose more “value” companies.

“Oh, a storm is threat’ning my very life today
If I don’t get some shelter oh yeah I’m gonna fade away” – Rolling Stones

The graph below plots 15 years’ worth of quarterly earnings per share for a large, well known publicly traded company. Within the graph’s time horizon is the 2008 financial crisis and recession. Can you spot where it occurred? Hint- it is not the big dip on the right side of the graph or the outsized increase in the middle.

The purpose of asking the question is to point out that this company has very steady earnings growth with few instances of marked variation. The recession of 2008 had no discernable effect on their earnings. It is not a stretch to say the company’s earnings are recession-proof.

The company was formed in 1886 and is the parent of an iconic name brand known around the world. The company has matured into a very predictable company, as defined by steady earnings growth.

Fundamentally, this company has all the trappings of a safe and conservative investment the likes of which are frequently classified as defensive value stocks. These kinds of companies traditionally provide a degree of safety to investors during market drawdowns. Today, however, this company and many other “shelter stocks” are trading at valuations that suggest otherwise.

What is Value?

Determining the intrinsic value for an investment is a crucial baseline metric that investors must calculate if they want to properly determine whether the share price of a company is rich, cheap, or fair.

Investors use a myriad of computations, forecasts, and assumptions to calculate intrinsic value. As such, the intrinsic value for a company can vary widely based on numerous factors. 

We broadly define intrinsic value as the price that a rational investor would pay for the discounted cash flows, after expenses, of a company. More simply, what is the future stream of net income worth to you? As value investors, we prefer to invest in companies where the market value is below the intrinsic value. Doing so provides a margin of safety.

Jim Rogers, the former partner of George Soros, put it this way: “If you buy value, you won’t lose much even if you’re wrong.”

Calculating the intrinsic value with a high level of confidence is difficult, if not impossible, for some companies. For instance, many smaller biotech companies are formed to find a cure or treatment for one or two medical ailments. These firms typically lose money and burn through funding during the research and development (R&D) stage. If they successfully find a treatment or cure and financially survive the long FDA approval process, the shareholders are likely to receive hefty returns. The outcome may also be positive if they have a promising medication and a suitor with deep pockets buys the company. Because the outcome is uncertain, many biotech companies fail to maintain enough funding through the R&D stage.

Calculating an intrinsic value for a small biotech company can be like trying to estimate what you may win or lose at a roulette table. The number of potential outcomes is immense and highly dependent on your assumptions. 

At the other end of the spectrum, there are mature companies with very predictable cash flows, making intrinsic value calculations somewhat simple, as we will show.

Coca-Cola

Coca Cola (KO) is the company we referenced in the opening section. KO is one of the most well-known companies in the world, with an array of products sold in almost every country. KO is mature in its lifecycle with very dependable sales and earnings growth. The question we raise in this analysis is not whether or not KO is a good company, but whether or not its stock is worth buying.  To answer this question, we will determine its intrinsic value and compare it to the current value of the company.

The textbook way to calculate intrinsic value is to discount the future cash flows of the company. The calculation entails projecting net income for the next 30 years, discounting those annual income figures at an appropriate rate, and summing up the discounted cash flows. The answer is the present value of the total earnings stream based on an assumed earnings growth rate.

In our intrinsic value model for KO, we assumed an earnings growth rate of 4.5%, derived from its 20 year annualized earnings growth rate of 5.4% and it’s more recent ten year annualized growth rate of 2.9%. Recent trends argue that using 5.4% is aggressive. We used a discounting factor of 7% representing the historical return on equities. The model discounted 30 years of estimated future earnings.

The model, with the assumptions above, yields an intrinsic value of $157 billion. The current market cap, or value, of KO is $235 billion, meaning the stock is about 51% overvalued. Even if we assume the longer-term 20-year growth rate (5.4%), the stock is still 35% overvalued.

To confirm the analysis and illustrate it in a different format, we calculated what the stock price would be on a rolling basis had it grown in line with the prior rate of ten years of earnings growth. As shown in the graph and table below, the market value is currently 55% above the model’s valuation for KO.  The green and red areas highlight how much the stock was overvalued and undervalued.

To check our analysis, we enlisted our friend David Robertson from Arete Asset Management and asked him what intrinsic value his cash flow based model assigned to KO. The following is from David:

In looking at the valuation of KO, I see a couple of familiar patterns. The most obvious one is that the warranted value, based on a long-term model that discounts expected cash flows, is substantially below the current market value. Specifically, the warranted value per share is about $21, and nowhere near the mid-50s current market price. The biggest reason for this is that the discounted value of future investments has declined the last few years substantially due to lower economic returns and lower sustainable growth rates. In other words, as the company’s ability to generate future returns has diminished, its stock price has completely failed to capture the change.

The chart below from David compares his model’s current and future intrinsic value (Arete target) with the annual high, low, and closing price for KO.  David’s graph is very similar to what we highlighted above; KO has been trading at a steep premium to its intrinsic value for the last few years.

Lastly, we share a few more facts about KO’s valuations.

• Revenues (sales) have been in decline since 2012
• Price to Sales (6.99) is at a 20 year high and three times greater than the faster growing S&P 500
• Price to Earnings (25.83 –trailing 12 mos.) is at a 17 year high
• Price to Book (11.24) is at an 18 year high
• Enterprise Value to EBITDA is at an eight-year high
• Capital Expenditures are at a 15 year low and have declined rapidly over the last eight years
• Book Value is at a ten year low
• Debt has tripled over the last ten years while revenues and earnings have grown at about 15-20% over the same period

When Value Becomes Growth

In 2018 we wrote a six-part RIA Pro series called Value Your Wealth. Part of the series was devoted to the current divergence between value and growth stocks and the potential for outsized returns for value investors when the market reverts to the mean. In the article, we explored mutual funds and S&P sectors to show how value can be defined, but also how the title “value” is being mischaracterized.

One of the key takeaway from the series is that finding value is not always as easy as buying an ETF or fund with the word “value” in it. Nor, as we show with KO, can you rely on traditional individual stock mainstays to provide true value. Today’s value hunters must work harder than in years past.

Based on our model, KO traded below the model’s intrinsic value from 2003 through 2013 and likely in the years prior. As noted, its average discount to intrinsic value during this period was 41%. Since 2014 KO has traded well above its intrinsic value.

In 2014 passive investing strategies started to gain popularity. As this occurred, many companies’ share prices rose faster than their earnings growth. These stocks became connected to popular indexes and disconnected from their fundamentals. The larger the company and the more indexes they are in, the more that the wave of passive investing helped the share price. KO meets all of those qualifications. As the old saying goes, if you buy enough of them, the price will go up.

Summary

Buying “Value” is not as easy as buying shares in well-known companies with great brand names, proven track records, and relative earnings stability. As we exemplified with KO, great companies do not necessarily make great investments.

The bull market starting in 2009 is unique in many aspects. One facet that we have written extensively on is how so many companies have become overpriced due to indiscriminate buying from passive investment strategies. This has big implications for the next equity market drawdown as companies like KO may go down every bit as much or even more than the broader market.

Be careful where you seek shelter in managing your portfolio of stocks; it may not be the safe bunker that you think it is.  

In a follow-up article for RIA Pro, we will present similar analysis and expose more “value” companies.

Value investing is an active management strategy that considers company fundamentals and the valuation of securities to acquire that which is undervalued. The time-proven investment style is most clearly defined by Ben Graham and David Dodd in their book, Security Analysis. In the book they state, “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

There are countless articles and textbooks written about, and accolades showered upon, the Mount Rushmore of value investors (Graham, Dodd, Berkowitz, Klarman, Buffett, et al.). Yet, present-day “investors” have shifted away from the value proposition these greats profess as the time-tested secret to successful investing and compounding wealth.  

The graph below shows running ten year return differentials between value and growth. Clearly, as shown, investors are chasing growth at the expense of value in a manner that is quite frankly unprecedented over the last 90 years.

Data Courtesy French, Fama, and Dartmouth

In the 83 ten year periods starting in 1936, growth outperformed value only eight times. Five of those ten year periods ended in each of the last five years.

Contrast

Value stocks naturally trade at a discount to the market. Companies with weaker than market fundamental growth leads to discounted valuations and a perception among investors that is too pessimistic about their ability to eventually achieve a stronger growth trajectory.

Growth stocks are those that pay little or no dividends but promise exceptional revenue and earnings growth in the future.

The outperformance of growth over value stocks is natural in times when investors become exuberant. Modern-day market participants claim superior insight into this Fed-controlled, growth-friendly environment. Based on the media, it appears as if the business cycle is dead, and recessions are an archaic thing of the past. Growth stocks promising terrific streams of cash flow at some point in the future rule the day. This naturally leads to investors becoming too optimistic and extrapolate strong growth far into the future.

Meanwhile, value companies tend to retain an advantage by offering higher market yields than growth stocks. That edge may only be 1 or 2% but compounded over time, it is significant. The problem is that when valuations on the broad market become elevated, as they are now, that premium compresses and diminishes the income effect. The problem is temporary, however, assuming valuations eventually mean-revert.

One other important distinction of value companies is that they, more commonly than growth companies, end up as takeover targets. Historically, this has served as another premium in favor of value investing. Over the course of the past 12 years, however, corporate capital has uncharacteristically been more focused on growth companies and the ability to tell their shareholder a tale of wild earnings growth that accompany their takeover targets. This is likely due to the environment of ultra-low interest rates, highly accommodative debt markets, and investors that are not focused on the inevitability of the current business cycle coming to an end.

Active versus Passive

Another related facet to the value versus growth discussion is active versus passive investment management. Although active management may be involved in either category, value investing, as mentioned above, must be an active strategy. Managers involved in active management require higher fees for those efforts. Yet, as value strategies have underperformed growth for the past 12 years, many investors are questioning the active management logic.

Why pay the high fees of active managers when passive management suffices at a cost of pennies on the dollar? But as Graham and Dodd defined it, passive strategies are not investing, they are speculating. As the graph below illustrates, the shift out of active management and into passive funds is stark.

Overlooking the historical benefits and outperformance of value managers, current investors seek to chase returns at the lowest cost. This behavior is reflective of a troubling lack of discipline and suggests that investors are complacent about the possibility of having their equity wealth cut in half as it was in two episodes since 2000.

Pure passive investing, investing in a mutual fund or exchange-traded fund (ETF) that mimics an index, represents a low-fee approach to speculation. It does not involve “thorough analysis,” the promise of “safety of principal,” or an “adequate return.” Capital received is immediately deployed and invested dollars are weighted most heavily toward the most expensive stocks. This approach represents the opposite of the “buy-low, sell-high” golden rule of investing.

Active management, on the other hand, involves analytical rigor by usually seasoned managers and investors seeking out opportunities in good companies in which to invest at the best price.

Definition of Terms

To properly emphasize the worth of value investing, it is important first to define a couple of key terms that many investors tend to take for granted.

Risk – Contrary to Wall Street marketing propaganda, risk is not a number calculated by a formula in a spreadsheet. Risk is simply the likelihood of a substantial and permanent loss of capital with no ability to ever recover. Exposure to risk cannot be mitigated by blind diversification. Real risk cannot be quantified by processing the standard deviation of historical returns or the sophisticated variations of Value-at-Risk. These calculations and the many assumptions within them lead to misperceptions and misplaced confidence.

Wealth – Wealth is savings. It is that which is left over after consumption and is the accumulation of savings over time. Wealth results from the compounding of earnings. Wealth is not the net value of assets minus liabilities. That is a balance sheet metric that can change dramatically and suddenly depending on economic circumstances. An investor who seeks to sell high and buy low, like a business owner who prudently waits for opportunities to buy out competitors when they are distressed, uniquely illustrates proper wealth management and are but two forms of value investors.

Economic Worldview

Understanding these terms is important because it affects one’s economic worldview and the ability to make prudent investment decisions consistently. As Dylan Grice of Edelweiss Holdings describes it:

“Language is the machinery with which we conceptualize the world around us. Devaluing language is tantamount to devaluing our ability to think and understand.” Grice continues, clarifying that point, “linguistic precision leads to cognitive precision.”

Value investors understand that compounding wealth depends on avoiding large losses. These terms and their proper definitions serve as a rock-solid foundation for sound reasoning and analytical rigor of market forces, central bank policies, and geopolitical dynamics that influence global liquidity, asset prices, and valuations. They enable critical foresight.

Proper definitional terms clarify the logical framework for an investor to benchmark their wealth, net of inflation, rather than obsessing with benchmarking returns to those of the S&P 500 or other passive indexes. Redefining one’s benchmark to inflation plus some excess return properly aligns target returns with life goals. Comparisons to the returns of the stock market are irrelevant to your goals and induce one to be dangerously urgent and speculative.

Value investing is having the courage to be opportunistic when others are pessimistic, to buy what others are selling, and to embrace volatility because it is in those times of upheaval that the greatest opportunities arise. That courage is derived from clarity of goals and a sturdy premise of assessing value. This is not an easy task in a world where the discounting mechanism itself has become so disfigured as to be rendered little more than a reckless guess.  

Properly executed, value investing seeks to find opportunities to deploy capital in such a way that reduces risk by acquiring assets at prices that are sufficiently below intrinsic value. This approach also extends to potential gains and creates a desirable performance asymmetry.

In the words of famed investor and former George Soros colleague, Jim Rogers, “If you buy value, you won’t lose much even if you’re wrong.” And let’s face it, everybody in this business is wrong far more than they’re right.

Summary

Analytically, safety, and profits are rooted in buying assets with abnormally large risk premiums and then having the patience to wait for mean reversion. It often requires the rather unconventional approach of identifying those areas where there is distress and misguided selling is occurring.

As briefly referenced above in the definition of wealth, a value investor manages money as a capitalist business owner would manage his company. A value investor is more interested in long-term survival. Their decisions are motivated by investing in companies that are doing those things that will add to the substance and durability of the enterprise. They are interested in companies that aim to enhance the cash flow of the operation and, ideally, do so with a very long time-preference and as a habitual pattern of behavior.

Unlike a business owner and an “investor,” most people who buy stocks think in terms of acquiring financial securities in hopes of selling them at a higher price. As a result, they make decisions primarily with a concern about what other investors’ expectations may be since that will determine tomorrow’s price. This is otherwise known as speculation, not investing, as properly defined by Graham and Dodd.

Although value investing strategies have underperformed relative to growth strategies for the past decade, the extent to which value has become cheap is reaching its limit.

We leave you with a question to ponder; why do you think Warren Buffet’s Berkshire Hathaway is sitting on $128 billion in cash?