Most of us who have been investing for a long time know what kind of investor we are. Some of us are growth investors, some are growth at a reasonable price and some of us are unabashed chickens -also known by the more prestigious pedigree of “value investors”. Given the unrelenting rise of stocks of all types from 2009 to 2017 as shown in the chart below, most chicken investors are having trouble channeling Graham or Dodd or, for that matter, scratching up an investment idea:
I took some comfort in a recent Barron’s interview of Bruce Greenwald by Leslie Norton called “Channeling Graham and Dodd in Today’s Market”. Professor Greenwald teaches Finance and Asset Management at Columbia and is the author of the popular “Value Investing: From Graham to Buffet and Beyond” which will see a second edition in 2018. When Mr. Greenwald took over the value investing course in 1991, he likened his quest to “an anthropologist trying to save a dying language”. Of course, Warren Buffet changed all that by reinterpreting the Dead Sea scrolls of Graham and Dodd in the modern vocabulary of his Coca-Cola investment and his home spun annual reports about Mr. Market.
Greenwald’s Secret Sauce
Interestingly, even in 2017 Professor Greenwald suggests that good value investors should start with a company’ balance sheet as its first indicator of value not the discounted cash flow model which has many opportunities for bad assumptions. Why the balance sheet? First it can tell you where the intrinsic bottom value lies by looking at liquidation value and also where the top intrinsic value lies in the cost of reproducing the assets that comprise that balance sheet. For example, The Wizard of Omaha would have found a pretty paltry downside balance sheet liquidation value for Coke (a few mixers) but a remarkably high replacement value for the Coke formulation which actually began with a small dose of a popular narcotic-cocaine.
Discounted Cash Flow Models Are a Deceit
Professor Greenwald then instructs that only after looking at the balance sheet should you look at the company’s earnings power TODAY (not the future) and ask how protected that earnings power really is? This reminds me a little bit of drafting fantasy baseball hitters based on how well they are protected by the hitters before and after them which could lead to The Encarnacion Effect where you actually pick a stock in major decline but well protected by Fransico Lindor and Carlos Santana. Nonetheless, I get his idea.
Professor Greenwald also wonders how value investing can have any place in a market that is primed by Fed monetary policy and tilted in favor of passive momentum investing. He is right that any card carrying value investor just cannot wrap his arms around Facebook, Amazon, Netflix and Google. They defy gravity buoyed by the human propensity to believe in cheerful forecasts. If Brexit and the Trump victory proved one thing to me, forecasters don’t have a clue, but humans are wired to believe in hopeful outcomes so experts stay employed. The main culprit in his estimation is discounted cash flow models built on faulty optimistic assumptions.
Value Grounded In What You Are Today
Value investors are more focused on what the company can do for me today. Professor Greenwald thinks those “today” insights are honed by industry specialization, a fixation on free cash flow generation as a percent of reported net income (Apple) and aftermarket service dominance (Deere). Would you believe that Apple was trading at less than 6x Enterprise Value to EBITDA and only 10-11x its unlevered free cash flow just one year ago? The only question a value investor had to ask then about Apple is how likely is abandonment of that device by that community? I defaulted to asking family and friends about Apple and they all said that substitution is too painful. Samsung reinforced that opinion recently when its phone was banned by the US Airline industry for catching on fire.
Buffet Says Don’t Try This Yourself
Professor Greenwald is also suspicious of Warren Buffet’s warning that only 1 % of the investor population has the skills to be an active manager. He seems to understand that “the nightmare scenario for value investors isn’t passive investing; it’s everybody takes a value approach”. As a value investor I feel pretty safe for the foreseeable future now that Warren Buffet has scared everyone away. Nonetheless, I still am searching for the next Coke in that pile of unloved equities even as my robo funds and ETFs are chunking out pretty good FANG dominated returns.