Sunday, 17 December 2017

"Cheap" classic value companies versus Quality (growing intrinsic value) companies

Classic value metrics such as P/B, P/E or DY do not represent intrinsic value. 

To illustrate this, Grantham says when he poses the following question to investment audiences

  • “I give you Coca Cola at 1.2x book or General Motors 1.0x. 
  • Which would you have?” he gets no takers for GM. 

That is the clearest difference between P/B as a corner stone of classic value, and not intrinsic value.

The extra qualities represented by Coca Cola are worth a premium. The only question is, “how much?’ 


What this means is that

  • any outperformance of intrinsic value (quality) is pure alpha
  • where outperformance of low P/B (as it is for many small caps) is compensation for a high risk premium. 

To support this point, Grantham points out that had the US government not bailed out the behemoths of the US financial system in the crises of 2008, many companies trading at low price to book ratios would have gone bankrupt (not just in the US, but across the world due to the interconnectedness of the global financial system).

What we learn from Buffett’s review of the first 25 years of his investment experience is that this risk premium sometimes comes back to bite you. 

It should not be surprising that in times of deep economic crises, more of these “cheap,” classic value companies go bust than is the case for the “expensive” intrinsic value companies.

Further studies found that classic value investment opportunities tend to coincide with other characteristics such as

  • small capitalization, 
  • illiquidity, 
  • high leverage, or 
  • dissipating fundamentals due to severe cyclical conditions.  

 “The pure administration of classic value investment style really needs a long term lock-up, like Warren Buffet (Partnership) has or it will have occasional quite dreadful client problems.” 

Investment history is replete with examples of such dreadful client problems – Gary Brinson of UBS in the late 90s, Tony Dye who ran a value based contrarian portfolio for Phillips and Drew, and low PE value manager David Dreman in 2008, all lost the majority of their clients due to severe underperformance. 

The big lesson to learn here is not that classic value investing doesn’t work. 

It is the fact that it works far less frequently in recent times than it used to, enough to produce dreadful client problems.  

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