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?’
OUTPERFORMANCE OF INTRINSIC VALUE (QUALITY) VS. OF LOW P/B.
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,
- high leverage, or
- dissipating fundamentals due to severe cyclical conditions.