The following was excerpted from our Winter letter to IMA clients.
I have a problem with both growth and value demagogues.
Growth demagogues will argue that valuation is irrelevant for high-growth companies because the price you pay for growth doesn’t matter. They usually say this after a very extended move in growth stocks, where these investors look like gods that walk on water. They call value investors “accountants.”
The price you pay matters (this is not a new message). As we’ve discussed in the past, if you bought great, high-growth companies near the end of the Nifty Fifty bubble in the 1960s or near the end of the dotcom bubble in the 1990s, it took more than a decade to break even (after first struggling through double-digit losses).
One company that comes to mind as I write this is Qualcomm. That stock went from $4 in 1999 to $80 – that’s a 20x increase. Qualcomm is truly an incredible company (we own its shares, which we bought for the first time in 2015). It owns essential patents on wireless technology. Your mobile phone runs on Qualcomm’s intellectual property. Every time a mobile phone is sold on any part of this large planet, Qualcomm collects a few bucks. An incredible and very profitable business. From 1999 the mobile phone market went through an incredible growth spurt – it’s hard to find a market that grew faster globally. However, this did not stop Qualcomm stock from declining to $14 (an 83% drop) in the early 2000s. It took 15 years for Qualcomm to revisit its 1999 high, while its revenues went up 6x over that time.
If Qualcomm doesn’t remind you of Tesla, it should – electric cars are the future. (I wrote a tiny book about it, which you can read here.) Tesla stock is up 8x in 2020; it has even been admitted into the exclusive S&P 500 Index club. The stock is trading at an incredible 22x revenues, or some (meaningless) price-to-earnings multiple (the company is barely profitable). I discussed Tesla’s valuation in the past, so I won’t waste digital ink on it here, but I’d wager that the expected return for the stock over the coming decade looks incredibly unattractive. The price you pay for even an incredible high-growth company (whose product you love) matters.
Now that I’ve made a lot of friends in the growth demagogue camp, let’s make some among the value demagogues.
Value demagoguery starts when value investors read Ben Graham’s Intelligent Investor and the main point they get out of the book is that they need to buy statistically cheap stocks. That is like visiting the Louvre and only learning that its bathroom has soft hand towels. Or reading the Ten Commandments and the only thing you get out of them is how to count to 10. Value demagogues often miss the value investing philosophy embedded in Graham’s book. I spelled out that philosophy in an essay, “The 6 Commandments of Value Investing” (click here to receive them in your inbox; or you can listen to it here).
The value demagogues also look at the high current statistical valuation of high-growth companies and ignore that this number is based on rear-view mirror earnings. They ignore that there is tremendous value in growth, and that value is unlocked when a growth company escapes its adolescence and enters maturity. Its costs start growing at a slower pace than its revenues, its margins expand, and its earnings skyrocket. This is why in our models we look at companies based on their earnings at least four years out. If we have a unique insight into the sustainability of a company’s future moat and exploding total addressable market, we are looking out farther than four years and then discounting back to today.
What makes the analysis of some of the growth darlings more difficult this time is that their income is distorted (depressed) by investments (in customer acquisition, for instance) that are made through their expense line on the income statement.
Let me give you this example. Walgreens, when it was opening several stores a day during its high growth stage, was doing so through its balance sheet. It would buy land, build a store, and stuff it with inventory – all these activities happened on Walgreens’ balance sheet. But a store is a long-term asset that will help Walgreens generate sales and profit for decades. Walgreens would depreciate the land and building over 30 years; thus, as an investor, you would only see 1/30 of the building’s cost going through the income statement in any given year. Inventory would show in the income statement as cost of goods sold when they were sold. Costs in the income statement matched revenues they helped to generate.
When software-as-a-service (SAAS) companies acquire customers, the costs are expensed through the income statement, depressing earnings (they never touch the balance sheet). Though the customer may stick around for 10 years, the cost of acquiring that customer hits the income statement on day one (e.g., in the salesperson’s commission). The faster you grow, the heavier the customer acquisition burden you carry.
Research and development (R&D) efforts also don’t flow through the balance sheet but are expensed through the income statement. R&D is building an asset that will have a long-term life (just like a Walgreens’ store), but almost all of R&D cost is expensed in the year it happens.
Modern accounting conventions were created for the industrial economy, which was heavy on physical, easy-to-identify, depreciable assets (stores, factories, etc.). Over the last two decades significant parts of the economy changed, but we are not going to wait for accounting conventions to change, so we need to change.
We don’t want to be either value or growth demagogues, though it is easy to turn into one or the other. Our goal is to produce good returns for our clients (and ourselves since we own the same stocks) while sleeping well at night. Or, in other words, we try to maximize returns per volatility of our clients’ blood pressure. We are constantly making a conscious and very deliberate effort to be neither type of demagogue. Our portfolio today looks a bit more eclectic than a traditional value portfolio. Over the years we’ve made gradual changes to our analytical process to capture value when it resides in growth, which allowed companies like Twilio, Uber, Twitter, and others to enter our portfolios.
Though I don’t want to be a demagogue, period, if I had to choose sides today, I’d rather err in being a value demagogue. Traditional value (defined as slower-growth companies) has been underperforming growth for too long. Also, the pandemic has widened this gap significantly. Today the stock market cannot get enough of high-growth stocks (even adjusting for nuances in their accounting). We believe many are tremendously, if not insanely, overvalued.
Today, we see value in the more traditional (slower-growth) names. At some point this will change.
The world around us is changing at an accelerating pace. We should strike a delicate balance of learning and adjusting to changes but at the same time remaining true to who we are as value investors (I highly recommend you read Six Commandments of Value Investing, (click here to receive them in your inbox).
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