Imagine the Creator allowing Ben Graham to visit Planet Earth for one day. Just one day to observe the progress of his intellectual children and his beloved Value Investing philosophy. What would he see? He will not be surprised to see the terrific investing success of his star pupil – Warren Buffett.
Nevertheless, he would be puzzled to find that Warren no longer follows Graham’s philosophy of cigar-butt Value Investing – taking the last thrill puff before the lip burn – buying a bunch of stocks that one knows nothing about except that they all trade below their net working capital values.
Graham would also shrewdly observe that Warren still follows him in letter, but not so much in spirit. Graham would be dismayed to see that his protege recommends that investors only read Chapters 8 & 20 of Graham’s classic ‘The Intelligent Investor’ and just get a gist of the ‘Margin of Safety’ and ‘The Investor and Market Fluctuation concepts. Furthermore, Graham would be shocked to find that Warren now follows in spirit another ex-Californian and his current heavenly investing rival called Philip Fisher. Mr Fisher, the author of ‘Common Stocks and Uncommon Profits’, advocated knowing about quality companies and growing with them, a strategy antithesis to that of Graham.
He would nod in admiration that Mr Buffett’s success has unwittingly spawned ‘The Church of Buffettology’. From its headquarters in Omaha, this church has spread its brand of Value Investing gospel far and wide and is now discussed even in the remotest corners of the world where two investors meet. However, he would also observe one strange happening. This church is aspirational. In this church, everyone prays for market salvation, but only the founder has gotten it. Mr Buffett and some of the investors mentioned in his 1984 ‘The Superinvestors of Graham-and-Doddsville’ may have, but the vast majority of the Buffettology priests and their parishioners are still bested by Graham’s near century-old creation – Mr Market. This market Frankenstein, in a new market cap-weighted avatar called Index funds, has now given generations of Value investors an expensive education on the limitations of Buffettology.
Why is this happening? What is the reason for this sad state of Value Investing? How did a philosophy which was born to supply de rigueur become intellectually sterile to the point that most of its living followers are simply mimicking the dead masters, like high school backbenchers craning their necks and blindly copying the good, bad and the absurd from the frontbenchers?
Is there hope for us? How do we slay this Mr Market dragon?
The Prescription is Description
One hope came from within the church of Buffettology itself. Robert Hagstrom, who has written extensively about Mr Buffett’s success, provided one clue in his book ‘Investing – The Last Liberal Art’. He quotes the great philosopher Ludwig Wittgenstein on the importance of narratives and how they create reality:
“Take an example the aspects of a triangle. This triangle can be seen as a triangular hole, as a solid, as a geometrical drawing, as standing on its base, as hanging from its apex; as a mountain, as a wedge, as an arrow or pointer, as an overturned object, which is meant to stand on the shorter side of the right triangle, as a half parallelogram, and as various other things…” Ludwig Wittgenstein – Philosophical Investigations
The implication was clear. We could describe an event in multiple ways and create multiple realities, all of which could be justified. Taking this concept into the stock markets, he describes his experience with Amazon and how Bears viewed it as an overvalued retailer as they compared it to Barnes & Noble and Wal-Mart. Bulls on the other hand viewed it akin to Dell and focussed on how they both had negative working capital, no large inventory, and leveraged the internet as a sales and distribution platform. Please note the shades of Relativism here, as both ways of describing Amazon were correct at the time, but only one proved to be profitable.
Hagstrom then concludes with a quote from a great mathematician:
“Failure to explain is caused by failure to describe.” – Benoit Mandelbrot.
In this view, if you are missing great stocks, the reason is that you are not describing them accurately. While there is some value in this approach, the limitation of this Prescription is Description approach soon became clear.
Amazon became the giant of today not because it became a better bookseller than Barnes and Noble, but because it leveraged the power of the internet to deliver a wide range of services, especially Amazon Web Services (AWS). AWS which is now the biggest profit engine of Amazon was non-existent when Hagstrom wrote that book. How could anyone describe something that does not exist? Additionally, in investing, the reality is not deterministic but is path dependent. One lucky breakthrough, one timely capital raising, and one key mistake by competition, all would change the trajectory of a company way beyond its original path. An analogy would be the economic life of a young person. This is continuously created and destructed by own actions, the actions of many others, and by the broad macro-economic changes in the global economies which are often idealised as the ‘Butterfly effect’ – A Butterfly flapping its wings in Amazon creating a hurricane in Australia. Hence, what we need as investors are not Newton’s laws of Static Markets but frameworks, a dynamic way of thinking which will adapt to the ever-changing markets.
What frameworks would help us in predicting the future of companies and go beyond traditional Buffettology? The help comes from outside of Finance, from the domains of other disciplines.
Seven Multidisciplinary Ideas
Power: An idea from History, how the power of companies is inextricably linked to their value creation potential.
Politics: An idea from Sociology, how Politics create and destruct shareholder value at the corporate, industry and country level.
Reflexivity: An idea from Physics, how the creation of positive/negative feedback loops and their potential to make stock valuation path dependent – famously used by the investing legend George Soros to break the Bank of England in 1992.
Bayesianism: An idea from Mathematics, Bayesian Statistics, on how the base rate for most companies is mediocrity, and the intellectual poverty of the long-term 30-year Discount Cashflow Valuations (DCF) done in most buy-side institutions today.
Disruption: An idea from technology, popularized by Harvard’s Clayton Christensen in his ‘The Innovator’s Dilemma’, and why this is so relevant for successful investing.
Scaling: An idea from Biology and Urban planning, where the concept of superlinear scaling is the norm, and how this same scaling is a key driver behind extraordinary returns of Growth stocks.
Dependent Arising: An idea from Buddhist logic, originally used by the scholars at the ancient Indian university of Nalanda to dispute the hypothesis of ‘self’ or ‘soul’. Extending this idea, we could postulate the improbability of specific factors which will create consistent stock returns, as often attempted in the Factor Models used in Quantitative Investing.
Value investors have traditionally emphasised ‘here and now‘ valuation as the primary alpha opportunity. Growth Investors on the other hand have looked at the future prospects of the company as sine qua non. However, both groups missed one key ingredient – Market Power.
Market Power can transform a low-growth stock into a high stock performer, high multiple stocks into a higher multiple star performer or allow this high-expectation stock to steadily grow into its valuation with attractive returns. One may think that Market Power is nothing but a traditional Moat or Competitive Advantage, which is usually diagnosed by frameworks such as Porter’s Five Forces, SWOT analysis (Strengths, Weaknesses, Opportunities, Threats), What Ifs, etc.
Moat is a subset of Market Power, as Moat is usually consciously created by the actions of a company (Patent, Economies of scale, Brand etc). However, Market power is a highly contextual higher abstraction and also includes power derived not from the conscious actions of a company. Some examples would be a favourable regulatory regime that incentivizes investment, Government policies protecting nationalist companies against foreign competition, Parent power optionality, Actions of customers inadvertently setting up a favourable environment for their suppliers etc. To see an example of the inadvertent supplier power creating large returns in the US stock markets, please see my article ‘Darwin’s Power and Porter’s Missing Force’.
For superior investment outcomes, we could marry Power and Valuation in a STAR stock matrix as shown below:
In quadrant I, we have stocks with high market power and high valuation.
These are usually companies that have early or first-mover penetration of a large market, companies that have pioneered a new category altogether, companies that are disrupting the business models of established incumbents etc.
The key watchword here is early as these companies are, to use an analogy from Cricket, still batting in the powerplay and have accumulated strong early runs to set up a base for a strong result in the future. The valuations will typically look artificially high on simple accounting matrices like Price to Earnings (P/E) or Enterprise Value to Earnings Before Interest, Taxes, Depreciation and Amortization (EV/EBITDA), and in many cases, earnings will be zero to negligible. If we model these companies using traditional DCF valuation and understand the implied expectations embedded in their stock prices, the assumptions and growths needed would seem optimistic or even outlandish in many cases. However, what most investors miss is that Power leads Valuation.
A company with strong market power is likely to grow into its high valuation. Surely, some companies from this category will stumble and not make it, but the odds of them becoming STAR stocks are much higher than for an average company. It is quite easy to give examples of this category in hindsight, as the early days of any successful Growth company would suffice. Some contemporary stocks traded on the ASX such as WiseTech (ASX: WTC), IDP Education (ASX: IEL), and Altium (ASX: ALU) would fit into this category.
In quadrant II, we have companies with high market power and low valuation.
This is the ideal scenario for investing as we could buy companies with high market power before the market has recognized their full potential. The key difference from the EMERGING STAR category is that these STAR companies are typically more mature and have diverse profit drivers. However, it could be the case that these companies have exhausted one major growth option and are awaiting the next one. Apple stock between the end of growth in iPods by the mid-2000s to the beginning of iPhone in 2007 is an example. In many such cases, Mr Market takes a wait-and-see ‘Doubting Thomas’ approach, which gives an alpha opportunity for imaginative investors.
Another opportunity is when an existing profit stream grows much farther than the expectations of consensus. Allow me to interject a personal note. In early 2006, while still at business school, I did some work to estimate the royalties from a Rheumatoid Arthritis drug called Humira. At that time consensus expectations for Humira sales were in the range of about US $2bn. When I flagged a report from the investment bank Credit Suisse of their estimate of $3bn, even many top investors in the US found that hard to believe. Fast forward a decade and a half, thanks to approvals for new indications (some of these indications potential were flagged in my report years before the approval, and so were predictable) and the ever-expanding reach, Humira sales reached more than US $20bn per year. The sources of the success of both companies were market power, their power to grow their blockbuster products significantly for extended periods, all the while minimizing the corroding effects of competition.
While it may seem that this quadrant is the domain of Growth Investors, traditional Value Investors also occupy a segment of this space as they focus on valuation irrespective of the market power situation. An example of this scenario would be the big four Australian banks, all of which have strong market power, low valuation, and high dividend yields, and are owned largely by Value Investors.
In quadrant III, we have companies with low power and low valuation.
These companies look superficially attractive on valuation but due to their low market power, they are highly vulnerable to a wide range of exogenous changes. Even modest changes like competitor pricing moves, changes in macroeconomic environments, and supplier price increases over even one of their key cost inputs would throw these companies off their rails quite easily. This quadrant is typically filled with Value investors who in their desire to buy cheap stocks, buy cheap companies without market power and end up owning ever cheaper stocks. An example would be AMP (ASX: AMP) which has been on a downtrend for almost two decades and looking attractive on valuation matrices most of that time. Stripped of the profit engines such as Unlisted Infrastructure and Funds management, AMP stock is now drifting aimlessly with a cohort of myopic Value Investors on board.
Apart from companies with no market power, this segment also includes large companies from commodity sectors which are at the receiving end of long macro-economic downturns, as they can control neither the price nor volume of their products and so de facto behave like companies with no market power. For instance, top mining companies like BHP & Rio Tinto for several years before the China-driven mining boom of the early 2000s, and many years after the GFC till the Chinese boom once again became their saviour. Growth Investors may also occasionally fall into this trap, especially when the once-good companies suddenly lose their market power. A case in point is Magellan (ASX: MFG), where the board’s failure to manage the key person risk made it one of the biggest ‘Sudden death’ investor stories in Australia. The management’s continued failure to recruit some of the world’s best stock pickers to run their key funds makes them vulnerable to continued shareholder value destruction, even as the stock looks attractive on most valuation matrices.
In quadrant IV, we have companies with low power and high valuation.
This quadrant is traditionally populated by momentum investors, for whom Price is Value, and rising Price the best Value. After all, if your philosophy is to buy high and sell higher to someone who is looking to do the same, valuation is immaterial. While no Growth investors would like to be seen in this quadrant, some sheepishly end up in this quadrant. This is the case with many low-quality IPOs which are floated at the market tops to maximize the valuation for the sellers with a short-term transaction-oriented life philosophy. Many Private Equity listings such as Myers and Dick Smith in Australia, and Debenhams and AA plc in the UK would have nicely fitted into this category. Many early-stage blue-sky stocks with some low probability to conquer large markets, but which usually die in traversing the execution minefields would also fit this category. The most shocking examples of this category were in the Dotcom boom when companies with even no revenues were listed at outrageous valuations and made COMET investors initially happy by doubling or tripling on the first day, till those stocks collapsed as they ran out of investors to buy at ever-increasing valuations.
Know thy style
Know thyself, was probably the most famous maxim handed down from ancient Greece. For investors could we paraphrase that into ‘know thy style?’
If you are a Value Investor whose skill is to buy a stock at fifty cents and sell at a dollar, you are unlikely to successfully metamorphosise into a Growth Investor who buys at a dollar and predicts the growth into two dollars. As seen in the game of Cricket, while almost no great batsmen have become great bowlers and vice-versa, most have become better batsmen or bowlers by continuously improving their techniques within their favoured domain.
In other words, if one is a Growth Investor one should stay in the EMERGING STAR and STAR quadrants. If one is a Value Investor one should stay in the STAR quadrant. However, within that broad framework of Value or Growth styles, one could add power analysis and become a better Value or Growth investor. For Instance, as shown in the Best Moves chart above, if you are a Growth Investor who often finds himself paying up for companies in the COMET zone, then you could improve your stock-picking success rate by simply choosing to study more companies in the EMERGING STAR zone. In other words, moving from the COMET zone to the EMERGING STAR zone, allows a Growth Investor to play to one’s strengths in high valuation amidst uncertainty, while reducing the potential negative surprises by focusing on high-power companies. If you are a Value investor who often finds himself trapped in the BLACK HOLE quadrant, it would be helpful to analyze more companies in the STAR quadrant and do nothing else.
In this way, one could still stay within one’s circle of competence and grow that competence at the same time.
When STARS Cross Borders
We often face in investing one of the major challenges of life itself: It is not what it looks like. Such as, one buys an EMERGING STAR, but it was a COMET. This could be the case when management put on a ‘Venetian Mask’ on the company’s prospects, or could be a genuine loss of power from competition, structural changes in industry etc.
What could we do? Some scenarios are mapped below:
“Both our operating and investment experience cause us to conclude that turnarounds seldom turn” – Warren Buffett 1979
As illustrated in the table above, if one buys an EMERGING STAR and it fades into a COMET or even worse a BLACK HOLE, it is better to cut your losses. Similarly, if one buys a STAR and it becomes a BLACK HOLE it is also better to sell. This is because the loss of power in both cases is likely to be structural, the scenario alluded to in Mr Buffett’s quote above. The exception to Mr Buffett’s quote usually happens when turnarounds are within the EMERGING STAR or STAR Zones. An example would be the successful turnaround of Microsoft after 2014. Even though Microsoft was sub-optimally managed for more than a decade, it was always in the STAR zone due to the strong market power of its desktop business.
If an EMERGING STAR transitions into a STAR, and the stock de-rates as a result, it is time to buy. This is because both the power structure and the profit engine are intact, and the slowing growth rates are just signs of more industry maturity or the mathematical difficulty of compounding large revenues. As seen in hindsight with almost all Growth stocks, when an EMERGING STAR moves to the STAR zone there are usually many value creation opportunities still ahead in an attractive industry, only the rate of future stock appreciation is likely to be lower than before.
If an EMERGING STAR or STAR provides earnings disappointments, but one estimates that it will remain in the EMERGING STAR or STAR Zone, it is a buying opportunity as these are usually temporary issues that could be solved by management, time, or a combination of both. A recent example is the de-rating of most EMERGING STAR and STAR stocks in 2022, in the rising rates environment created by the global Central Banks. If these companies have not shifted their resident zones downwards into COMET or BLACK HOLE zones (for example, through the unwinding of excess leverage by the forced sale of Crown Jewels), most of them should rebound and provide attractive long-term returns. Hence a power overlay with a STAR STOCK MATRIX, helps an investor reach different stock picking and portfolio management decisions, than those provided by traditional Value or Growth philosophies.
Written by George Kurian
Portfolio Manager of Australian Equities
Oracle Investment Management