Mark, I guess that I never thought of you as the new economy investor.
I thought that a grape grower was to busy to keep current.
So, now I'm starting to get it.
From business week, page 128, "Value Investors Learn New Tricks".
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Value Investors Learn New Tricks
How they're adapting to the New Economy
For years, two great armies of investors have done battle on Wall Street. In one camp stand the growth investors, willing to pay dearly for companies that they believe can generate big profits for years to come. In the other camp are the value investors. They're leery of the rosy forecasts. They'll buy only into companies with real assets and solid earnings in the here and now--and at bargain prices.
For nearly a quarter-century, the value investors have been winning (chart, page 132). Since 1975, the average annual return for value came to 17.6%, compared with 16.2% for growth investing. But in the 1990s, the trend shifted, and since 1995, growth has beaten value hands down, 32% to 25.4%.
The conventional explanation for value's recent poor showing is that the payoffs from these two investment disciplines move in cycles as investor sentiment shifts: Some years, value does better; some years, growth. The recent cycle is atypical, goes the thinking, and may well have ended in April, when investors moved from the glamorous growth stocks and into long-neglected, grittier value companies.
But there may be a more profound reason for value's underperformance, one that has nothing to do with cycles in sentiment. What has changed is the economy. It is no longer driven by manufacturing and smokestack industries, but by rapid-fire innovations in technology and services. In this sort of economy, big winners are not metal-benders, such as General Motors Corp., but those that can manipulate bits and bytes, like Microsoft Corp. The traditional measures that value investors use to pick the stars on the investment horizon, such as low price-earnings or low price-to-book value ratios, give the wrong answers.
In response, a new method of value investing is emerging. As yet, it is more a framework than a set of codified rules. It tries to come to grips with the New Economy's growth engines, such as America Online, Amazon.com, and Microsoft.
The new value investing relies more on forecasting--long a taboo for value investors. Benjamin Graham and David L. Dodd, who laid down the principles of value investing in the 1930s, frowned on earnings forecasts because they were too speculative. The new value investing looks more to another author of the same era, economist John Burr Williams. Williams' Theory of Investment Value taught that an investment was worth the present value of its future cash flows--which, of course, had to be estimated. ''People have been using static methods to think about a dynamic world,'' says Michael J. Mauboussin, an investment strategist at Credit Suisse First Boston. ''No wonder value investing hasn't worked well.''
In New Economy companies, says Mauboussin, ''the business model is entirely different from what [value investors] are used to looking at.'' Compared with a bricks-and-mortar retailer, say, a New Economy retailer such as Amazon.com makes minuscule capital expenditures. Even more significant, he says, Amazon collects revenues immediately when customers charge their purchases, but it doesn't have to pay suppliers for 50 days. In effect, it is the suppliers, not the shareholders, that are funding the company's growth. ''It's the balance sheet--the working capital accounts--not the income statement, that generates the mountains of cash,'' says Mauboussin. Dell Computer Corp. is also cash-rich: By building pcs to order, the company collects immediately, slashes inventory cost, and waits to pay suppliers.
SNAPSHOT. Of course, value investors have always looked at the balance sheet--but more as a snapshot than as a motion picture. They tried identifying the tangible assets--and a value stock was one that was cheap relative to those assets. The result? ''Value investors have ended up in tangible-asset businesses, mainly manufacturing and natural-resource companies,'' says William H. Miller III, portfolio manager at the $11.3 billion Legg Mason Value Trust, one of the few diversified mutual funds to beat the Standard & Poor's 500-stock index over the past five years. ''But those companies are an ever-smaller part of the economy and the market. If you limit yourself that way, you're going to miss opportunities.''
Miller found his two most successful investments, America Online Inc. and Dell, much the way many value investors first find theirs--in the aftermath of bad news or a disappointing profit report. But these were tech companies, and most value investors shun the sector. Product cycles are short, business risk is high, and the companies rarely look cheap even when they're beaten up. But Miller recognized the companies' potential to generate cash if they could solve their short-term problems. To come up with an idea of a company's worth, Miller estimates future cash flows and discounts them back to the present. For a rapidly growing company such as aol, he gives himself some wiggle room by using a high discount rate--30%. That's about three times what he uses on IBM, and provides the margin of safety that is a critical part of the value discipline. Adjusted for splits, his cost for AOL is $3 a share, and for Dell, $1. The stocks now trade at 119 and 34 7/16, respectively.
Miller doesn't have any illusions that AOL is cheap. By his own estimate, the stock is worth 80 at best. So why is he holding it? Indeed, AOL is 12% of the fund, his largest holding. ''There's still a high probability that AOL will outperform the market over the next 5 to 10 years,'' says Miller. ''So why should I sell now and force my shareholders to pay a lot of capital-gains taxes?''
Miller's huge success has not been lost on value-fund managers, whose business has slowed to a trickle as growth investing carries the day. Edward Keon, director of quantitative analysis at Prudential Securities Inc., says that now, at least, managers will listen to some ''outside-the-box thinking.'' And what Keon is telling them is heretical to all they know. He argues that Microsoft, one of the bull market's greatest growth performers, is really a value stock.
A value stock? First, says Keon, examine the quality of earnings. About 67% of Microsoft's profits come from sales that are booked in the same quarter, vs. 38.9% for the median company in the S&P. It's almost as if two-thirds of the profits come in cold cash. ''With receivables, there's always a risk you may not get paid,'' says Keon.
NARROWER GAP. To put the average S&P company on the same footing as Microsoft, Keon adjusts the total S&P earnings for the cash factor. This adjustment lowers forecasted earnings from $54 to about $31, according to Keon. That raises the S&P's p-e to nearly 42 from 24. In that light, Microsoft, with a 52 p-e, is not that much more expensive than the average stock. ''The real gap between Microsoft's valuation and the market's valuation may not be as wide as the raw numbers indicate,'' says Keon.
Keon also looks at the growth rate of earnings. Microsoft profits grew at about 40% a year during the past five years, and Keon says the Street now expects 24%-per-year gains for the next five. S&P 500 earnings, on the other hand, grew at a 10% rate over the past five years, but are forecast to grow 15% a year during the next five. So Microsoft's p-e is 2.2 times its estimated earnings growth rate, while the S&P's cash-adjusted 500 p-e is 2.8 times the forecasted earnings growth rate. To Keon, all this means Microsoft is cheaper than the average company, which makes it, well, a value stock.
While most old-line value investors would rather fold their tents than welcome Microsoft into their camp, they do acknowledge that their models need tinkering. For instance, the old idea--that the cheaper the stock, measured by p-e or price-to-book, the better the investment--makes little sense today. Robert G. Morris, chief investment officer at Lord, Abbett & Co., says most really cheap stocks are cheap for good reason, and buying a raft of them is no way to make money. Instead, value investors may buy slightly pricier stocks that have better management or growth prospects.
Many value investors are taking heart from the resurgence of value stocks over the past two months, pointing to it as a validation of their tradition. Says Roger DeBard, managing director at Hotchkis & Wiley, an institutional investment firm: ''Value investing as we know it is still a viable premise.'' Indeed, many on Wall Street argue that value stocks offer the best moneymaking opportunities for the remainder of the year (page 138).
Perhaps. But the current rally could also be the last hurrah for old-style value investing. Such investing produces its best results in a traditional business cycle. Value stocks typically make most of their gains from the bottom of a recession to the top of the expansion as the rising economic tide lifts revenues and profits. Growth stocks--those with more reliable earnings streams--then outperform value stocks in the down phase of the business cycle. In a period of declining profits, the market prizes the companies whose earnings can continue to grow. But now, thanks to technology, globalization, and a savvier monetary policy, the business cycle has been dampened and elongated. From 1945 to 1991, the U.S. economy went through nine recessions. The current expansion is eight years old, with no recession in sight. With fewer recessions, there are fewer opportunities for the typical value stocks to shine.
Low inflation also works against value investing. ''A strong economy used to give companies pricing power, and that's what drove their profits,'' says Richard Bernstein, chief quantitative analyst at Merrill Lynch & Co. For several years, however, while the economy has been strong, companies have been unable to raise prices. Indeed, in diagnosing several years of weak performance at Lindner Funds, the new chief operating officer, Mark Finn, realized the investment selection process there favored stocks that performed best under higher-than-expected inflation. Yet inflation was coming in well below expectations. The solution: He modified the process to lessen its sensitivity to inflation.
Will value investors change their ways? Don't expect anything radical, as they are by nature a cautious bunch. But value investing has evolved quite a bit from the 1930s, when Graham and Dodd first wrote their seminal work, Security Analysis. When balance-sheet bargains dried up, value investors turned to corporate income statements, looking for stocks selling cheap relative to earnings.
Value investors such as Mario J. Gabelli took a more holistic look at companies, valuing them for the cash they generated, rather than their assets or earnings. That approach allowed investors to derive a ''private market value''--supposedly what a knowledgeable investor would pay for the entire company. That was the basis of the 1980s leveraged-buyout boom. Dealmakers borrowed heavily to buy these companies and then used the company's cash to pay down the debt.
Warren E. Buffett, a student of Graham's at Columbia Business School and later an employee of Graham's investment firm, pushed the envelope even further. Sure, he looked for value in the traditional ways--and made some great investments along the way, like buying stakes in the insurer geico and the Washington Post Co. for peanuts.
PRINCELY PRICES. But Buffett stunned the Street a decade ago, when his Berkshire Hathaway Inc. took a $1.3 billion stake in Coca-Cola Co. and a $600 million stake in Gillette Co. Neither was a traditional value stock, and the prices he paid looked princely--their p-e ratios were twice that of the average stock at the time. But he came at these investments from a different vantage point. He reasoned that the two were unassailable global franchises, then an undervalued attribute in the market. Buffett's bet paid off handsomely. Both investments are up about tenfold.
Bruce C.N. Greenwald, a professor of finance and asset management at Columbia, says the ''franchise value'' advanced by Buffett works well in a value framework. ''Any service company with a great franchise, such as Wal-Mart [Stores Inc.], can be a lot less volatile than a manufacturing company,'' he says. The point is, if value investors now have to make forecasts, they should at least be dealing with steady-Eddie companies. Greenwald adds: ''I don't believe that buying hopes and dreams is value investing.''
Graham and Dodd are no longer around. But Legg Mason's Miller doesn't believe Ben Graham would disapprove of the new value investing, one that marries more forward-looking analysis with Graham's rigid attention to the margin of safety. ''Graham's philosophy was born of his experiences with the stock market crash and the Depression, and he brought new analytical methods to bear on the investment problems of the day,'' says Miller.
The new value investing is a response to the upheaval that's taking place in the economy. An investor can no longer value the opportunities of the New Economy with only Old Economy methods.
BY JEFFREY M. LADERMAN
Copyright 1999 The McGraw-Hill Companies, Inc. All rights reserved. Any use is subject to (1) terms and conditions of this service and (2) rules stated under ''Read This First'' in the ''About Business Week'' area.<<
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