I began this series of posts by quoting a remark of Benjamin Graham’s that Warren Buffett believed was the wisest sentence ever written about investing: “Investment is most intelligent when it is most businesslike.”
That sentence is important because Graham (with David Dodd) was the first to recognize the investment importance of the fact that a share of stock represents an ownership interest in an operating business. Of course, everyone knew that corporations were owned by their stockholders, but no one had thought to analyze the value of a stockholding in terms of the value of the underlying business.
The Graham and Dodd approach to investing, though complicated in its details, is at the highest level simplicity itself. By closely studying a firm’s financial statements, management, dividend policies and similar matters it is possible to determine that the firm’s fair value is, say, $100 million. That’s what a sensible buyer might pay for the business. Therefore, a 1% stockholding in the firm is worth $1 million.(1) All an investor has to do is wait for the opportunity to buy that 1% position at a discount – to get a “margin of safety” – which will happen eventually because Mr. Market is a bipolar lunatic.
The only problem with this approach is that it is emotionally very difficult to do. Investors aren’t machines. We get depressed when the stock we own collapses in price. We get wildly excited when stock prices are zooming upward. But “intelligent” investors won’t behave like that. They will calculate the value of the business, patiently wait until they can buy a part of it at a discount, and then patiently wait again until other investors recognize the true value of the business. It might take a while – it might take a very long time – but it will happen. And in the meantime investors have that margin of safety working for them.
Most of the great investors of the 20th century have followed the Graham and Dodd method. Warren Buffett, of course (Buffett studied under Graham at Columbia and later worked for him), along with Bill Ruane, Walter Schloss, Irving Kahn, Philip Fisher, Peter Lynch, John Templeton, Marty Whitman, David Swensen, John Neff, Charles Brandes, William Bernstein, and so on.
What is amazing, however, is that this isn’t the way most investors operate. The great majority of investors aren’t “value” investors, they are “growth” investors. The reasons people like growth stocks are simple and two in number. First, buying growth stocks is fun. Rapidly growing companies are usually operating in new and exciting sectors of the economy, they represent the future, everyone is talking about them.
The second reason people like investing in growth stocks is because it’s easy. There’s no mucking around in complicated, musty financial statements. There’s no need to be patient. Any boob can notice that a company has been growing rapidly and that everyone is excited about its prospects. You simply go out and buy it, figuring that it will continue to grow rapidly and, therefore, the fact that you’re paying way up for the stock doesn’t matter, it can only get even pricier.
You’ve noticed, let’s say, that Goomazon Inc.(2) has been growing like kudzu, everyone you know is buying it. Goomazon is expected to earn $2/share next year, and it’s selling for $60, so its price-earnings ratio is 30. Pretty steep for a value investor, but a pittance – a steal – for a growth investor. After all, at the rate Goomazon is growing it will probably earn $3/share next year. Even if the P/E ratio stays the same, that suggests Goomazon will be worth $90! More likely, as other enthusiastic investors jump on the bandwagon, the P/E will go up, maybe to 40. That implies a price of $120 – you’ll double your money in one year!
Well, maybe. But there’s many a slip between cup and lip. One of these slips involves the fact that trees actually don’t grow to the sky. There have been thousands of exciting growth stocks over the years, and every one of them – every single one of them – has hit the wall. If you just paid 40x for a company that is no longer growing very fast, you’ve made a very serious mistake.
Another problem with growth investing is that it depends on our ability to know the future. Just because a company is growing rapidly doesn’t mean that it will continue to grow rapidly forever. Blockbuster grew like crazy year after year and then, quite suddenly, it was obsoleted by Netflix. Even experts who spend their lives studying a particular market sector are notoriously lousy at predicting the future. What chance does an ordinary investor have?
But the fundamental problem with growth investing is that growth stocks are really just momentum stocks in disguise. Lots of rapidly growing companies actually aren’t growing their earnings, they’re only growing their revenues. After all, it costs money to grow, and so rapidly growing companies have to spend like crazy, postponing the day when they can achieve high earnings and pay high dividends. This means that the main way growth stocks increase in value is through a change in their P/Es.
As more and more investors become enthusiastic about Goomazon, they bid up its stock price far beyond any sensible level. In the late 1990s many Internet stocks had no earnings at all, but sold for astronomical multiples of revenues. This is really, really fun – until it isn’t. The original growth stock, IBM, lost half its value not once but twice (in 1961-62 and again 1969-70). Cisco Systems lost 70% between 2000 and 2002. Many wildly popular Internet and tech mutual funds lost 60% to 80% of their value during the same period.
According to Graham, “intelligent” investors won’t play the growth/momentum game because it isn’t investing at all, it’s speculating, gambling. No matter how long growth/momentum stocks are in vogue, intelligent investors will avoid them. After all, an intelligent investor’s value stocks will still be doing well, just not as well as the speculative stocks.
Unfortunately, as we’ll see next Friday, most of us aren’t “intelligent” investors, we’re “semi-intelligent” investors.
(1) Actually, of course, a control position in the business might be worth more than a non-control position.
(2) Terrified Europeans refer to American alpha competitor firms as “Gafa,” an acronym for Google, Apple, Facebook and Amazon.
Next up: The Semi-Intelligent Investor, Part 3
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.
