Mark Twain may or may not have said “The reports of my death are greatly exaggerated.” However, value investing surely can use the quote in response to questions asked about whether value investing has died.
Before we come to the proof of the life of value investing, let us first try to understand what value investing (or any sensible investing) is. The concept of investment value is at least 82 years old. John Burr Williams first propounded the concept in his PhD thesis/book “The Theory of Investment Value.” This book, which focused on dividends (over time, this changed to cash flow), was an early version of the Discounted Cash Flow method of valuing equities.
Investing (called value or by any other name) is the process of buying securities which are trading at a discount to their true worth. Even a self-proclaimed growth investor will never say that she buys securities which are trading at a price above their true worth.
Method of valuing equities
Theoretically, the Discounted Cash Flow (DCF) calculation is the only correct method of valuing equities. However, like beauty, the DCF value is in the eye of the beholder. The assumptions that go into DCF vary from person to person and there is no objective number that one can arrive at for DCF. Hence, over the years, numerous valuation metrics have been used as proxies for comparing price to intrinsic value.
These proxies go by popular names: Price to Book value, Price to Earnings, Price to Free Cash Flow, Price to Sales and Enterprise Value to EBITDA.
Academia, in particular, got fixated on the book value based metrics for judging the efficacy of value as a measure of investment performance. Hence, when any study says that value investing works or does not work, it is most likely that the study would be using Price to Book value (or Book to Market) as a measure to estimate the valuation!
Practitioners of value investing have moved away from using book value as the sole measure of value, decades back. While book value may be relevant for certain cyclical or commodity based businesses, it is mostly an accounting relic of little use to practitioners.
The book value of an equity share has lost relevance due to the following factors.
Inflation: Because of inflation, the book value of an old company would vastly understate the true value of the assets owned.
Accounting Assumptions: Different companies have different accounting assumptions for revenue recognition, inventory valuation, depreciation and so on. Because of these assumptions, the book value of an equity share can be vastly different across different companies even if the underlying business numbers are the same.
Revaluation & Mark-to-Market accounting: Some companies in certain sectors are required to revalue the assets based on the current market price of tradeable assets, while others may be holding those assets at cost price. In the two cases, the book value may be significantly different.
Mergers & Acquisitions (M&A): Companies that do lots of M&As also have somewhat distorted book values.
Brands / Patents / Technology: However, the most significant reason that book value has ceased to be a predictor of investment values is that a lot of businesses rely on brands, patents and technology for earning profits and cash flows rather than physical assets. Brands, patents and technology are mostly absent in company balance sheets and do not show up in the book value. If one thinks about companies such as Hindustan Unilever or Google, the value of these companies is in the brands and technology rather than their book values.
One reason why academia has been favouring book value-based measures is that Benjamin Graham, considered to be the father of value investing, was a big fan of balance sheet based investing rather than earnings and cash flow. However, recent research has shown that earnings and cash flow based measures are better predictors of value-based strategies rather than book value-based measures.
For people measuring the performance (or lack of it) of value strategies, it may be time to move from Benjamin Graham to John Burr Williams.
(The writer is chief investment officer, PPFAS AMC)
