Shares for safety

Current market conditions would seem made for a value investing revival, but investors must remember that investing with a margin of safety on hand is still important.

One of the questions that sometimes troubles value investors is why the theoretical work on which they base their strategies has seen very few updates over the years. Most people will have read Benjamin Graham – and brandished the Intelligent Investor with all the fervour of revolutionary Red Guards – but this is still a book that, apart from an update in the early 1970s, bases the bulk of its theory on the author’s experiences of the depression and the post-war boom. Some may even point to Seth Klarman’s almost impossible to obtain investing bible Margin of Safety as an updated treatise for value investors, published in 1991 – although the £2,500 price tag on the out-of-print book gives the notion of 'value' a whole new definition.

On one level, the dearth of new books on the subject might suggest a discipline that has become intellectually moribund but, as Sven Carlin, author of Modern Value Investing, told Investors’ Chronicle: “Some concepts in value investing have never changed because they are fundamental insights. If you invest with enough margin of safety, you can maximise your returns at the same time as minimising the risk. It is the opposite of what normally happens in the market where investors generally exchange safety for risk based not on fundamental analysis, but simply on what the crowd is doing… Benjamin Graham noted that in the short term the market is a voting machine, and a weighing machine in the long term, and that logic still holds true.”

The ascent of value

There is no doubt that value investors have been in the ascendency in the market since the end of last year. The great value rotation saw a severe correction in growth shares, which has thrown many investment portfolios that concentrated on buying fashionable companies into losses, with the emphasis now on finding cash-generating mature companies at reasonable prices. That change in market direction has impacted growth investors such as Terry Smith – the value of his eponymous fund has fallen by 12 per cent, although this is admittedly far better than some of the underlying indices on which his investments are based.

Most notorious are the fabulous losses run up by Softbank’s Vision Fund and its enigmatic founder Masayoshi Son. Vision bet big on stakes in Chinese ecommerce company Alibaba (HK:9988), ride hailing app Didi (switching its listing from the US to Hong Kong) and South Korean ecommerce company Coupang (US:CPNG), but the global rout in tech stocks, combined with an official crackdown on tech companies in China, caught the Vision Fund cold and left Softbank with its biggest ever quarterly loss of ¥2.1 trillion ($16bn) as the value of its stakes had to be radically written down. Softbank’s losses illustrate two areas where growth strategies tend to go wrong and where a value approach might have saved a great deal of investor capital.

The Rightmove paradox

The first point is that the business models of technology companies rely inherently on gearing to get ahead on research & development spending, as well as marketing activities and client acquisition. That is not usual in the case of most start-ups, but the key difference in the case of tech companies is that the gearing goes towards funding intangible assets such as branding, intellectual property and reputation and very little is needed for expensive, depreciating tangible assets such as buildings and inventory. This is either a strength, or a weakness, depending on how successful the company ultimately is. If the business takes off quickly, then the low capital cost base means much better returns on invested capital and shareholders can reap the proceeds of growth.

For argument’s sake we can say that Rightmove (RMV) is an excellent example of a technology business that quickly gained a monopoly position within the UK property search market, leading to market-leading returns on capital employed (ROCE) as a result (more than 200 per cent at the last results).

The only problem is that all those high returns are already reflected in the very high rating for the shares – at one point reaching a debt adjusted forward price/earnings (PE) ratio of 50 and a definite sign that they were priced for perfection. Unfortunately, since reaching a peak of 800p at the end of 2021, the shares have endured a grinding fall of 27 per cent since, while the rest of the FTSE 100 is up 1.8 per cent over the same period because of its preponderance of large, mature companies with high dividend yields and relatively low PE ratings. The example illustrates the logic behind selling growth shares and rotating back to lower PE value shares.

No one doubts that Rightmove is a high-quality, well-run business, but like everyone else it is also reliant on the performance of its underlying market to generate its returns, and, in this case, that means investors have to take a view on the UK’s highly dysfunctional housing market. Rightmove earns fees whether its houses for sale are sold or not, but the question for value investors is whether or not the price contains enough of a discount to justify holding the shares over a long period of time. In other words, is there enough compensation for enduring volatility?

In chasing the growth story, rather than assessing the risk, the market itself has created a situation whereby even a good company’s shares, such as Rightmove’s, can be the source of heavy losses even when the underlying index posts a generally respectable performance. Growth investors always seem to overpay for predicted, rather than actual, performance which is odd considering that statistically the share prices of all companies, and any individual industry, will collapse at least twice during the investing lifetime of the average investor. And that is even before we get to the issues that surround meme stocks, rather than genuinely profitable companies with excellent records.

Building in a margin of safety that matches the discount to book value with risk mitigation, and putting these ahead of immediate returns, would have prevented tech investors from running up such large losses on individual shares. Always invest with a margin of safety in mind. This will be different for some people depending on the risk they are willing to take, but it will guard against such drastic reversals over a long period of time as market prices revert to the mean.

The inversion of risk

The second point is that growth companies tend to give a one-sided picture of their fundamental position. They are rarely significant generators of sales or profits, which makes quantifying their intrinsic value even more difficult. Tellingly, most analysts use financial ratios based on balance sheet strength to assign a value to growth tech firms, which is where the investment case tends to disappear down the rabbit hole of 'net present value' – essentially less reliable than throwing a dice and basing calculations on the outcome.

Overall, this implies that the main purpose of investing in growth companies is to see those companies acquired at a profit at some future date – which is why it tends to benefit founders/angel investors and venture capitalists the most. It is a business model that works well for small biotech and biopharmaceutical companies as there is a clear understanding in that industry that the barriers to achieving regulatory and commercial scale are too big for two people in a laboratory to grow to a global pharmaceutical company. Therefore, the expectation of partnerships and profit-sharing deals is baked into the share offering and the risk quotient is automatically set at a very high level.

The premise that acquisition is the main purpose of growth firms was entirely acceptable when interest rates were very low, but now that the rate environment is increasing and inflation is eroding fixed values, the attraction of acquiring already leveraged companies with increasingly more expensive bank debt is fading rapidly. The high valuations of tech shares were, in some sense, an expression of hope that someone else was prepared to pay even more for them. It is safe to say that many of those easy money assumptions are now out of date, hence the precipitous slide in valuations on the Nasdaq.  

Indeed, it could be argued that this sums up the margin of safety argument that even some value investors struggle to adequately articulate. In essence, it explains the paradox that higher PE levels are not true indications of value or future earnings, but are instead a numerical expression of higher levels of risk and of the fickle expectations of market sentiment. Unfortunately, in many cases investors are simply unaware that what they have bought at such levels is merely a proxy for the market’s broader volatility. Without a stable base of earnings, such shares will inevitably generate significant losses when sentiment changes.  

Looking for emerging market value

Sitting on positions that might underperform the index for years is a speciality which British-born value investor Jeremy Grantham, co-founder of Grantham, Mayo & Van Otterloo (GMO), has perfected since starting one of the first tracker funds on the US stock market in 1971 (the novelty factor meant it wasn’t a success). Grantham has often been characterised as a permabear – one of his newsletter headlines in 2021 was 'Waiting for the Last Dance'. However, Grantham’s investing philosophy has a tinge of behavioural finance about it.

His fund tends to avoid shares that attract the greatest amount of 'optimism'. The approach seems to work – while his funds have sat out some major market highs over the past 25 years, his returns have averaged 19 per cent a year, in the process steering clear of the dotcom crash, the US housing and finance crash and the tech bubble.

Grantham’s value strategy is relatively simple: avoid buying shares in a highly rated index when there are at least three super bubble signals: 1) high valuations for popular stocks, 2) house prices rising rapidly, and 3) supply shocks on commodities prices.

In fact, Grantham has become so bearish on the US market that he predicts a minus 7 per cent annual return for US large- and mid-cap companies through to 2028, broadly based on a seven-year investment cycle. So if market attrition has not been enough to deflate valuations in developed economies, the question becomes where to find value now?   

Grantham’s answer, which is echoed by some other value investment commentators, is to look at Asian and emerging market shares for opportunities, although it is fair to say that this view is likely to divide opinion (never mention Chinese shares to short seller Jim Chanos, who has firm views on state capitalism in China).

However, it is a fact that some Asian shares and indices are trading at two standard deviations below their long-term average, with the effect that many valuations have stayed at relatively modest levels in comparison with the growth of the underlying economy.

From ‘just-in-time’ ‘to just-in-case’

It is often said that scarcity of necessities is the mother of inventory (I paraphrase) but the disruptive change in the markets over the past couple of years is having a profound effect on how value investors must measure investment opportunities.

One trend to note is the return of the stocking effect on share valuations – a phenomenon not really seen since the late 1970s. In essence, there is clear evidence that companies are increasingly moving away from 'just-in-time' delivery systems to filling warehouses full of stock to guard against the supply disruption that has marred the past two years.

The impact, as The Economist recently noted, is that investors could begin to discount companies that invest in stock, rather than in activities that might prove to be more profitable. So far, we have seen profits fall at large retailers such as Amazon (US:AMZN) and Walmart (US:WMT) because of over-stocking in the aftermath of the pandemic, but it seems likely that more chief executives are looking nervously at disruption in supply chains and taking on more stock to offset that risk. Hence, in part, why warehousing is suddenly at such a premium.

Overall, the impact on earnings, and by extension share prices, could be higher volatility and a greater possibility that significant discounts could emerge for decent companies that value investors can exploit to their own profit, which suggests it is time to dig out that old copy of The Intelligent Investor.