The Value of Low Value
THE VALUE OF LOW VALUE
Value investing is more than a style box. It is an investment practice capable of outperforming any benchmark over the long-term, as demonstrated by Buffett’s numerous “Superinvestors.”
First and foremost, value investing protects from valuation risk. The first rule of investing is to protect capital against permanent loss, and overpaying is the primary cause of capital destruction.
Unfortunately, the cost of this protection is often painful underperformance for years or decades. It was easy for Benjamin Graham to believe that “the danger of paying the wrong price is almost as great as that of buying the wrong issue” after ?the Great Depression.[1]
In addition to this valuation protection, low value businesses naturally and intrinsically offer investors additional benefits that don’t require infinite patience; these benefits include enhanced capital allocation opportunities, more focused management execution, and rationally grounded valuation principles.
Enhanced Capital Allocation
Management teams are likely to allocate capital accretively simply by working for businesses trading at low multiples; this is an invisible benefit value investors enjoy. With limited growth opportunities, value investments generally return cash via dividends, historically a key driver of market returns.
More valuable, share buybacks are highly accretive to businesses trading at low valuations. Value investors, owning assets unfavored by the market, are immediately protected from dilutive share buybacks at unreasonable prices and instead enjoy the compounding benefits of buybacks made at low prices.[2]
Low value businesses also have difficulty justifying M&A, a counter-intuitive benefit. Acquiring a business trading at a higher multiple (dilutive M&A) is frowned upon by the market, thereby raising the bar for M&A for value investments.
Highly valued businesses enjoy the benefit of "accretion" when buying businesses at lower multiples and are therefore incentivized to pursue M&A even if they are paying prices that will ultimately prove to be value destructive, as research studies continually show.
Focused Management Execution
Leading a business that trades at a high multiple, and being paid in stock, makes it more valuable for a management? team to preserve or grow a multiple than drive incremental business improvement.
“Story stocks” require an ever-increasing number of investors to believe a narrative; management is expected to sell the story. Bad outcomes are likely to follow when focus strays from managing a business to managing a multiple.
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Managers leading low valuation businesses have more incentive to focus on their operations, ignore their share prices, and trust the market to recognize value over time.
Objective Valuation
Finally, from an investor’s perspective, it is easier to objectively evaluate investments with low multiples. High multiples implicitly assume growth rates and margins projected far into the future.
In addition, as with management’s focus, an investor’s focus may also stray towards the preservation of a multiple, particularly if the multiple has only theoretical, future-based underpinning.[3]
In contrast, the ability to calculate an absolute valuation, based on actual cash return, keeps value investors from getting caught adrift in a relative value world. Low valuation businesses offer a rational, absolute underpinning to valuation, allowing for clear decision making in both frothy and depressed markets.
CONTRARIAN VALUE
Value investing is not just a style box or index construction but a true investment discipline that has driven sustainable, long-term returns for generations of investors. Understanding the “value of low value” results in a contrarian viewpoint.
Value investors root for share prices to decline, not rise, provided the earnings power of a business is unimpaired. A declining share price allows long-term investors to generate future returns via more accretive buybacks, higher dividend yields, and reduced valuation risk.
This sense of opportunity in low valuations makes value investors pessimistic, bordering on perma-bearish, but this pessimism is only unwelcome by those that do not see the silver lining.
FOOTNOTES
1. Security Analysis (1934)
2. Graham makes a related point in Security Analysis. He notes that Edgar Lawrence Smith, in “Common Stocks as Long-Term Investments”, correctly identified the previously underappreciated value of retained profits, not returned to shareholders as dividends, and the compounding benefit these profits provide. But, as Graham noted, “as soon as the price [of the stock] advanced to a much higher price in relation to earnings, this advantage disappeared.” Overpaying not only increases the risk of losing principle in? a downturn, but also dilutes the compounding effects of both buybacks and retained earnings.
?3. Keynes likens these games to Old Maid or musical chairs where the “games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.” (via The Money Game by Adam Smith)
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