Value investing can be counter-intuitive at times. Acting against our own intuitions is not an easy thing to do; it’s uncomfortable. We form our thoughts and reasons based on what we see and experience in the present, and extrapolating our present situation into what the future holds is something we all do. Predicting the trajectory of long-term trends that have already begun is not rocket science, but investing requires you to be right about the trend, as well as the timing of that trend.
Bill Gates wrote the following a while ago
‘we always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don’t let yourself be lulled into inaction.’
It comes to mind as I think about some of the stocks we hold, some of the stocks that are doing really well and the difference between a great company and a great investment. There is a lesson in the drivers of value investing and how it interacts with momentum, and more broadly on real visceral fears that are out there, manifesting themselves in the politics of both the left and the right. One way to think of value vs growth investing is as extrapolations of the current set of worries out to the future. Everyone remembers the Blockbuster video example, killed off by Netflix, and see that story writ large across big chunks of the rest of the economy and stock market. Disrupted businesses are everywhere – just this week Hertz announced a bad set of numbers, sequential declines in revenues and a bigger than expected loss. The stock got hit hard. On the other side? The new ride sharing services, Uber and Lyft, raising money at high valuations as people extrapolate to a future of self-driving on demand cars, and no place for old school Hertz. Amazon making it tough for big box retail is another example. Tech, robots and AI are coming for jobs and business as we know it.
Many instances of these seem perfectly valid, and it’s easy to paint the picture. The likes of Amazon, Netflix and Tesla are amazing businesses that have changed the world and achieved incredible things. The issue we have is that they seem priced for ever greater levels of growth into perpetuity, and don’t seem to take into account what we think is one of the key reasons value investing works – the people running the businesses are scared as well, and where they can, they fight back. Some will be unable to. But not all. Take General Motors and Tesla. General Motors trades around a 5 PE and pays a dividend north of 4%, and the last couple of years has about $9bn in income. The numbers are a bit different for Ford, but the picture about the same. That income is an enormous amount of firepower. The people running these businesses are not stupid, and I’ll bet are more worried about electric vehicles and driverless cars than you or I. The market focuses on Tesla and the incredible way it’s broken into the car market, its Gigafactory, and its solar roof product. They are extrapolating a future whereby Tesla hits the big time with its $35k Model 3 and kills off Ford and GM – at these prices that’s what is implied. Relating it to option buying, by buying Tesla investors are effectively buying calls on this amazing future – things need to get to this new world quicker, and it needs to be more amazing than it seems now. They may be right, but boy are those calls expensive here. With GM and Ford, we see value investing as akin to buying puts on the speed and scale of this societal change, and think that the extrapolation has gone too far – and doesn’t take into account the firepower of the businesses. If the transformation doesn’t happen, takes longer, or investors decide to pull financing from the Tesla project (and they sure will need a lot of funding to build out the scale the stock price is banking on) maybe things looks different and old Detroit transforms itself. That $9bn pays for a huge amount of R&D to fight back – indeed when you look at it, the first few firms to get an electric vehicle to market at a mass market price point have already done so. They Chevy Volt, the electric Ford Focus, the Nissan Leaf. GM is hiring 1000 engineers in Silicon Valley to expand Cruise Automation, the self-driving car unit it spent some $600m on last year. Ford is doing similar, investing $1bn in a self-driving car firm in Pittsburgh. GM is into the battery game as well, opening battery factory in Shanghai. One can make the same case with Walmart and Amazon – Walmart has some $20bn in operating income, and an e-commerce business growing at 30% a year. At its root, Walmart isn’t too far from being an Amazon warehouse with a door and a checkout – it has a brand name, incredible logistics and supply chains – and won’t go down without a fight.
All of this isn’t to say that Tesla and Amazon aren’t incredible companies pushing the world forward – they certainly are. What they also do though, is to bring others up with them, galvanizing competitors into action. Capitalism in all its glory. We think the markets are extrapolating the future too far in both directions – the new kings Tesla and Amazon and their ilk to the high side and older world names to the low side. Back to the Bill Gates quote, investors are focused on the first part, over estimating the next two years at the expense of how things will look in ten years. The people in Detroit and Bentonville are focused on the second part, and not being lulled into inaction. Buying old Detroit at valuations like this is hard, it goes against the story of change. What you are doing by buying is really selling a put on the speed and scale of the change. We’ve seen a movie like this before at the turn of the century. New world growth expectations were out of hand and the growth premium over that five year period was enormous. The following five years were reversed, as value investing outperformed strongly. The chart below has some details on it. That’s how value investing works, in cycles, and it works because it’s uncomfortable.