By Antonio Mauro and Marco Bruccoleri
In 1949 Benjamin Graham published the first edition of “The Intelligent Investor”, an essay concerning the technicalities of financial investments, formalizing for the first time the basics of Value Investing. Graham’s bold and sometimes controversial mindset was very critical about Mr. Market (M.M). This “individual” is the personification of a market which provides investors with prices that should reflect the true value of the underlying business. If on the one hand M.M quotations look fair and rational, on the other hand it can happen that they are driven by the emotional sphere, so that prices result to be biased and distant from the fundamental value of the business in question. In such a contest, The Intelligent Investor is the one who knows when to trust M.M. and when to reach her conclusions independently, disregarding market’s excesses. Graham’s theories have sparked a debate at the preferability between value and growth stocks, and the empirical evidence has, in fact, confirmed the existence of a long-term value-growth spread called: “Value Premium”.
Nevertheless, after the upheaval of 2008, this spread, whose foundations remain subject to controversial explanations, seems to be disappeared. The critics is now even more divided than before in front of a world that in less than two decades is completely changed. Today, The Intelligent Investor has to face a new and more controversial Mr. Market, in a contest that result to be increasingly frenetic and unpredictable and where Technology has gained a fundamental role. Graham’s principles as they were originally theorized are about to open the doors to an industry that does not represent a threat anymore, but instead an opportunity to relaunch investing to a new level, where value and growth coexist.
In this article, we are going to carry out an analysis that will allow us to shed more light on the reasons behind the disappearance of the value-growth spread. We will try to understand what changed for those value investors that made the success of Graham and Doddsville’s theories, if the crisis was a point of no return for value and growth investing and the way these to strategies have approached a Technology that is driving a world of constant progress.
Value and Growth stocks from the dotcom bubble to the present day
At the end of the ’80s the first style indices were born. These indices were a powerful tool to track the performance of different investment styles, among which there were value and growth investing. A few years later, the graphs of these indices showed a transitional trend reversal in the value-growth spread. At the outset of the technological age, the global economy was populated by promising and growing firms delivering new products and services that would have shaped the tech industry. Such a contest seemed to be a favourable landscape for growth investing, but at the same time, it was particularly vulnerable to excesses and speculations.
As we can see from the chart, showing the performance of the two style indices: Russel 1000 Growth and Russel 1000 Value, growth investors and the US market as a whole rode the wave of one of the most violent bubble in history. The Russel 1000 Growth obtained a 148.8% return between ’95 and 99’, an outstanding result compared to the 54.1 percentage points of its Value peer. One year later, in 2000, the Value and Growth index both experienced a dramatic fall, ending up to -26% and -61.8% respectively. From the burst of the dotcom bubble to 2007, the value premium phenomena arose again, until both value and growth were washed away by a global financial meltdown without precedents. The sharp fall experienced by the Russel 1000 stopped in 2009. From that moment, the two indices followed the same pattern and, in 2014, the spread was inverted. Growth stocks had officially took the lead.
Some investment banks and funds ascribe this positive trend to the effects of Quantitative Easing, seen as “a rising tide that lifted all boats”. At the same time, growth stocks benefitted of the introduction of new technologies in the social media and biotech industry, whilst, value stocks exploited the progress obtained in Financial Services and Healthcare, two sectors that, in an environment of extremely low interest rates, conducted a very successful Buyback policy.
The years following the financial crisis were a period of “fly to quality” during which aversion to risk and mistrust rose consistently, so that the only feasible investments were solid businesses with a very low risk profile. Today, uncertainty is still high: current macroeconomic environment is still characterized by low interest rates, but financial systems have started to recover and people feel more confident about market conditions.
Companies that in the last years have maintained a low profile could be ready to relaunch their investment programs, trying to exploit the low cost of capital before it is too late. In this contest, we need to understand if we are living a transitional phase or if something has definitely changed for Graham’s followers, to such an extent that they have to revise their point of view regarding an “obsolete” value investing. The answer will not be easy to find, but, without presumptions, we will look for clues that could orient us toward the right direction. To do so, we will investigate a Technological Age that in the last two decades has astonished the entire world.
The “Big Bang Disruption” Era
Let’s make a one century step back: when Alexander Graham Bell invented the Telephone, it took 56 years to see 50% of American households having this new technology.
As the graph shows, from that moment on, the adoption rate of new technologies has constantly accelerated, so that it took less than a decade for smartphone and tablet to reach almost the entire US population. From the pursuit of innovation to the accelerated ability of technology to penetrate in people’s lives, we now stand into a market environment of wild competition where internet companies show outstanding growth potential.
Furthermore, the gaps to fill do not limit to the tech sector, but extend also to more traditional industries that cannot remain indifferent to the disruption brought by new technologies and innovations. This phenomenon has been given the name of “Big Bang Disruption” and consists in the abrupt disintegration of consolidated business and industries caused by the continuous introduction of innovative products and services into the market. In this way, businesses that were historically reputed predictable, are now at the mercy of an unstoppable innovating process, so that for value investors is becoming more and more difficult to make the right long-term bet on undervalued companies.
The “Big Bang Disruption” phenomenon could be an explicative clue for the disappearance of the Value Premium: the time for a compromise between Growth and Value is probably arrived, and the arbiter of the game is a growing and pervasive innovation which is able to disorient even the Oracle of Omaha, Warren Buffet.
The “Dollar Shave Club” case
In 1989 Warren Buffet invested $600 million in preferred stocks of Gillette, leader in the production of razors. At that time, he claimed that, similarly to Coca-Cola, Gillette was “a must”, defining it as an unavoidable investment. Indeed, a firm such as Gillette had always been in Buffet’s grace: it was the stereotype of the value investment, a very predictable business with strong fundamentals and which was likely to express its full potential in the long run. Then, after a long period of success, in 2006 Procter & Gamble launched a $57 billion offer to buy Gillette. On the conclusion of the deal, Buffett was very content and gained several millions by converting his stocks.
Yet, in the same year, a new revolutionary service was launched: Amazon Web Service (AWS). This service was aimed at substantially easing the creation of internet companies via a cloud computing service on an on-demand platform: that was basically a “monster” that a technology-reluctant investor such as Buffet never paid attention to. In 2011, AWS, Facebook, and YouTube launched “Dollar Shave Club” (DSC), an internet company providing an e-commerce platform dedicated to razors and following a simple but effective business model: by paying the ridiculous amount of $1 per month, clients would have received high quality razors directly at home.
Acting as a direct competitor, DSC made a well-established market leader such as Gillette losing more than 10% market share in a couple of years, despite the latter’s strong brand and conspicuous R&D. Gillette’s market share is still decreasing in favour of the online market which, according to WSJ, should grow by 25% in the next 5 years. Moreover, its leadership might be threatened even further after the $1 billion acquisition of DSC by Unilever.
If a formerly stable and foreseeable sector like the razors’ one is now become difficult to predict because of technological disruption, the same phenomenon applies to many other industries. As the Gillette case shows, this fact will surely make value-investing strategies more risky and difficult to implement and this could have had an influence on Buffet’s decision to rebalance his portfolio while allocating a substantial part of his capital to technology.
Buffet’s renewed appeal for technology
Warren Buffet has always been considered THE value investor. As Chairman and CEO of Berkshire Hathaway, Buffett managed to outperform the market with an average yearly return of 20.3% from 1964 to 2008.
During the financial crisis, he obtained fabulous returns by investing in distressed giant companies such as Goldman Sachs and Bank of America and, nowadays, he appears to be more open to industries he never invested in, such as the Technology one. Next to insurance and financial companies (33% of Berkshire’s portfolio), Buffet concentrates a huge amount of his capital in consumer goods businesses such as Coca Cola, Kinder and Procter & Gamble. This two sectors, financials and consumers, account for approximately 65% of Buffet’s portfolio, a percentage which is way higher than the respective weights of the same industries in the S&P500.
However, it is worth to mention that while these two sectors used to weight for approximately 90% of Buffet’s portfolio, they have been substantially reduced to leave room to a 15% investment in Information Technology. This demonstrates part of the general concern Buffet and other value investors have recently shown towards a more flexible application of Graham’s basics, trying to make them compatible with shorter term investments in “non-conventional” companies. Maybe Gillette’s recent story helped Buffet to open his eyes and start doubting about businesses that risk to be weakened by new companies with revolutionary business models. Thus, this is probably why he started investing $11 billion in IBM from 2011 onwards, accepting to bear great losses ($2 billion), while making it the second largest stake in a company of Berkshire’s portfolio, behind Coca-Cola.
Despite the economic success which has not been reached yet, this act shows a sharp change in Buffet approach given that he invested in an “unknown” sector, while retaining the fundamental basics of long-term investment in a strong company such as IBM. Namely, IBM is a distressed but solid company backed up by a good management able to face periods of crisis and thus able to generate good long-term returns.
However, another event demonstrates Buffet’s willingness to make non-core value investments. Indeed, another recent investment made by Berkshire is Apple which, unlike IBM, is not distressed at all and, in fact, is still part of the Russel 1000 Growth index. Having said that, Apple itself shows some hybrid features between value and growth stock. Its P/E ratio is 17.22 and the company has recently started to increase its distributed dividends, despite opinions about its under/over valuation are still contradictory. Up to now, the current stake in Apple is represented by a “miserable” $1 billion. It will be interesting to see how Berkshire will evolve its thoughts about the giant from Palo Alto.
In conclusion, having analyzed the recent actions of one of the most successful investor of all time, the only certain thing is that with the arrival of disruptive technologies, many of those companies which allowed Buffet to outperform the market have realigned with the growth rates of the respective industries. From 2009 onwards, Berkshire has made returns which are slightly lower than the ones on the market. On the one hand, this performance might be partially explained by the heavier weight of tech companies in market indices such as the S&P 500 that have registered very positive returns. On the other hand, it is worth to mention that the huge dimensions Berkshire has reached make more difficult to find the right investments to keep the returns on the outstanding historical levels, without considering the high and hostile competition put in place by Private Equity funds.
Although the analysis we carried out did not lead us to scientific conclusion regarding the flattening of the Value-Growth spread, it allowed us to raise some interesting clues on the topic. We can eventually say that the world we live in today is completely different from the one where Graham and Doddsville theorized their investment strategies. Nowadays, the “Intelligent Investor” has to face a new and more controversial Mr. Market that follows different rules in a frenetic and unpredictable environment, in which Value and Growth embody new connotations and express new potentials.
At the outset of the technology age, investors have to leave the past behind in order to reorient their choices towards attractive and unexplored businesses, always paying attention to a Disruption which becomes as much an opportunity as a risk. Those businesses which were born during the dotcom bubble now provide investors with a time series of data and facts which allow them to make more conscious and informed choices.
In our debatable opinion, investors should stop talking about Value and Growth investing and realize that the only successful strategy, whose principles would never be taught, is called Smart Investing: it simply consists in going beyond academic categorizations and reinventing itself whenever is needed. Having said that, we do not want to instill any sort of doubt on the grounds of Graham, Fisher, Price Jr. and all other theorists of different investment strategies.
We rather want to grasp the best essence of their studies which have set unfailing and beneficial pillars for every investor willing to make the right investment decisions.
BlackRock (2014) Interpreting innovation impact on productivity, inflation & investing
Private Bank (2015) Investing For Value and Growth- CIO White Paper
Louis K.C. Chan and Josef Lakonishok (2004) Value and Growth Investing: Review and Update
Aswath Damodaran, Stern Business School (2012) Investing for grown ups? Value Investing
Perpetual Investment Management Limited (2016) Investment Insights VALUE OR GROWTH?
Benjamin Graham (1949) The Intelligent Investor
B. Graham e D. Doddsville (1934) Security Analysis
Long Chen,Ralitsa Petkova, Lu Zhang (2007) The Expected Value Premium