We’re all about finding the next big thing. Those hewing to the benchmarks, which are backwards-looking, are not about the future. They are about what has worked. We’re all about what is going to work. Cathie Wood Ark Invest CEO/CIO.
If you buy something because it’s undervalued, then you have to think about selling it when it approaches your calculation of its intrinsic value. That’s hard. But if you buy a few great companies, then you can sit on your ass. That’s a good thing. Charlie Munger, Berkshire Hathaway
INVESTMENT STYLES - The active management of equities comes in two main styles. Value, where shares are bought that trade in the market at a material discount to a measure of “intrinsic value”; and growth, where shares are bought that offer access to faster-growing segments of the economy, often, but not exclusively, where new technologies or business models are disrupting established ones.
VALUE - Value investing is premised on the notion of mean reversion of share prices over time. The idea is that share prices move randomly but tend to revert to an underlying value. Because the distribution of a shares’ market price compared to its intrinsic value will follow a normal distribution, it follows that the market value will most likely show a reversionary trend following a significant outlier return in a given period. In other words, a sharp negative outcome will, over time, be followed by a positive reversal, and vice versa. Value investing often overlaps with contrarian investing.
GROWTH - Growth investing has more focus on the factors that might lead a particular share to grow more quickly than the average over a sustained period. There are several ways the growth investor can identify such companies. A common method is to look at past financial returns that the company has delivered. Companies that have delivered sustained revenue growth at high levels of profit and cash generation are indicative that the company has a moat or defendable competitive advantage. Other factors that growth investors look for are, high ownership levels by founders or other “insiders” and strong capital allocation disciplines around future investment, acquisitions, dividends and share buybacks. Shares in companies with these characteristics tend to trade on high valuation metrics such as earnings multiples and sales multiples. However, valuation is of less concern than the share’s future share price trajectory. Growth investing often overlaps with momentum investing.
DRAWBACKS - Both styles of investing have their drawbacks. Value investing is a good way of buying cheap typewriter companies, known as value traps. In contrast, growth investors can have a predisposition to get sucked into bubbles and even frauds, such as Enron or Wirecard. Value investors stance is one of overt scepticism if not cynicism, whereas growth investors are looking for upside are more prepared to engage in “blue sky”, or new “paradigm” thinking.
HISTORY - Value investing was first described by Benjamin Graham in the 1930s with his book Security Analysis followed up by the Intelligent Investor in 1949. Graham’s early disciples, such as Warren Buffet and Charlie Munger, have utilised the main thesis of value investing with exceptional results. Buffet described buying bombed-out low-value equities in the late 1940s as “cigar butt investing”. The aftermath of the Great Depression and World War Two offered a wide array of unresearched shares in companies that traded at big discounts to book value, low multiples of sales and earnings, as well as having decent prospects. Benjamin Graham’s view that companies like this would trend towards their (higher) intrinsic value was proven to be accurate, as the post-war economies recovered.
GROWTH PATH - However, despite Warren Buffet and Charlie Munger’s long term performance record and legendary status in the world of investment management, over the last 20 years, value investment strategies have significantly underperformed growth strategies. Why this has happened, and more importantly whether the outperformance of growth will persist, is a matter for debate. Like many other secular trends, 2020 initially saw an acceleration of the trend toward growth investing. However, in November last year, the news of the Pfizer vaccine sparked a sharp value-led recovery. Interestingly, this period of strong performance in the value-laden sectors such as travel, leisure, retail and banking was accompanied by a significant pick up in market concerns over inflation.
ROLE OF INFLATION - The role of inflation and the interplay of other macroeconomic factors is significant in the context of the debate over value and growth. The period in which growth has predominated over value has coincided with a period where inflation and interest rates have been in decline or at least subdued. Indeed the factors behind this benign scenario for inflationary expectations: a combination of the labour arbitrage in favour of Chinese manufacturing, technological advancement and “whatever it takes” monetary policies among Western central banks; has amplified the future value component of equities, leading to a multiple expansion for growth shares. The sharp recovery of value shares and fears over the impact of inflation in Q4 2020 are two sides of the same coin. All other things being equal, value investing likes inflation, growth investing does not.
BUY VALUE? – One conclusion from this is that if we think that inflation is about to take hold then we should move long term equity holdings into value stocks. Sell Amazon and PayPal and buy department stores and banks. However, this would be overly simplistic and short term. The reality is that since the days of Benjamin Graham the world has changed dramatically. In Graham’s day, the economy and its financial markets were seen as component parts to an equilibrium seeking evenly rotating machine. Keynesianism and the New Deal were both in their infancy. The world’s economy had taken a short-term beating by the impact of the Great Depression followed by a World War. The system had been de-stabilised but was about to bounce back to “normalcy”. (Remind you of anything?). This economic model looked like the reality as the recovery in the 1950s and 1960s allowed politicians to claim “we have never had it so good”, as the British Prime Minister Harold MacMillan did in 1957.
NIFTY FIFTY - However, what was fuelling this period of growth was not just the functioning of an evenly rotating economy of the classical model. The adoption of technological advances (often spurred on during the crisis of war) such as the jet engine, plastics, broadcast TV, consumer electronics and branded consumer goods, provided a secular element to progress. Indeed, this technology shift led to a stock market trend in the 1960s known as the Nifty Fifty. This was the name given to a loosely defined list of dependable growth stocks that led the market rally of the 1960s and early 1970s (remind you of anything)? Among them are names that have faded from view over subsequent decades: International Telephone and Telegraph, Eastman Kodak and Digital Equipment Corporation. However, a surprising number of these names remain recognisable and are sizeable players in today’s world: Walt Disney, Coca Cola and Walmart. Having led the stock market rally, the Nifty Fifty suffered more than most in the tumultuous stock markets of the mid to late 1970s. Indeed, until the imposition of monetarism and the control of inflation in the early 1980s, equities underperformed, and value beat growth.
EVER LOWER INTEREST RATES - The dominant macroeconomic trend in the subsequent period, from the early 1980s to the present, has been the demise of inflation and the ascendancy of bonds. Although value has enjoyed periods of relative success during this time, such as the years from 2000 to 2007, the longer-term trend has been strongly growth orientated. Today’s version of the Nifty Fifty are the FANGs of big tech. Interestingly, just as he did in the early 1970s, Warren Buffet has appeared to draw in his horns in 2020, while other market sages have likened today’s market conditions to the dotcom boom with a worrying overextension of growth valuations.
PARADIGM SHIFT - While it is hard not to interpret some current market moves as bubble-like, it is also premature to consider a wholesale opt-out, selling growth in favour of value. While the crises of the 1930s and 1940s gave rise to important growth drivers, our current period has fuelled an altogether more powerful growth engine based on broad adoption of data science, artificial intelligence, clean energy and bioengineering.
RETURNS TO SCALE - Previous periods of rapid disruptive growth have been tempered by the law of diminishing returns to scale commonly associated with the manufacture and distribution of physical products. Companies operating railways in the mid-19th century or fibre optic infrastructure in the late 1990s were unable to scale their businesses quickly enough to meet expectations. However, today’s growth engines are less constrained and indeed have in many cases been fuelled by accelerating returns to scale enjoyed by networks and platforms, such as those enjoyed by social network, cloud computing and digital payments companies.
ALL CHANGE - In this context, it is interesting that Howard Marks of Oaktree Capital, a widely followed value investor has acknowledged, in his latest newsletter, that the rules of value investing need to be flexed to adapt to the reality of our times. He describes over eighteen pages how spending lockdown with his son-in-law, a successful growth investor, had forced him to reconsider some of his value principles. Marks concludes with seven concessions about the shortcomings of orthodox value investing:
REMODELLING REALITY – Each of these points is a concession that the old model of Benjamin Graham no longer is the best fit for our world. Rather than conforming to a mechanistic model of classical economic equilibrium and mean reversion, the modern economy has more affinity to an organic complex adaptive system that has evolved in a manner of self-replication and adaptation. The pace of technological change has accelerated over a broad spread of applications. Artificial intelligence has helped a group of fell runners beat the world record for traversing all of the Lake District Peaks in one route as well as determine how amino acids fold into complex proteins, a key building block to understanding how life itself is formed.
FAT TAILS – Our collective knowledge of the world we inhabit and how to better our lives within it is on an exponential trajectory, and critically the returns to those entities that innovate successfully offer “winner take all”, or fat tail, return profiles. This is why today’s global rich lists are populated with self-made billionaires who have generated their wealth in the last 20 years, while the frugal and patient Warren Buffet and Charlie Munger took 2-3 times as long.
ARK OF INNOVATION – One of the biggest success stories of growth investing over the past few years has been led by Cathie Wood at Ark Invest. Ark invests thematically by first identifying the long-term megatrends that are driving disruptive growth in society and then forming views around the companies that benefit from those trends. The approach is unconstrained by benchmarks. Indeed, Wood describes fund managers’ obsession with index benchmarks as a false adulation that forces a pre-occupation with the past, where the investment process should be about profiting from a firm view of the future. Five of Ark’s equity funds were in the top 20 best performing equity funds in 2020 and they have grown AUM of $3bn in 2018, to $45bn today.
JUST GETTING STARTED – The main thematic categories of disruptive growth of Ark’s focus are DNA sequencing, robotics, energy storage, artificial intelligence and blockchain technology. Within these categories, they have identified 15 Big Ideas for 2021. They predict that these trends will converge and disrupt the existing structure of today’s capital markets. For example, Ark forecast that in response to the 28 per cent cost decline in lithium-ion batteries for every cumulative doubling in units produced globally, prices will continue to fall, “turbocharging” electric vehicle sales in coming years. Digital wallets such as Square’s CashApp or PayPal’s Venmo will undermine the economics of retail banks, while blockchain and decentralised finance will do the same to wholesale banks. They believe that deep learning AI heralds a new era that will deliver more value to companies with access to this technology than the advent of the internet has to date. In other words, forget the FANGs, we haven’t seen anything yet!
IT’S DIFFERENT THIS TIME - Interestingly, the Ark view of the future also includes a positive view of the outlook for inflation and the dangers of debt finance to the disrupted. Wood stated recently: growth in the value of goods and inflation are likely to surprise on the low side of expectations as market share shifts to the poorly measured digital world and as the “good” deflation associated with technology takes hold… In harm’s way are companies that have engineered their financial results to satisfy the short-term demands of short-sighted investors. Those that have leveraged their balance sheets to buy back shares and pay dividends are at particular risk as they will have less balance sheet flexibility to invest in response to the technological shift. In a few short lines, Wood describes Howard Marks’ point about how we are always surprised by the impact of compound growth, but also the risks of the excessive use of debt in a fast-changing world. Furthermore, she helpfully suggests that we don’t need to worry about inflation again either.
THE FORCE BE WITH YOU - The reality is that the Ark invest view of the technological utopia might be overly optimistic. The positives forces of technological change and structural growth may in the short term be overwhelmed by periodic setbacks as bubbling markets pop, and government implement policies designed to aid the left behind. Inflation cannot be so easily ignored. Despite this, it is hard to repudiate the long-term trends that Ark have identified and push back too strongly on the disruptive effect they will ultimately have.
NOT SO DIFFERENT - As Charlie Munger and Warren Buffet identified, buying truly great businesses that can compound growth for the long term is an unparalleled way to accumulate wealth. For all their attribution to Benjamin Graham’s value-led approach, it was their inspired purchase of disruptive innovator, GEICO Insurance, combined with decades of patience, that has delivered a large part of Berkshire Hathaway’s spectacular performance over the last half-century. Ultimately both value and growth investors want to own quality companies for the long term, the style they adopt to find them is of secondary importance.
THE DOWGATE APPROACH
Dowgate’s investment process is all about buying and holding great businesses for the long term as a cornerstone to managing our clients’ wealth. However, we are not immune from the opportunities that gyrations of the financial markets present to seek relative value, without losing sight of our quality threshold.
In a typical week, we meet up to 20 company management teams in an ongoing search to find valuable opportunities. Our first objective in these meetings is to establish some basic understanding of the companies and their prospects. We want to understand the sense of purpose and drive from the leadership. Specifically, the importance they focus on financial and other operational metrics, including their capital allocation process. Our goal is to assess if these are the people and organisations sufficiently differentiated and trustworthy to which we are prepared to allocate our clients’ capital. There is a multitude of factors that we consider before taking this decision. Some of the important ones are experience, financial track record, access to technology (product or process know-how), and shareholder focus.
Part of our process is to understand the main drivers of innovative growth that impact all companies. These include the adoption of networked knowledge, deep learning AI, green energy, robotics and autonomous transport, DNA sequencing and frictionless finance. All these factors are, to differing degrees, impacting our universe of investable companies. This aspect of our process is increasingly important as technological change accelerates and its adoption becomes more widely implemented.
However, we are also alert to the value opportunities the market can present. UK small and medium-size companies include many world-class capabilities that drive and benefit from identifiable secular trends. Currently, UK companies are lowly valued, particularly compared to their US peers. It is among these companies that we see the most attractive opportunities for us to add value as part of ongoing process of managing our clients’ wealth.
Written by Jeremy McKeown
