One of the value investors we like to follow closely here at The Acquirer’s Multiple is Mason Hawkins, Chairman and Chief Executive Officer at Longleaf Partners (Longleaf).
Last week Longleaf released its Q218 Shareholder Letter which contains a number of warnings for today’s investors saying:
“Managers who say convincingly today that value does not matter much at their holdings because the outcome is all about their compounding machines probably have lower odds of being right in the longterm than they think, and from this point, they will not get bailed out by rates and multiples.”
The letter also provides some great reminders on the importance of sticking with your value investing strategy in a world dominated by the more popular method of heavily weighing the qualitative factors of the business and minimizing the importance of valuation.
Here is an excerpt from that letter:
Over the last ten years, “growth” has outperformed “value” across most public equity universes by a substantial amount, ranging from a 1.3% difference per year in the MSCI EAFE Index, 1.4% in Russell 2000, 2.1% in MSCI World, to as much as a 3.3% annual difference in the S&P 500.
Our form of value investing, where we calculate an intrinsic valuation of a business and then pay a big discount, is even more out of fashion. Many consider a single point estimate of value arbitrary. They view appraising a business down to a single number as a static waste of time, because real life is actually full of ranges and scenarios. They also disregard the idea of buying “60-cent dollars,” believing multiples do not matter as much as the franchise, moat, and/or competitive advantage that will drive the long-term outcome. We concur with the importance of business quality and strength, but the price paid also impacts results.
Just as passive proponents have adopted Buffett to argue against active investing, many investors reference Buffett to dismiss value investing. The first thing I ever read at Southeastern was Buffett’s “The Super Investors of Graham and Doddsville.” He persuasively argued in favor of value investing as implemented differently by various students of Ben Graham.
At that point, Buffett was synonymous with value investing. But, his brilliant 1989 letter discussed lessons learned from the previous 25 years, talking about “cigar butts,” “bargain-purchase folly,” and that “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” His repetition of that theme in the years since has conditioned many to dismiss the price paid as unimportant. Whether or not that is what Buffett meant, it has been the prevalent interpretation.
The quality of a business and its ability to grow have substantial impact on our investment outcome, but the price paid relative to value is also critical for several reasons. First, the very long-term evidence suggests buying undervalued companies has earned better returns. Value stocks have outperformed growth stocks by almost 3% per year since 1926, even incorporating growth’s dominance in the last decade.
More specifically, we and our best value peers have long-term records beating various benchmarks over decades, even with the challenged numbers of the last five to ten years. Second, the discipline of determining a single-point estimate of value enables us to know the discount we are paying, even though we recognize that the appraisal reflects probabilities not certainties. Our mindset is similar to the insurance industry where actuaries grant that the world they underwrite has multiple scenarios and different probabilities of various claims, but at the end of the day, they need to quote a price on a policy with a relevant margin of safety built in.
We acknowledge uncertainty but still need to nail down our best estimate of a company’s value to know that we are paying a big discount. In spite of people’s interpretations, Buffett exhibits a valuation based discipline, using a single-point measure of 1.2X book value to dictate Berkshire Hathaway’s share repurchase policy. Third, real value investing has a humility not present in today’s more popular method of heavily weighing the qualitative factors of the business and minimizing the importance of valuation.
Paying a low multiple admits to not knowing the future. The discount helps guard against a negative outcome rather than banking on the future to turn out as we predict. Conversely, paying a fair or high price based on confidence in a business’s great prospects means more room to suffer if things actually go wrong.
More can go wrong than most assume, especially when dealing with longer term forecasts. The multiple paid is short-hand for the present value of a company’s discounted cash flow (DCF), mostly comprised of the terminal value (Years 5+ through perpetuity). Today’s high multiples extrapolate great circumstances for many years. Not only is accurately forecasting into perpetuity next to impossible, but also the number of “wonderful companies” that can sustain moats for that long is small.
Unforeseen competitive disruptions make moats vulnerable, especially beyond five years. Seemingly unassailable quality businesses for the long term unexpectedly had moats erode or destroyed within less than ten years in numerous relatively recent examples. The great companies of only a decade ago included packaged food companies subsequently hurt by healthy eating, soft drink companies hurt by sugar worries, beer companies hurt by microbrewers, tobacco hurt by regulation, brands and retailers smoked by Amazon, media companies threatened by cord cutting, advertising companies disintermediated by Google and Facebook, and banks whose cultures were supposed to be their competitive advantage but weren’t.
Trying to discern the future cannot possibly incorporate all the potential disruptions that can occur. Over the past decade, many qualitative assessment misses were bailed out as all multiples rose because of rates dropping through the floor, making moat or franchise assessments of little importance to successful returns in those industries.
Managers who say convincingly today that value does not matter much at their holdings because the outcome is all about their compounding machines probably have lower odds of being right in the longterm than they think, and from this point, they will not get bailed out by rates and multiples.
This seems a modern day replay of Ben Graham’s quote published in The Intelligent Investor:
“Today’s investor is so concerned with anticipating the future that he is already paying handsomely for it in advance. Thus what he has projected with so much study and care may actually happen and still not bring him any profit. If it should fail to materialize to the degree expected, he may in fact be faced with serious temporary and perhaps even permanent loss.”
Insisting on paying a discount does not remotely dismiss the importance of demanding a high quality business. The people running it are also every bit as important, if not more so. Their allocation of capital and reinvestment rate will make our appraisal wrong, either on the high side or the low side. We require a quality business and management because they increase the probability that the company’s future value per share and our outcome will be better than expected. And we must purchase that quality at a discount to our appraisal to have a margin of safety in the event of unexpected challenges in the unknowable future.
Finding all three criteria – strong business, great people, and discounted price – is extremely hard, which is why we have concentrated portfolios. To find a few qualifying investments each year, something in the near-term must be obscuring their high quality or status as a “wonderful company.” If the strength is obvious, as Buffett said, “You pay a very high price in the stock market for a cheery consensus.” We try to find hidden quality and therefore, a low price.
You can read the entire Q218 Longleaf Shareholders Letter here.
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