We made our annual pilgrimage to Omaha, Nebraska last week to attend the annual Berkshire Hathaway Shareholders Meeting. One of my favourite things about the meeting is that the shareholders of Berkshire Hathaway are among the friendliest and most interesting people you could ever meet. We met people from all walks of life and from all over the world while we were walking around the CHI Health Centre along with 40,000 other shareholders.
Aside from the obvious financial benefits of being a Berkshire shareholder, these opportunities to meet your fellow shareholders and learn about their stories is probably one of the best perks of attending the meeting. Though of course, the best non-financial perk, is to soak up the wisdom of Berkshire's legendary Warren Buffett and Charlie Munger.
For those who have followed Warren Buffett and Charlie Munger throughout their careers, you will know that they are practitioners of a specific style of investing called "Value Investing". The basic idea behind value investing is that you try to buy investments at a price which is less than their true value. Value investors tend to describe true value as a company's "Intrinsic Value". So for example, if I think a business is worth $1,000,000 but the owner is willing to sell it to me for $500,000 that would be very attractive to myself as a value investor (arguably it should be attractive to any investor but I'll get into that a bit later).
There are many different ways to calculate the Intrinsic Value of the business. One method is to simply add up the value of all of the assets of a business. If I buy a business with $1,000,000 in the bank for the amount of $500,000 then I am definitely getting good value for my investment. You wouldn't think this would be possible but occasionally the markets do strange things. Usually these companies are awful businesses that just happen to have a lot of assets. They're often described as 'cigar butts' and the objective for the investor is to get the one last puff out of the business.
Early on in Warren Buffett's career, he looked for companies that were trading at a value less than their assets and made a lot of money this way. As other investors started to wise up to this strategy however those opportunities became harder to come by. Enter Charlie Munger and a new method of Value Investing. Another method of investing is to calculate the value of the cash flows that a business will generate for shareholders in the future. This is a more complicated exercise than just valuing the assets because it requires you to make certain assumptions about what is going to happen in the future.
Nevertheless this method is usually a more accurate way of valuing a business that is likely to stay in operation for a long period of time. Often investors who do this look to certain ratios like Price to Earnings (P/E) or Price to Cash Flows (P/CF). Up until the past few years, almost all of Berkshire's investments were in companies with P/E ratios of less than 15 (meaning $15 of purchase price for every $1 of earnings).
However in recent years Berkshire made a very large investment in Precision Castparts which was at a PE ratio far above 15. There was also rumblings about Berkshire making an investment in UBER, a company that has no earnings and therefore wouldn't even qualify for a PE ratio. Even more recently we got word that Berkshire had bought shares in Amazon, a company which currently trades at a PE Ratio of 76.8, way above the previous limit of 15. So what does this mean? Does it signal that value investing is dead, as many pundits have suggested lately?
Well the question came up at the annual Berkshire Hathaway meeting this year. In particular one shareholder asked if Berkshire was abandoning its value investing principles and changing its investment philosophy. You can see the question and answer right here if you are interested. Warren's answer was what I would have expected and provides a great lesson on what value investing actually is. Warren's comment was "All investing is value investing".
Nobody wants to pay more for an investment than what they think its worth. In order to be a value investor there is no requirement that you rely on certain P/E ratios or Price to Asset Value. Investing at its core is the act of giving up some amount now to get more in the future. There are some businesses which warrant a high P/E ratio because they have a high probability of growing their earnings substantially in the future.
Amazon is one of those companies where its business is so strong that a rational investor should be willing to pay a higher P/E ratio for that business. If an investor calculates that she is likely to receive much more in the future then she is paying out right now, then it's a good value stock, regardless of what the PE ratio is. Now she may be wrong in her calculation, but that doesn't change the fact that her initial analysis was based on value investing principles.
I think it's clear that Berkshire's investment philosophy has changed over the years as the company has grown larger and as the investing world has changed. As Charlie Munger often says "You fish where the fish are". When Buffett originally started investing it was much easier for him to find cigar butts trading at less than their asset value. Nowadays Berkshire is too big and the world has changed too much for that style of value investing to work for them.
It doesn't mean that value investing as a concept is dead. It just means that how they find value has changed. Now if you were to google "is value investing dead" you would get no shortage of articles like this "Is Value Investing Dead?". I think it's important to understand that whenever you see articles like this, the author is probably taking a very narrow view of what value investing is. In my view this is a foolish approach.
If you instead try to listen to what Warren Buffet said, and try and think about value in a less rigid way, you will be on the right track to becoming a great value investor yourself.
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at the award winning firm Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
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