Value investing in a world of accelerating change
Accelerating change swirls around us, placing us in the middle of a vortex that is not without investment implications. In this new world of change, traditional value investing – buying a business or asset at a discount that offers the potential for upside appreciation while providing downside protection – is not what it used to be.
The existential risk to corporations is greater than it has ever been and businesses are either disappearing or facing shorter lifespans in the face of digitisation, technology and data availability.
In the 1960s, the vast majority of corporations listed on a stock exchange would be expected to remain in the index for at least five years before they were either acquired, bankrupt or overtaken in market capitalisation by other public companies. Now, those odds have fallen to the mid-60% range and are continuing to decline. Furthermore, where in the late 1970s and early 1980s, the average company had been in the S&P 500 for almost 40 years – a study by Innosight* suggests that the average lifespan of a company in the S&P 500 index is expected to hit a new low of 12-13 years.
A case in point is General Electric (GE). It is the only company currently listed in the Dow Jones Industrial Index that was included in the original 1896 index. One can only wonder if its Dow days are numbered.
The art of finding value today
When we model a company’s potential outcomes, we do not try to predict earnings this year or next, let alone this quarter. We build a low, base and high case. We make investments in those businesses that should offer a reasonable rate of return in our base case, have upside to the high case and the low case should not be too bad. Furthermore, we expect the base or high cases to be more likely than the low case.
A good investor must always understand the competitive pressures from existing and new businesses and technologies but we would argue that it holds even greater importance today. We have evolved to recognise that many of the better investment opportunities have seen the margin of safety shift from the balance sheet to the business. A business that can increase its free cash flow over time and appropriately reinvest or distribute that cash flow might afford greater downside protection than another business that could be liquidated at a premium to its current market price. This is because the business that could be liquidated at a premium to its current market price could have stagnant or shrinking cash flow in the face of new, more innovative competition.
We face the daily choice of change or decay. We opt for the former. Whereas we once might have been more willing to buy mediocre businesses at unbelievable prices, we are now committed to buying good businesses at great prices and great businesses at good prices.
Steven Romick will be discussing his views on: "Is the US heading for recession or not?" at FundForum, Berlin, 11-13 June 2018
*Scott D. Anthony, S. Patrick Viguerie and Andrew Waldeck. “Corporate Longevity: Turbulence Ahead for Large Organizations” Innosight, Spring 2016