Wednesday 6 February 2019

The value of what is vs. what could be, and the economics of disruption redux

In the past, I have blogged about both the often-tortured debate on the growth vs. value investing dichotomy, and how in my assessment, many self-described value investors are today practicing strategies more akin to growth investing than value investing. Meanwhile, I've also outlined some thoughts on how the economics of disruption is often misunderstood (see here). I hope to pull together these strands here, and offer some additional insights.

There is a long standing debate in the value investing community about how 'growth' should factor into the value equation. In the past, Buffett has called the dichotomy between growth and value styles a false one, noting that "growth and value are joint at the hip". Many would-be value investors have seized upon this quote to justify buying high-multiple growth stocks, some with unproven business models. But in so doing, these investors generally neglect the significant emphasis Buffett also places on a margin of safety. Indeed, even today, Buffett claims to be '80% Ben Graham, and 20% Phil Fisher', and a margin of safety was absolutely fundamental to Graham's approach. But many investors are behaving as if he said he was '100% Fisher'

Here is how I believe the distinction between growth and value should be framed: Value investing is fundamentally about buying what 'is' today at a discount (margin of safety), whereas growth investing is fundamentally about investing in what 'could be' in the future, at a discount to what 'could be', but at a premium to what 'is' today. Many of the growth stripe confuse a margin of safety with buying at a discount to what 'could be' in the future. But that is not a margin of safety - that's just your future upside if everything goes according to plan. If the stock didn't trade at a discount to what investors believed 'could be' in the future, no one would buy it, as there would be no upside. A margin of safety is fundamentally about downside protection, not upside, and downside protection comes from buying at a discount to what exists today.

In my submission, when Buffett talks about growth often being a positive attribute of value, while also emphasising a margin of safety, what he should be interpreted to be saying is 'we would prefer to own companies with attractive 'could be' upside, at a price representing a discount to what exists today, than companies with no 'could be' upside, at a discount to what exists today'. The need for a discount and a margin of safety is taken for granted by Buffett, so was unexpressed when he was discussing growth, but at least in my interpretation of Buffett's philosophy, I have little doubt he would endorse the above. However, the important caveat I've added is something that is now omitted from the investment process of a large portion of the current generation of value investors, and in paying up for a portion of future 'could be' upside today, such investors are abandoning the need for a margin of safety wholesale. If the upside does not materialise as hoped for, the stocks will significantly decline.

The value of what 'is' today is not determined purely by today's earnings or P/E. There are many situations where companies might own economically valuable assets that are not contributing to current earnings (e.g. dormant assets such as landbanks; discovered and economic mineral reserves in the ground; or new patented drugs or medical devices in various stages of approval). There are also situations where earnings are depressed by upfront investments that are being expensed rather than capitalised, including marketing/customer acquisition costs and R&D, the ramping up of new products/factories, and investments in networked businesses, where a lot of upfront expenditure is going into boosting adoption and customer lock in. So I'm not arguing that current earnings are the be all and end all in assessing value. But an assessment of value is fundamentally about analysing the economic value of what exists today, rather than value creation that could happen tomorrow.

The world is also uncertain and ever changing, so the value of what exists today will change over time as technology, management actions, and competition evolves, and so is never set in stone. A fundamental part of being a competent value investor is having the ability to assess with sufficient accuracy, what a reasonable valuation is today of what currently exists, taking into account all the various risks and uncertainties associated with the future. And buying what 'is' at a discount is not a guarantee of a good future outcome, as future values can decline. But it does mean that the expectancy of outcomes at the time of purchase should be attractive on a risk-reward basis.

The second mental model I want to bring into the picture here is the economics of disruption/new business models. I previously outlined some thoughts on the issue here, which I recommend reading to gain further context for this discussion. However, upon reflection, and after reading Jacob Taylor's excellent new book The Rebel Allocator (no relation, although he does have a very fine surname if I may say), I realised that I could and should have used the much more elegant model outlined in book's 'straw' model: that customer value (v) has to exceed price (p), and price has to exceed cost (c). I.e. a viable business meets this equation: c < p < v.

One could go further and say c should also include the cost of capital. We could replace c with c(e), or the economic cost, which is cash costs plus a level of profits that generate a fair risk-adjusted return on the capital committed to the business. If c(e) < p < v, you have a good business generating excess returns; if c(e) = p < v, you have a mediocre business earning its cost of capital; and if c(e) > p < v, but c < p, you have a poor business which - while profitable and surviving - is earning a substandard return on capital. If c > p, you lose money and eventually go out of business, and if v < p, you are destined to have no customers and will also go out of business. In short, c(e) < p < v is the equation businesses need to optimise.

However, some new-age 'disruptive' businesses seem to be optimising an altogether different equation: v(1) > v(2). In other words, the value provided by the product or service offered by company #1 (disruptor) exceeds the customer value provided by company #2 (incumbent). But from the standpoint of business economics, the level of value offered to customers is irrelevant if price and cost are not also taken into consideration. And in many cases the equations for disruptor #1 look like this: v(1) > v(2), but c(e) > p < v(1), or even c > p < v(1).

Not surprisingly, these companies are growing fast and taking market share off incumbent #2, as they are providing more customer value relative to price - i.e. (v(1) - p(1)) > (v(2) - p(2)) - but they are often losing copious amounts of money while doing so, because c > p. And they have only been able to do this because capital markets have been funding the difference between c and p, and in turn, capital markets have only been doing this because private 'disruptors' have been conducting capital raising rounds at higher and higher valuations, thereby manufacturing 'paper' profits for their investors that don't exist in economic reality. This is why I believe there has been a privately-funded tech bubble.

So how do these two issues - the value of what 'is' vs. 'could be', and the economics of disruption - relate? Let's consider an example of an investment into a 'disruptor' I have seen several self-described value investors make in recent years - Metro Bank in the UK.

Metro Bank is a 'challenger' bank in the UK. It is growing, off a low base, by opening expensive, spacious, well-staffed, and sleekly-designed bank branches, and keeping those costly branches open for long hours, with a significant focus on improved customer service vis-a-vis traditional incumbents. I have seen whole investment theses for Metro Bank based around the idea that its branches and customer service are objectively better than traditional banks, and therefore that the bank is likely to grow, prosper, and 'disrupt' traditional banks.

Granted - their branches and customer service is indeed objectively better. But do you see a potential problem with this investment case? The issue is that what is being argued is that v(1) > v(2), and so therefore #1 is a good business and will grow and prosper. But the value being offered is irrelevant without a consideration of price and the cost of delivery. And the investment case also pays little regard to how much of the share price reflects the value of what 'is' compared to what 'could be'.

Traditional banks have been in the banking business for a long time, and have therefore had to adapt to market forces, which have required they optimise the equation c(e) < p < v. If big lavish branches with huge staffs of people seeking to provide the best customer service was the optimal economic approach, one might reasonably ask why the traditional banks aren't already doing it that way. In business, there is a clear trade off between cost and customer value. It's easy to provide more value by taking on more costs. As Taylor said in The Rebel Allocator, you could offer a free ticket to Hawaii with every burger. It would provide a lot more customer value, but it's not a viable business.

Now, I'm not saying that Metro Bank's strategy is definitely not going to work. The world is not perfect, and nor are traditional banks - far from it. Maybe the traditional banks are indeed doing it all wrong. But what I am saying is that we simply can't and don't know if it's going to work yet - the business model is entirely unproven, so most of the putative 'value' these investors are buying is in what 'could be' if things happen to work. I would argue that given that markets are competitive, and traditional banks have been operating in their businesses for a very long time, it is at least as likely as not that there is a very good economic reason why traditional banks have evolved their businesses in the manner they have. They are trying to strike the optimal balance between cost and customer value, probably reflecting the fact that while customers prefer better service, there is a limit to how much they are prepared to pay for it. And reliable and time-tested systems are also costly and slow.

Unsurprisingly, Metro Bank has been making very little money, and yet was recently trading at more than 2x book, while strong incumbent Lloyds was trading at closer to 1x. Lloyds is earning an underlying return on equity of close to 15%, and is investing heavily in efficiency measures, including technology and automation, that both reduce costs and improve the customer experience. This is how you optimise c(e) < p < v - these measures both reduce c and increase v, and they are bankable, measurable, and low risk, and sit atop a well-positioned business that is already making a lot of money. However, Metro Bank has been trying to improve the customer experience by spending more money - increasing c to increase v, and the economics of doing so are entirely unproven. So why exactly were 'value' investors paying twice as much for Metro Bank on a P/BV basis, despite having much lower profitability and an unproven business model? And why would it be so hard for Lloyds to adopt Metro's branch strategy itself if it deemed it economically worthwhile?

Another issue to consider is that banks need to generate sufficient returns on capital to support balance sheet growth. This is fundamentally different to many 'capital light', scalable technology businesses. You need capital to support growth, and you need profits to accrete capital (one reason, along with heavy regulation, why we have seen much less 'disruption' of the banking industry). If you have a very low (or negative) return on capital, you can't grow as a bank unless you raise external capital. But if you're returns are low and your share price is depressed, you can't raise much capital.

So market forces over time have selected for banks that have managed their businesses for profitability - they have been able to grow faster and take market share (probably one reason why many large banks have got themselves into trouble focusing too much on growth and not enough on risk in the past as well). Indeed, it is perhaps exactly for this reason that Metro Bank has recently been caught under-appraising its risk weighted assets (and hence the amount of capital it needs to hold against those assets), suggesting its actual RoE should be even lower than the meagre amount it has already been reporting. With such low returns, it is hard to see how they can continue to fund and grow their current business model, unless they keep raising money from markets at high valuations. But because capital markets are fickle, the latter is not a sustainable strategy.

That is not to say you can't win owning something like Metro Bank. It just means that the business model is unproven, and so you are investing in what 'could be', rather than in the value of what 'is', with no margin of safety. The idea that this is 'value' investing is, in my submission, absurd. It is the antithesis of value investing: basing your investment case on future anticipated value creation, which may or may not happen, with a limited margin of safety if your subjective expectations for the future prove wrong. And when assessing the value of what 'could be', many investors have also been using flawed mental models that focus primarily on customer value instead of business economics.

By contrast, Lloyds is a classic value stock. Trading at 7x underlying earnings, and about 1x tangible book, with PPI redress winding down, the value of what 'is' already amply justifies its existing price. Again, that's not to say things can't go wrong and value can't decline in the future, but on an expectancy basis, the company's existing assets/equity and earnings profile more than justifies its current price.

A good place to start, in determining 'what kind of investment is this', is to ask, will a perpetuation of the status quo yield a good outcome? For Lloyds, with an earnings yield of nearly 15%, with buybacks and dividends underway, the answer is very clearly "yes". You can just sit there and collect the near 15% earnings yield and double your money every 6 years or so. Nothing new or spectacular has to happen. Meanwhile, the answer for Metro Bank for many years, including at present, has been "no". Their business model has to work, and profits need to significantly increase, to justify their price.

So why then were all these so-called value investors rushing to buy Metro Bank at 2x book and >30x earnings, when they could have instead been buying Lloyd's at less than 1x and 7x? The preference for growth stocks with exciting 'could be' upside is likely being coloured by a decade of strong performance by tech/growth stocks, as well as typically-fallible human intuitions - the fallibility of which accounts for the historical underperformance of high-multiple could-be stocks as a group. Real value investing is a process of investing in a manner that defies our normal human intuitions - that's why it's hard (and rare).

As I've noted in the past, human beings often decide emotionally what they want to do, and then find rationalisations to justify it. And at their core, most investors emotionally/intuitively want to jump into exciting growth stories, and focus on industries that have done well. And these 'value' investors, just like everyone else, intuitively gravitate towards sexy growth stories with large perceived upside, rather than to boring, dull, 'get rich slowly' cash flows with downside protection.

One of the drivers of our flawed intuitions is survivorship bias. People look back at past winners, like Starbucks, Microsoft, Google, etc, which were invariably growth stocks that were priced in that manner all the way up, but they nevertheless did very well. But this method focuses on ex post outcomes, rather than the uncertainties that existed ex ante, and it also ignores the large number of companies with seemingly promising outlooks at the time that ended up falling by the wayside. At one point, everyone thought Yahoo would become what Google has today become. If it had, people would have looked back at era valuations and said, that was fully justified; see, starting point valuations are less relevant than growth prospects. But the future doesn't always play out the way we expect. Indeed, history shows investors hugely underestimate the likelihood of unexpected change, and this is - at its core - why growth investing has delivered relatively poor outcomes historically.

Value investing is all about investing in what is dull and unexciting, but solidly profitable and low risk. It's about getting 'on base' consistently rather than swinging hard in an effort to hit home runs, and ending up getting struck out all the time. But as in baseball, a high 'on-base' percentage can yield fantastic team (portfolio) outcomes over time, even if it's less exciting than a spectacular home run. Unfortunately, it's simply more fun to swing for the fences, and stalk a huge winner. And that's why people keep doing it - even 'value' investors.