Thursday, 20 January 2022

Taking (slight) issue with Graham's "weighing machine"; and unpacking "intrinsic value"

In this post, I thought I'd kick off the new year with some minor sacrilege, by taking slight issue with some of Ben Graham's most-quoted ideas. Ben Graham very famously asserted that "in the short run, the stock market is a voting machine, but in the long run, it is a weighing machine". However, when subsequently asked what the specific mechanism was by which stocks were, in time, pushed towards their fair, weighted value, Graham was unable to specify one (though a quick Google for the specific quote did not yield a source I can supply here).1 He also advocated for the disposition of positions after a specified holding period, should the said appropriate re-weighting fail to transpire (2-3 years from memory).2 As I will discuss, this is not a policy/framework I agree with. 

Though Graham's insights were profound for his time, and his thinking remains exceedingly useful, on this issue I see things somewhat differently. In my opinion, in the short run, the market is indeed a voting machine, but in the long run, the market is also a voting machine. The market is always a voting machine, though the number of available ballots to cast is influenced - amongst other things - by Fed policy and the liquidity environment (when the Fed prints money, there are a lot more buy votes that can be cast, and vice versa). Furthermore, the long run is comprised of a series of sequential short runs, and whatever the relevant moment in time - now or in the future - it is the short run for those actively investing at the time. There is no magical transition point where the short run becomes the long run.

Nevertheless, fundamentals and "intrinsic value" absolutely do matter in the long run - indeed in the very long run, they are all that matter to aggregate investment results. As a long term value investor, if you get the fundamentals and your value assessments right (and do not do anything stupid along the way, such as being scared into untimely liquidations; i.e. have the right "temperament"), your realized returns will steadily trend towards those of the underlying businesses you hold relative to the prices you paid for them, and the "votes" of the investment community will become increasingly irrelevant to your reported marked-to-market investment results. How do we resolve this apparent inconsistency?

The answer requires a preliminary understanding of the fact that stocks have intrinsic value (at least those companies that can reasonably be expected to pay out at least some cash in the future); and that the "intrinsic value" of a stock - on my definition - is simply the present value of future distributed cash flows, with the discount rate being the market-clearing cost of capital on long duration assets (which I have argued in the past is ever changing and often volatile). Alternatively (and perhaps superiorly), the intrinsic value to you is the discount rate you apply to those cash flows that reflects some combination of the return you would like to earn, and the opportunity cost of your capital (the next best available opportunity). In this latter respect, the level of intrinsic value may therefore differ between investors depending on their own costs of capital (personally, I focus less on "intrinsic value", and more on my estimate of the IRR-based cash flow return I expect to earn over time from holding an asset). 

Many investors incline towards assessing intrinsic value based on cash flows at the corporate level. However, I think that only makes sense if you own either a controlling interest in a company, or at least one with significant potential influence (or where you are confident management will implement optimal capital allocation choices). If you are a small minority holder without any capacity to influence the capital management policies of a company, you are stuck with whatever capital allocation decisions management makes on your behalf, both good and bad. Consequently, for minority investors, I think it makes far more sense to value a stock based on the present value of future distributed cash flows - after all, that is the cash you get in your pocket, so it is what the stock is intrinsically worth to you. 

Importantly, this means that assessing the likely capital management decisions management will make in the future is as important to assessing intrinsic value as the business itself. You can offset a lot of (slow and steady) organic cash flow generation with one or two large capital allocation mistakes (witness the outcomes AT&T investors have endured over the past decade, for instance).

What the existence of this (practical) intrinsic value means is that, as time goes by, more of your initial investment will convert to cash-in-your-pocket as companies earn profits and pay out dividends, while the "discount rate" embedded in your valuation will steadily unwind, ultimately translating into your return (assuming no analytical errors have been made). Consequently, in the long run, what happens to the share price becomes increasingly irrelevant to your overall returns as more and more of your investment converts to cash; i.e. potential is steadily translated into actual. This is ultimately why in the long run, value investing works regardless of prevailing market prices. The "weighing" component of your return - cash in your pocket - manifests over time even if the "price" component remains forever hostage to market votes.

This view stands in contrast to how many investors see value investing, and the mechanism by which value investors putatively generate their returns. Many if not most investors believe that value investors make their returns by buying a stock at 8x, waiting for it to re-rate to say 12x, and then selling it and buying something else at 8x, etc, and to be fair, there are definite elements of this approach evident in Ben Graham's thinking. This often gives rise to the belief that value stocks need a "catalyst" to generate a return, and don't generate "compounding" returns. After all, if it stays at 8x, how do you make money?

But arguments such as these implicitly ignore the very existence of intrinsic value - i.e. that there are actually cash flows associated with holding the asset, which justify its price (or should). Indeed, the right to receive future cash flows (dividends) is the very thing that gives a stock value in the first place, and it is those entitlements that are traded in the open market every day. You can exchange $27 in cash today for the right to receive the future per share dividends AT&T pays (for example), or if you're an existing holder, you can trade out those dividend rights for US$27 in cash today. At base, that is really all that is happening in stock markets, and what investing is all about (or should be). If you get your analysis right, and buy a stock on an attractive dividend-based IRR, you can earn a quite satisfactory (and compounding) return without any multiple re-rate whatsoever. You simply hold the stock, collect the dividends, and compound your money over time by reinvesting those dividends.

What differentiates an asset with intrinsic value from one without (such as Bitcoin) is that assets with intrinsic value will generate value/put cash in your pocket over time even if you can never sell them. Consequently, you can "buy to keep", and are not reliant on the asset's resale value to yield a satisfactory return. Indeed, you are free to completely ignore the price and deem it a total irrelevance, aside from the potential it may offer you to buy more or sell opportunistically at an advantageous price.

With this context understood, let's delve into the question that befuddled Graham about the specific mechanisms by which stocks seemingly move towards their intrinsic value over time. The first mechanism by which prices may rise is simply that there are a lot of investors constantly circling around in markets looking for bargains, and if something is genuinely cheap, it is probably only a matter of time before someone (or a group of someones) discovers it, buys stock, and pushes up the price. This may give the appearance of being a "weighing" process, but at base it is actually still voting, and there is no inevitability it will happen. But given a long enough passage of time, it is probable that at some point people will vote "correctly" enough to push the price to levels that approximate or exceed fair value.

However, a second and perhaps more relevant mechanism by which it can happen is that companies pay dividends, and when companies do, their holders will have additional cash resources at their disposal which they may use to purchase more shares. Some will not, of course, for a variety of reasons, but a portion of the investor base likely will - particularly if the stock is cheap - and if they continue to reinvest their dividends over time into the purchase of ever more shares, the forces of compounding will eventually manifest and be sufficient to start pushing up the share price. Moreover, the greater the disparity between intrinsic value and the share price, the more quickly this process can reasonably be expected to occur, because reinvestable cash distributions relative to the company's share price/market cap will be correspondingly larger. If a company were to get forever cheaper, eventually the dividend yield would rise to 10%, 15%, 20%, and 25% etc, and there would simply be too much reinvestment demand to keep prices that low indefinitely.

It is the existence of distributed cash flows that generates a necessary linkage - within a wide range to be sure - between what price a stock can realistically trade at for any sustained period of time, and its underlying intrinsic value. If a stock were to fall to 1.0x earnings, 0.5x earnings, or 0.1x earnings, for instance, any amount of dividends and/or buybacks would quickly create a vast excess of buying power in the market over the supply of available shares that would overwhelm any ongoing negative "votes". This is why, over time, as per share business value accumulates, the share price will of necessity eventually be dragged up along with accumulating intrinsic value; "weighed", as it were. But it will continue to trade in a wide range round that value, the price always hostage to short term votes.

By contrast, assets that lack any distributable cash flows (which include buybacks as well as dividends) do not have any mechanism to enforce an ultimate linkage between the share price and underlying intrinsic business value. Such stocks can (and often do) remain perpetual voting machines, for sometimes extraordinary lengths of time, if not indefinitely. But people do not cast votes in ways that wholly disregard the likely capacity and willingness to pay future dividends/institute buybacks. This is why Berkshire, for instance, always traded fairly close to intrinsic value, despite never paying a dividend and only recently instituting buybacks of consequence. Investors knew that Buffett would eventually buy back stock if the stock got cheap enough, and cast their votes accordingly. 

However, suppose for the moment they hadn't cast their ballots in such a way, and Berkshire had traded down to ever cheaper levels. What would have happened is that Buffett would have bought back loads of stock, and that would have created the necessary transmission mechanism between underlying intrinsic business value and how the share price traded. In other words, irrespective of the voting behaviour of market participants, Berkshire's share price would ultimately end up tracking underlying value over time, and thus give the appearance of acting as a "weighing machine".

However, a problem emerges when there is no such connection/transmission mechanism between intrinsic business value and the underlying stock price because there are no distributed cash flows, nor any reasonable likelihood of them. This is a problem that has manifested in many value stocks in markets such as HK, Japan, and South Korea, where many family run companies have had a tendency to stockpile cash on balance sheet for years or even decades on end, rather than paying it out or buying back shares. In such cases, stock prices remains forever dependent on the whims of investors' voting behaviour, because there is no causal mechanism by which the share price can interconnect with its underlying business value. And many value investors in such markets have discovered, to their dismay, that the promised weighing machine never seemed to arrive, even after a decade or more. 

Graham seems to have resolved this issue by simply declaring an arbitrary time-based cut off point for holdings, beyond which he would simply sell the stocks (for instance after 2-3 years had elapsed). However, a better approach, in my view, would be to understand the above mechanisms by which intrinsic business value is transmitted into share prices, and to define value based on the level of distributed cash flows, rather than at the corporate level. There would then be no need to dispose of stocks after an arbitrary period if they had not gone up, provided sufficient cash was being distributed (or was likely to be distributed); while stocks with poor capital allocation yielding intrinsic values to minority holders far below intrinsic business value to a controlling party, might be more readily avoided at the very outset.

Incidentally, it is often argued that such stocks are cheap and are merely awaiting a "catalyst" for investors to "recognize the value". But the problem with this way of thinking is that it ignores the fact that capital allocation is itself an essential ingredient of intrinsic value, and especially when you define intrinsic value in the way I have - the discounted value of future distributed cash flows. When companies are managed in this way, they are actually actively destroying value through poor capital allocation choices, and share prices should reflect not just underlying business/balance sheet value, but also an assessment of the likely value creation/destruction that will be entailed by future capital management choices as well. This "present value of future minority shareholder wealth destruction" absolutely should be included as part of the valuation process, and if a company's capital allocation choices have been poor in the past and are likely to remain poor in the future, in many cases the problem is not a lack of a catalyst, but that the stock is not actually cheap in the first place. 

Graham has made an immeasurable contribution to the modern day value investment cannon, and unlike most investors/commentators today, made unique contributions to the field rather than merely copying and implementing what those before him had done. He virtually single handedly birthed the very notion of value investing. However, sustained investment success comes to those who think for themselves from first principles, rather than who devote themselves slavishly to the preachings of others, and Graham did not have the luxury of standing on the shoulders of giants, as those that came after him did.

This can be seen quite clearly in the evolution of Warren Buffett. Though Graham accelerated the development of Buffett's investment thinking immeasurably, and for that Buffett remains eternally grateful and feels forever in Graham's intellectual debt, Buffett did not forever slavishly devote himself to a set of ideas as if it were timeless gospel. He instead took what was useful of Graham's teachings, thought for himself, and developed his own ideas atop the foundation Graham had laid. I think a willingness to do so is an essential prerequisite to sustained investment success.


Postscript: Subsequent to publication, a Finnish blog reader helpfully emailed me the specific sources/quotes referenced in the first paragraph: 

1. The rediscovered Benjamin Graham” by Janet Lowe (1999) pp. 139-140, Testimony before the committee on banking and currency, United States senate, March 11, 1955

Senator: [How is the process of value appreciation of undervalued securities brought about?]

Graham: ”That is one of the mysteries of our business, and it is a mystery to me as well as to everyone else. We know from experience that eventually the market catches up with value. It realized it in one way or another.”

2. Ibid, p263

"You have to set a limit on your holding period in advance. My research shows that two to three years works out best. So I recommend this rule: If a stock hasn't met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price."