Over the last few years there’s been a lot of talk about whether value investing still works. Without rehashing what the two sides are, I would argue that it’s not dead, but rather simply misunderstood, and it’s important to assess what value investing is on a first principle basis.
Say you have two businesses, company X which is highly valued at some X multiple of revenue, and a company V which is valued very cheaply at some small multiple of FCF or earnings. Over the last several years, investors may have observed that company X have enjoyed more share price growth than company V even though it looks like company X is more expensive. Some may go as far as to say value investing in companies like V simply doesn’t work anymore. I would argue this is an incorrect assumption based on faulty interpretations of recent market trends.
To assess if value investing is still alive and well, it’s important to first recognize why value investing works in the first place. The basic element of value investing is you’re buying some business that’s valued at a low Price/FCF basis which results in a good yield on your invested cash annually. This is an attractive way of investing because it offers investors a sense of confidence, in that their valuation of a business is grounded on something, and that something is real returns. The keyword here is real returns.
The problem I see with many of these ‘value’ picks today, is that while the business is generating cash, it isn’t returning it. This causes people to question if value investing works when they should really be reassessing whether the business they’ve invested in is truly returning the FCF they generate.
While many investors may have a slightly different flavor of value investing, mine is that it offers an acceptable return on my investments.
However that return of value generated by the business must be real. I would generally accept the following 3 ways of being paid back for my investments:
- The business is reinvesting earnings into more (real) growth
- The business is buying back stock
- The business is paying a dividend
#2 and #3 are traditionally how you would be paid back, but I would argue #1 is a more attractive way of being ‘paid’ back, and also my preferred method.
The problem with many of the value stocks I see out there today is that they do not grow, they do not buy back stock, and they do not pay a dividend. At which point, I would ask the question; when am I going to be paid for my investments? The companies that do not take action to repay investors the FCF they generate are NOT value investments, they are simply retirement homes for management and board members to reap all the rewards while investors question if value investing works.
Value investing works, some investors are simply not invested in a company that is returning value to investors. Instead of questioning if value investing works, it’s important investors reassess if these ‘value’ businesses are really of high value from a first principle basis as opposed to simply looking at their multiples (are they returning their cash to you?).