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Sunday, 15 March 2009

Is Intrinsic Value Real?

Intrinsic Value Means Different Things to Different People

The doyen of all value investors is Ben Graham, whose investing style was based around the concept of “intrinsic value”. For Graham intrinsic value was fundamentally about buying companies trading below NTAV (see Shoot the Company - Valuing By Assets). However, his most famous pupil, Warren Buffett, has redefined the concept to mean something rather different.

So if intrinsic value means something different to different people and changes its meaning over time, what’s the use of it? Is it real or illusory?

Margin of Safety

Ben Graham’s heyday was the 1930’s and 1940’s when he trashed the markets by averaging a return of around 20% a year. Brilliant though he was he still nearly went out of business in 1930 after he geared up to take advantage of cheap stocks following the Wall Street Crash. The subsequent second wave collapse nearly wiped him out, although with the aid of a timely loan he was able to make his, and his investors’, losses back in the next two years. He was ever after wary of gearing.

For Graham intrinsic value was about buying a company for less than it was worth, based on its net assets. His aim was to buy companies with a sufficient margin of safety so that if the company’s performance was less good than expected there would still be the underlying asset value to rely on. On the other hand if the company’s performance was better than expected the price would respond positively.

In those decades you could hardly give stocks away to Americans, stunned and made risk adverse by the collapse of the markets in ’29 and ’31. There were swathes of companies meeting Graham’s criteria at valuation levels that haven’t been seen again until, well, now. Even now it’s a lot more difficult to find decent stocks trading at a discount to net tangible asset value. (And Graham actually set an even tougher hurdle than this, a discount to net tangible current assets – excluding anything that couldn’t
instantly be turned into cash).

Buffett Continues the Graham Way

Warren Buffett is Graham’s most famous pupil and initially made his money by trading the Graham way – although characteristically he put his own stamp on this style by savagely curtailing the number of stocks he held. When Graham shut up shop Buffett set up his partnerships and continued on until the end of the sixties.

At that point he shut the partnerships down because he could no longer find the cheap stocks that he and Graham had made their money with. He was dead right of course – it was nearly twenty years before markets rose again in real terms. His disappointed investors wound up with a bunch of cash and a few shares in some unknown failing textiles company called ... Berkshire Hathaway.

Intrinsic Value Mutates

From 1970 onwards Buffett’s style of investing changed and with it the definition of intrinsic value. This seems to have part been a response to the changes in the market and part due to the influence of his partner, Charlie Munger. What they now started to do was to look for companies with the ability to grow their earnings in the long-term.

Arguably this was a switch from a value investing to a growth investing style. However, there’s a crucial difference between normal growth investing and Berkshire type growth investing: the target companies must have some feature about them that means long-term earnings growth is assured, this is not speculative. Buffett says that growth and value are both part of the valuation equation and central to this is intrinsic value, modern style – the feature required in investments to make this long-term growth realistically achievable.

Long-Term Growth is not Predictable

The problem with this, as any investor knows, is that predicting a company’s earnings from one year to the next is just about impossible. (At the moment they can’t even do it from week to week). So it’s important to note that Berkshire doesn’t expect smooth growth in earnings on its investments, but it does expect to see a substantial growth in earnings over time. The concept of intrinsic value is essential to this – a Buffett and Munger type investment is one that’s trading a significant discount to intrinsic value.

The word “significant” is, well, significant – intrinsic value is not an absolute number that you can pin down. It’s a range of possible values which are largely dependent on the long-term ability of the company to grow its earnings. Because future earnings growth is always dependent on stuff that’s, err ... in the future, this can only be, at best, estimated.

Intrinsic Value and Moats

This should give some clues to what intrinsic value is about. The investment has to be a company that can pretty well guarantee a long-term increase in earnings over and above what you’d expect the market to provide (otherwise you might as well invest in an index tracker). Yet as future earnings are, by definition, an unknown this suggests some interesting requirements about the nature of the target company.

What type of company can virtually guarantee a long-term increase in earnings? Well, in Buffett terminology, it’s a company which provides something essential and has a defensive moat that prevents competitors from muscling in. Any company serving a market in which competitors can easily enter will eventually struggle to grow at more than the market rate – this is simply Adam Smith’s invisible hand in operation as competition drives down prices and margins. So any company with real intrinsic value has some kind of moat.

Looking at Berkshire’s main investments it’s pretty easy to identify the kinds of stuff this translates to. Coca Cola’s brand and distribution network is nigh on impossible to break down. The Nebraska Furniture Mart is the biggest distributor of its kind in the Mid-West and uses its buying power to get stock cheaply and pass on the savings to its customers. Sees Candy has the best customer service reputation of any business in its class. Berkshire’s insurance companies use their financial power to either beat the opposition on price or, when necessary, to refrain from quoting in order to not make losses on policies. Buffett will even incentivise staff not to write business on some occasions.

Intrinsic Value and Margin of Safety

These moats are simple but powerful and properly managed they provide companies with enormous long-term competitive advantages when backed by a management prepared to ignore short-term fluctuations. However, there is a problem with this: generally any company with such a built-in advantage will trade at a premium to other companies on the stockmarket. They’re expensive and this expense destroys the margin of safety which Graham would have insisted on.

Buffett also insists on a margin of safety. So how does he square this circle?

Stockmarkets are Dumb

Remember that he’s looking for a discount to intrinsic value where intrinsic value is the long-term value of the earnings stream that the company can generate. However, the stockmarket, being a creature with no memory and precious little intelligence, generally values companies based on short-term earnings. Which means that sometimes, although not often, the premium that well-moated companies trade at disappears.

One of Buffett’s maxims is that he prefers to buy great companies at fair prices than fair companies at cheap prices: a recognition that companies with a high intrinsic value will rarely trade at really cheap prices. However, a great company going through a temporary blip may occasionally trade at a fair price and by buying that company at such a price he gains access to the long-term earnings stream that it will provide when normal service is resumed.

Because history shows that, for anything other than dying industries, normal service will be resumed. Humans overweight the short-term and underweight the long-term. By effectively ignoring this and buying companies trading at a discount to intrinsic value Berkshire obtains access to a long-term income stream at a discounted price.

Intrinsic Value works in the Long-Term

There is one caveat to this – the company must do something that will continue to be required for a long time. Buying a cheap company in a dying industry is exactly the wrong thing to do. Which is ironic because, of course, that’s exactly what Berkshire Hathaway was when Buffett bought into it. Still, his investors aren’t complaining even though their stock has seen significant paper losses this year. Buffett and Munger are still investing with their eyes on the next twenty years, ignoring the short-term chaos in the markets and focusing fiercely on intrinsic value.

There’s a lot of it about, if you’re good and brave enough to spot it.

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