The evolution of value investing

The world’s technology has evolved, and investing has evolved with it.

Like a Manchester derby or the bitter rivalry between Mercedes-Benz and Ferrari, “value” and “growth” investors engage in intellectual battles about investment styles. Their audience is FinTwit and their field of play is the market.

As with most extremes, the sensible approach is a combination of the two.

A quick history lesson

You may have heard the term “value investing” before and you’ve almost certainly heard of Warren Buffett. He is arguably the most famous of all value investors, but he didn’t invent the concept.

Developed in the heart of the Great Depression in America by Benjamin Graham and David Dodd, with famous economist John Maynard Keynes following a similar approach at the time, value investing aims to identify companies that appear to be underpriced using fundamental analysis.

Such investors would usually favour companies trading at discount to book value, paying high dividends or trading on lower price-to-earnings multiples. The key point is that value investing, especially in the traditional sense, places a strong emphasis on the financial statements which reflect today’s realities rather than tomorrow’s potential.

Growth investing, in contrast, focuses on capital appreciation and chases companies with strong growth rates, even if the share price is trading at a demanding valuation. Growth investors love sectors that have immense potential, even if the companies in those sectors aren’t currently generating attractive profits.

The tech sector should immediately come to mind as an example of where growth investors get stuck in.

Even the best must evolve

It can be argued that modern value investing is a combination of the two. Buffett’s approach over time has evolved, influenced by his right-hand man Charlie Munger. This amended approach places importance on potential growth but also avoids overpaying for it.

Buffett has publicly berated himself for missing out on the Big Tech boom of the past decade, but he is now making up for it. Berkshire Hathaway participated in the Snowflake IPO and will likely increase its tech exposure in the coming years.

It’s an intelligent way to think, which is no surprise from the Berkshire Hathaway men who have defined an era of investing.

Balance sheets can’t measure the magic of platforms

The platform models operated by tech companies are like nothing the world has seen before.

The underlying strategy of these platform companies is usually a land grab. They raise billions of dollars from venture capital (VC) funds and spend mercilessly, building a massive user base and putting in place various monetisation strategies with these users.

For as long as there are examples of terrific success stories, there will be VC funds willing to fund entrepreneurs with big ideas in the tech space.

But why are these platforms so powerful? Let’s touch on just two reasons that have forced traditional value investors to question their approaches.

Reason 1: the network effect

Facebook enjoys a position of great power because people are locked in – not contractually, but because of the social capital of the platform. If all your friends are on Facebook, would you bother trying to join a competing social platform?

Google thought that you might bother, launching Google+ in 2011 at the start of a watershed decade for Big Tech. Google had correctly identified the power of social media but had underestimated the head start that Facebook had.

Facebook went on to list in 2012 and has generated terrific returns for shareholders since then, although the first 18 months of its life as a listed company looked wobbly as the share price went in the wrong direction. As the investment community denounced the “craziness” of a stock like Facebook, the company buckled down and implemented its strategy. The rest is history.

In contrast, despite Google’s power and abilities, Google+ failed and was shut down in 2019.

Reason 2: the cash flow profile

Platform companies burn cash right up until the year that they don’t.

There’s a point why the platform has been built. The users are there. Sure, there’s always going to be an investment required in the product, but the cash investment slows down and user numbers pick up exponentially.

At that stage, a successful platform company swings from a cash-hungry monster into a cash-spitting work of art, generating enormous cash flows and buying up any companies that might threaten that position in future.

This usually results in the “winner-take-all” economics that regulators dislike. A single winner in a specific product or platform category emerges and the rest fall away.

This is a non-linear cash flow profile that traditional thinking struggles to cope with. Platform companies don’t tick up at 20% a year. They go sideways for a long-time and then skyrocket.

Platform thinking, grounded in value

Traditional value investing may not be appropriate in sectors with platform businesses, but the underlying message of “don’t overpay” certainly is. It’s still important to pick out the winners and avoid the losers or the companies with share prices that are far too hot.

Nevertheless, it’s exciting to think that a Berkshire Hathaway investment committee report must now include measures like engagement and average revenue per user (ARPU). The world’s technology has evolved, and investing has evolved with it.

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Now we wait and see how we can develop better ways to audit companies, Also decentralizing banks (BTC) and wondering how BNPL purchase tech can evolve.

Energy is key as well. That is my area of interest.

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