When we talk about investing in tech companies like Zomato or EaseMyTrip with a different valuation method, one question keeps coming up. Do traditional investors miss something while looking at technology firms?
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When we start investing, most of us tend to look at Benjamin Graham and Warren Buffett. Their value investing principles have remained a bedrock for all investors who start their investing journey. Even Buffett moved towards growth investing in the 60s after spending a considerable amount of time with Charlie Munger. As value investing is based on predictability and discounting future cash flows, growth investing tends to give more importance to the growth of companies - typically, small companies whose earnings are expected to increase at an above average growth rate compared to their industry peers or overall market.
But there is always an emphasis on profits of companies. Whereas, tech investing can be considered a modified version of growth investing without any focus on profitability in the beginning. Moreover, value investing has not worked in the last 13 years. There is an interesting memo written by Howard Marks about this exact question. I will produce some of the key points mentioned by him in his memo. This should answer investors who have been asking this question regularly.
Why did value investing work during the earlier eras?
Low Competition:
During the earlier decades, the competition was very low. We didn’t have so many investors looking at opportunities to make money in stocks. Hence, a cigarbutt approach could easily work. Value investing works on this principle - buy below intrinsic value and sell once the stock price crosses its intrinsic value. Since the competition was low, so many companies were trading below their intrinsic value.
2. Information was extremely hard to come by
In today’s internet era, it is easy to get information with the click of a button. It was not the case earlier. It was difficult to even obtain basic data. You had to put in efforts to even get annual reports and read basic numbers from the balance sheet, income and cash flow statements. Hence, the privileged ones or the ones who were able to put in efforts to get information were able to do well. But things have changed. There is an overload of information today. All the available data that can be taken from financial statements are going to be factored in stock prices.
3. Investment thought process was not broadly developed
The industry itself was not matured. There were only a few analytical frameworks available at that time. Searching was very difficult and very few investors knew how to convert data into actual investment conclusions. So, it was easy to find bargains in such a market.
Grahamian framework was created at a time when stocks could be easily cheap based on observable facts. It was because the search process was difficult. Things have drastically changed today. Investing has become a competitive industry with tons of information available across different blogs, podcasts, books, forums. And we also have specialised teams that are focused on data mining and extracting crucial information from existing data related to a company's financials. So, it is not easy to find bargains in this era of investing. Hence, efficient market hypothesis is likely to occur. This hypothesis states that stock prices reflect all available information.
Benjamin Graham
It was easy to identify companies that are expected to remain leaders for long periods of time. But it is not the case any more. Readily available quantitative data alone may not produce great investment opportunities.
If a stock is available at a low valuation, there is probably a reason for it
And investing is not just about quantitative data. One has to make superior judgements about qualitative information and how the company’s business is likely to unfold in the future
Companies have become far more global. With the advent of technology, businesses can become much more valuable than they used to be. Profit potential is also humongous
There is massive innovation going on. Firms are innovating massively and hence, one has to start investing with a VC mindset
As entrepreneurship is encouraged, there is more capital available to innovate and it has become easy to start a company and work on innovating/disrupting in industries
Highly capable people used to stick to a day job. But it is changing. They are coming out and are starting and building companies
Tech companies incur low cost. You sell the same product to multiple end users. Hence, cost, human capital requirements are low. Whereas, the profitability is extremely high
With internet and economies of scale, firms can keep growing rapidly than ever
Today, it is acceptable for publicly listed companies to lose money in order to gain big in the long run. This in turn leads to obfuscation of the real potential economics of winners and makes differentiating between winners and losers difficult without great, insightful effort to peel back the onion
As it is easy to scale in the digital era, companies have new avenues to grow which extend their total addressable market. Hence, one has to put more emphasis on intangibles like management, engineering talent, strategic positioning with customers etc.
Businesses are more vulnerable as well as more dominant these days. Hence, an intrinsic value based on value investing principles may not give you the real picture. There is a huge diversion. The range for intrinsic value has broadened and increased a lot. In terms of positives, businesses have very high potential with a long runway for high growth, superior economics and extremely high durability. This leads to valuations that look unjustifiable based on traditional valuation metrics. Whereas in terms of negatives, this also leads to some mediocre companies getting very high valuation. And there is a thin line as new competitors come in, innovate and take market share away from leaders.
Today, an investor has to give more emphasis to intangibles to get real insights. This thought process is an oxymoron for traditional value investors. A value investor focuses on observable value and has an aversion to anything that is uncertain. Value investors tend to remain skeptical of market exuberance, and when there are a lot of intangibles, this skepticism grows further. And they tend to dismiss ideas too soon.
This is one sentence that is regularly uttered during bull markets. And experienced investors tell you that every time when this sentence is uttered, it is not believable and will eventually lead to a crash. But Howard Marks says this sentence is right 20% of the time. So, if it is said it’s different this time, it need not have to be always wrong. And he goes on to say that this number 20% could be high in this new world. So, it may actually be different this time.
He also warns us about extreme levels of optimism during extreme bull markets.
Every company in the sector (tech stocks) leading the bull run is treated as a winner
If purchased at extreme valuation, even the greatest companies may not give great returns (Buying Infosys in dot com bubble is always given as an example for this)
Hence, you need sharp analysis to differentiate between high quality companies and mediocre companies (especially, when there is more emphasis on intangibles)
Overall, the range of outcomes for tech stocks is very wide. This is one reason why we see extreme volatilities in tech stocks. This volatility will continue to remain high. While analysing tech companies, it becomes more difficult as one has to give more emphasis and do more analysis on tech, competitive advantage, latent earning power, ability of human capital and their innovating capabilities, and also the value of future growth opportunities that might open up later. So, valuing a rapidly growing new gen company through traditional value parameters to superficial projections is virtually impossible.
If you have any queries, send an email to investinggurukul@gmail.com. I will answer them.