Buying something for less than it’s worth is alive and well, writes Morgan Stanley’s Michael Mauboussin in a recent article for the Financial Times.
“You might not know that by reading headlines in the financial press or witnessing the poor returns of stocks with low multiples of price to earnings or book value per share,” he argues, adding, “But here’s why you don’t need to fret about value investing” outlining the following points:
- Value investing should not be confused with the simple purchase of stocks with low earnings multiples.
- The Capital Asset Pricing Model (CAPM) dictates that in an efficient market, more risk should come with more reward. Mauboussin notes, “the theory is beautiful in principle but doesn’t work in practice.”
- He cites the 1992 findings of finance professors Eugene Fama and Kenneth French showing that considering size and value factors “righted the relationship between risk and reward” — specifically, that small-cap companies earned higher average returns than large-caps and stocks with low multiples performed better. But Mauboussin contends that many then conflated value investing with the value factor, noting, “Value investing is buying something for less than it is worth. The value factor is an ersatz measure of gaps between price and value.”
- “Earnings and book value are losing their ability to represent economic value,” writes Mauboussin, explaining that while tangible assets once represented the foundation of business value, intangible investment (i.e., research and development) has risen steadily for decades. “Investments are outlays today in the expectation of higher cash flows tomorrow,” Mauboussin writes, although they are treated as expenses on the income statement and tangible assets are recorded as assets on the balance sheet. Therefore, a company with high intangible-related spending will show lower earnings than a business with an equivalent amount of tangible spending, even though their cash flows are identical.
Mauboussin concludes, “Fundamental value investors should focus on gaps between price and value for individual securities. The present value of future cash flows, not misleading multiples, are the source of value.”