In this letter we would like to discuss two different styles of investing – momentum investing and value investing and then we would like to look at two different kinds of value investing.
Momentum investing is popularly defined as an investment strategy that aims to capitalise on the continuance of an existing trend. A momentum investor is looking to buy a stock that is rising, in the expectation that the price will rise further. Proponents of this style of investing have pointed to Newton’s First Law of Motion as per which an object in motion will stay in motion until it is acted upon by an external force. The valuation of a company is less of a factor of consideration here. Critics however have called this “The Greater Fool Theory” where you are looking for the greater fool to take the stock off you when you are ready to sell.
Value investing is an investment strategy that involves picking stocks that are trading at a discount to their intrinsic value. Within value investing, there are broadly two groups – one which is the traditional deep value investing as described by Benjamin Graham, considered the Father of Value Investing. Here the focus is on assets of the company – Ben Graham was looking to buy stocks of companies whose market value is less than the net current assets, i.e. cash, investments in marketable securities, inventories and sundry debtors. This has also been called cigar butt style of investing – because typically these are poor quality businesses, which are not growing their intrinsic value. While the strategy is theoretically sound, our criticism of this style of investing is that one often does not know how long it will take for the market price of the stock to catch up to the intrinsic value and the intrinsic value may not be growing– so time is your enemy in this strategy.
The second subgroup within value investing is what is known as GARP or Growth At a Reasonable Price. GARP investors are focused on buying businesses whose value is growing with time – usually growth which is close to nominal GDP growth or higher. Here the intrinsic value may be defined as the sum total of all free cashflows of a company until infinity, discounted back to today. Here the accent is on free cash flows (FCF) rather than on earnings – FCF is net profit plus depreciation minus the capex and working capital required to maintain the business. Higher the sustainable growth in free cash flows into the future, higher should therefore be the value of the business. In GARP investing, you make time your friend.
GARP investing is also what we practise a lot of, as in our view it also offers a lower risk approach to investing because the value of the business is growing. The difficulty often becomes the price to be paid for a company growing its free cash flows into the foreseeable future. Over the last several years many stocks in India have been trading at expensive valuations on the basis of a prevalent momentum style of investing which says that whatever is going up, will continue to go up. This of course works for a while but eventually the gravity of valuation has to have its say – either the companies in question need to grow into their valuations by exhibiting high growth in revenues and free cash flows or there could be an eventual correction in these stocks. We have been mentioning in past letters that we are finding it difficult to find high quality companies growing at a pace near or higher than historical nominal GDP growth at a reasonable price – our quest continues.