It has been nearly 90 years since Ben Graham, widely considered as the Father of value investing, propounded the theory of value investing in the classroom in Columbia Business School. Ben Graham put a lot of emphasis on deep value investing, where one buys into a company at a significant discount to its intrinsic value, where a lot of focus is on net current asset value of the business – this is also known as “cigar butt” investing. His famous student Warren Buffett refined that concept further with the help of his business partner Charlie Munger and many value investing practitioners draw inspiration from the gentlemen mentioned above. Buffett focused on buying a great business, having a sustainable competitive advantage, at a discount to its intrinsic worth.
The cigar butt investing approach revolves around buying a company trading at a significant discount to book value and often even to the liquid assets of the company. This approach though sound in theory, has a limitation – it can sometimes become a value trap, because although one is buying at a discount to intrinsic value, the underlying value of the business may not be growing and if it takes the market price several years to catch up with the intrinsic value, the expected return may be a lot lower than what was originally anticipated. In bad situations, the intrinsic value may even decline over time, further whittling away one’s expected return from the stock.
Growth in the underlying intrinsic value is thus an important attribute of a high-quality company, in our opinion. With India’s nominal GDP expected to grow at about 10-12% pa over the next several years, it would be fair to expect a good company to grow at least at this rate, if not higher. Needless to say, the higher the sustainable growth rates, the better it is for the investor. We have typically seen such growth coming from companies operating in simple businesses, having a sustainable competitive edge, a large and underpenetrated market opportunity and a management with a proven track record of execution.
Predictable and high growth alone are not sufficient conditions that make for a high-quality business. There are many businesses which can keep growing as long as you can fuel the growth with capital, either equity or debt. On the other hand, these may fail on the critical question – is the business generating a high enough return on the invested capital, and more importantly evident as free cash generation which is used to pay growing dividends over the years.
Finding a high-quality company too is not enough – an important concept of value investing is that such a business must be available at a price that is reasonable in relation to its future prospects. The current market environment has bid up prices for high quality companies in some instances to levels where one is reminded of past occasions like 1994 and 2000 when valuations became excessive and subsequent returns were not too favourable, even for these high-quality companies. We believe that the price you pay in relation to the underlying intrinsic value of the company has a large bearing on the subsequent long term returns from the stock. So as and when valuations of particular stocks reach levels which are in our opinion excessive, we will not hesitate to sell down our positions and continue to look for other opportunities to invest in quality companies which are trading at a discount to their intrinsic value.