The term “value investing” is usually associated with buying stocks and assets cheaply. This is true, to a certain extent. However, due to investors’ search for an easy way to determine value, some value investors have become reliant on metrics and ratios such as the price-earnings ratio and price-book ratio.
These are commonly used shortcuts for deciding whether or not a stock is cheap, but unfortunately, these figures have significant drawbacks and don’t provide the full picture on if a company is trading at a discount to its intrinsic worth.
Some investors may quote Warren Buffett (Trades, Portfolio) as an example to explain why these shortcuts could work over the long run, but this is incorrect. The Oracle of Omaha moved away from these ratios many decades ago as the markets have changed.
Indeed, in Buffett’s 1992 letter to investors of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), the value investor declared:
“Such characteristics [P/B and P/E], even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.”
He went on to opine that “opposite characteristics,” such as a high price-book or price-earnings ratios, are also “in no way inconsistent with a ‘value’ purchase.”
“We think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).”
He went on to explain that investors should also be aware of and utilize business growth rates, though again, this isn’t the full picture:
“Similarly, business growth, per se, tells us little about value. It’s true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.”
Looking at these comments, it becomes clear that Buffett had moved away from his traditional value investing style by the early 90s. This process began several decades before with the purchase of See’s Candy.
In the decades after this deal, Berkshire avoided so-called deep value stocks and started to concentrate on companies that looked to offer growth at a reasonable price.
If there’s one thing we should take away from these comments, it is that putting value or growth stocks into individual buckets is a waste of time. Every company and investment opportunity has its own qualities. Segregating an asset into a particular bracket based on a simple valuation ratio may be a waste of time and effort. It may also lead investors to draw misleading conclusions due to faulty evidence.
A high price-earnings ratio, for example, may discourage value investors from buying a stock. However, the price-earnings ratio alone provides no insight into a company’s cash flows or productivity. It is just one piece of the valuation puzzle. The same can be said for anything else.
Disclosure: The author owns shares in Berkshire Hathaway.
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This article first appeared on GuruFocus.