This is a November 2020 interview but pertinent nonetheless. Not just because Professor Bruce Greenwald’s ideas are timeless but this happened when value investing in the conventional sense was considered to be dead and has since staged a comeback. Greenwald is the Founding Director of the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School. He is the author of two must read books – Value Investing: From Graham to Buffett and Beyond and Competition Demystified. This interview was soon after the launch of the second edition of the former. Greenwald demystifies for us why traditional definitions of value and growth investing don’t make sense anymore. But more importantly he stresses on how crucial understanding industry structure, capital allocation and barriers to entry are to investing. The long read is a treatise in itself much as his books but here are some excerpts:
On value versus growth:
“…if you look at reasonably well-developed models of value versus growth, you’ll see the value premium is still there but not obvious….if you do the crudest definitions, you could call cheap stocks value stocks then you call the expensive stocks growth stocks – by this crude measure, value has underperformed for as much as 10 years…”
He talks about how value and growth investing have evolved through history to now when the lines are blurred because of the changing nature of franchise value. Using case studies of Walmart, John Deere and the tech companies, he shows why marrying barriers to entry that protect growth with valuations can blend the two streams of investing.
“We live in a world…where growth turns out because franchises are getting stronger and more valuable than people thought. If you’re not looking at growth – and also, if you’re not looking at intangible assets because that has also changed with these technologies and the trend toward services – you won’t do a good job of buying where the real opportunities are. That is the fundamental change value investors must come to terms with. They must be much better at valuation and intelligently buying growth. They can’t just do what Ben Graham and David Dodd did and say, “Look, we just don’t do growth.”
Why it is important to do deep research to establish franchise value:
“If you think of a growing firm and buying a growing firm, most of the value is way out there in the future. Typically, when you do a DCF on a growth stock, you’ll do five years of cash flow projections, and then you’ll do a terminal value. Somewhere above 80% of all the value will be in the terminal value. The terminal value will be a terminal cash flow times a multiple, and the multiple is one over the difference between the growth rate in that terminal cash flow and the cost of capital. If the growth rate is four and the cost of capital is eight, 4% is the difference. The multiple will be one over four percent or 25%. But suppose you’re off by 1% in either of those numbers. Suppose the growth rate is not 4%, it’s 3% instead. The cost of capital is not 8%, it’s 9% minus 3%, 6%. One over six percent is 16x, not 25x. On the flip side of that, suppose the growth rate is 5% and the cost of capital is 7% and these are 1% errors in projecting a long-term future. Seven minus five is 2%. One over two percent is a 50x multiple. Within a narrow range of forecasted growth rates and what future risks might look like, you can get a 3:1 variation in multiples. You had better be an expert if you play that game….
… If you’re going to buy growth, you must not say, “This is what it’s worth,” because you’ll get those inaccuracy problems I just described. What you must say is, “If I buy at this price, what kind of return will I earn?” You must look at these growth stocks and returns base. What you’ll do is an earnings power. The assets probably won’t matter because it’ll be a franchise business. You won’t invest in any growth if you don’t have confidence in the existence of a franchise or the barriers to entry. You’ll verify that they dominate the market, they have customer captivity or proprietary technology, and that there’s real market share stability. For an entrant to be viable, it must get to, say, a 20% market share. Two-tenths of one percent changes hands of market share every year, so it will take them 100 years to get here, which is a powerful moat. Then you’ll say, okay, as that franchise sits there today, what are the earnings? That’ll be a traditional earnings power calculation. You’ll divide that number by what you’re paying for the company. That’s a cash return, and this is an enterprise value. You say you think you’ll make $100 million and you’re paying $1.2 billion. It’s an 8% earnings return.”
And then the importance of capital allocation to establish longevity of growth:
“…You don’t get all of that. You can’t just stop there because the management will give you some of that in cash, and they’ll reinvest some of it. You must have a feel for how much of that you’ll get in cash, which is what the distribution policy looks like now and in the future. Let’s say you think they’ll distribute half of the 8% earnings with growth. You’ll get a 4% cash return. Everything else must come from growth, and the growth will have two sources. One source – and here it’s important to recognize it’s just organic growth because the market is protected by barriers to entry – organic growth in demand and margins from cost reduction will benefit you. But you must know what those numbers will look like. You must know and be able to forecast what these long-run growth rates and revenue will be. Typically, because you’re talking about long-run revenue growth, it won’t be more than 3% above GDP growth. If it’s temporary growing at 20% faster than GDP, that won’t last. You won’t be able to tell when that stops, and that’ll be too tough to call.”
Importance of industry analysis to assess management’s capital allocation decisions:
“You must have a long-term revenue growth rate, and you must have a long-term trend in cost reduction to improve margins. To understand both of those, you better understand industry demand and how it’s evolving; you better understand industry technology and how it’s likely to evolve. Then you’ve got the 4% return they reinvested. What you get for that depends on how good the management is and will be at capital allocation. If they’re terrible at capital allocation – and there are companies out there that typically earn about $0.20 on the dollar for everything they retain; understanding that number requires real industry knowledge – then that 4% will be worth less than 1%. If they have a disciplined strategy – they spend money first on cost reduction and, when they grow, they grow either at the margins of their existing markets where their economies of scale carry over, or like adding food products for Walmart within the markets they dominate – you could have a case where every dollar reinvested earns $2, in which case that 4% would be increasing. But you better understand the evolution of that management, how good they are at capital allocation, and that’s a lot of detail.
Once you have that number – it consists of the cash return, the organic growth return, and the active reinvestment return – you must compare that to the cost of capital because you want a margin of safety. If the cost of capital is seven percent, which is a reasonable cost these days, you want returns of at least 10% or 11%.”
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