Against the Top Down Approach (Again)
Guru Focus recently reprinted my post “Against the Top Down Approach”. In the discussion forum, there was a post by an author who disagreed with me. I wrote a response, and thought it was worth sharing on the blog. By the way, If you haven’t visited Guru Focus yet, you should. It’s a great resource.
Considerations as to the future growth or profitability of an industry are a part of a bottom up approach insofar as they affect the individual security being evaluated.
Obviously, any evaluation of a property in Baghdad would have included an analysis of the risks associated with the ownership of such a property. The fact that those risks also apply to many other properties does not mean a top down approach is necessary. A top down approach begins with those risks. A bottom up approach considers them only insofar as they affect each investment.
An intrinsic value analysis is not the same thing as applying a multiple to current levels of free cash flow. I know this is not what you suggested. However, it is implied in some of your criticism (particularly the Baghdad example).
For instance, if you believe current steel prices are unsustainable, your intrinsic value estimates for steel producers will be lower than they would be if you simply projected current free cash flow levels into the distant future. A belief that steel prices are high is not inconsistent with a bottom up approach. A bottom up approach simply requires you compare your intrinsic value estimates for each investment against your estimates for all other investments regardless of industry.
A retailer, a homebuilder, a steel producer, and a bank should all be judged on the basis of a conservative intrinsic value analysis. There is no need to first determine that any one of these groups is inherently more attractive than any other.
Buffett’s “play” on the dollar is exactly that. I wouldn’t criticize him for it. However, I believe that, if you were to ask him, he would say it was merely the best opportunity to deploy large amounts of capital for a short period of time. He would much rather make long term investments in common stocks at attractive prices. Mr. Buffett would not be doing the same thing if he had less capital to deploy, and therefore a much larger investment universe.
I suspect his attitudes toward the dollar play are similar to those he has expressed about his past arbitrage operations. They are short term commitments with limited upside, and are far less attractive than long term commitments in common stocks made at bargain prices. Berkshire’s investment universe has shrunk considerably as its pool of capital has grown. This is not the kind of investment Buffet made with his own money back in the 1950s, with the partnership’s money, or with Berkshire’s money in earlier years. I doubt he would suggest it is an attractive option for individual investors.
In my article, I wrote:
“All investments are ultimately cash to cash operations. As such, they should be judged by a single measure: the discounted value of their future cash flows. For this reason, a top down approach to investing is nonsensical.”
In his 1992 Annual Letter to Shareholders Mr. Buffet wrote:
“The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.”
I believe these two statements make exactly the same point. I did not argue that bonds are always inferior investments; neither did Mr. Buffet. I stated, just as he has, that all investments must be judged by a single measure. The investment shown to be most attractive by that measure is the one to buy. Neither the form of the security, nor the industry of the issuer is of any independent importance. It is of importance only insofar as it affects the intrinsic value analysis.
Let me now provide a few examples to illustrate the dangers of a top down approach and the advantages of a bottom up approach. I will begin with a very unattractive business: grocery stores.
Below is a 10 year chart of the S&P; 500, Wal – Mart Stores (WMT), and Village Supermarket (VLGEA). Village Supermarket is one of the largest members of the Shop – Rite retailer co-op. Shop – Rite is the largest retail cooperative in the U.S. grocery business. From 1996 – 2004 VLGEA has been available at a price/book ratio of 0.45 – 0.84.
Note that this is not what Village sold for at its lowest points for the year. This is the average price/book value ratio. It is reasonable to expect an individual investor who sought to acquire shares of VLGEA during this period would have purchased them within this range of a 55% to 16% discount to book value. During this same period the average P/E ratios were 5.0 – 13.4. The average price to sales ratios were 0.04 – 0.11. The average debt/equity ratio for any one year never exceeded 0.50. This was not a high risk investment. However, as you can see from the chart, Village easily outperformed Wal – Mart during this 10 year period (which was a good one for WMT). Any top down approach would have told you to steer clear of grocery stores. You would have missed this great low – risk, high – return investment.
As another illustration, here is a list of the “17 Stocks That Go Up Year After Year” from an article by Jon D. Markman:
• Chico’s FAS (CHS)
• SCP Pool (POOL)
• Expeditors International of Washington (EXPD)
• Center Financial (CLFC)
• Brown & Brown (BRO)
• Florida Rock Industries (FRK)
• Genlyte Group (GLYT)
• Cathay General Bancorp (CATY)
• Graco (GGG)
• Southwest Water (SWWC)
• Simpson Manufacturing (SSD)
• Harbor Florida Bancshares (HARB)
• Franklin Electric (FELE)
• Australia and New Zealand Banking (ANZ)
• Home Properties (HME)
• National Australia Bank (NAB)
• New Jersey Resources (NJR)
A few industries provide several companies on this list (e.g., construction / materials, banks). However, what top down approach would have kept you in these stocks for the last ten years? I can’t think of any. At times, a top down approach may have lead you to the right industries. But, this is not quite the same thing. For instance, over the last ten years, you would have done better investing in these banks than in banking as a whole.
What top down approach would have lead you to Genlyte (GLYT)? That stock has returned about 1,400% since 1996. I can’t imagine a top down approach ever leading you to that stock (it makes lighting fixtures for commercial, residential, and industrial customers).
I do, however, know of one approach that would have lead you to this stock and kept you in it. A simple bottom up value investing approach would have done the trick. The stock has consistently traded at low P/E and P/S ratios and earned good returns on capital while employing relatively little debt. It’s always had a high ROA (a trait it has in common with many of the best bargains).
I could go on and on. But, I won’t. I’ll just mention two more stocks that were very obvious bargains from a bottom up approach and yet never all that conspicuous from the top down standpoint. They are both relatively small companies yet they both have relatively well know names. They are CEC Entertainment (CEC) and Timberland (TBL). CEC stands for Chuck E. Cheese. Here’s a 10 – year chart of CEC, TBL, and the S&P; 500.
While Timberland looks like a growth stock, it’s high return on capital, low debt, reasonable multiples, and tons of free cash flow that are present today were also present throughout the vast majority of the last ten years. A bottom up value investor looking for a good company would have been happy to buy and hold this stock for 10 years.
Chuck E. Cheese has been, perhaps, a little more expensive. However, it was still quite clearly a bargain relative to the market in each and every year. Both of these stocks were. If you asked most diligent, concentrated bottom up value investors for their opinion on whether CEC and TBL were bargains relative to the market, each and every year for the last ten, you would have received an emphatic yes.
So, respectfully, I don’t think there’s anything limiting about a bottom up approach.