Geoff Gannon November 9, 2016

Is Value Investing Broken?

Someone who reads the blog emailed me this question:

Is value investing broken? 

To clarify: with worldwide debt at 200+ trillion and incomes stagnating or falling who exactly is going to go out and buy new products (whether from Luxottica, Movado, Swatch etc.) when they have record debt levels and are getting by at $10/hr? I realize that is a limited example but in many industries there is massive change going on that will, temporarily at least, push down income levels (driverless cars and trucks, robotic everything etc.) and people will therefore be spending less. Does value investing still work in this environment? Do you bother investing at all?

Apologies for the gloomy tone of this email but I don’t see a good place currently to invest and am frustrated by my inability to figure it out. Please help!


No. Value investing is not dead. There’s a tendency for people – people of any time – to see the time they live in as unique, dangerous, different, unlike any other age. In some ways, they are always right. Some things really are different this time from all other times. But, mostly, they’re wrong. And what they are wrong about is reading a golden age of stability into the past. I was talking with a value investor once and this value investor said that sure Ben Graham’s ideas worked in Ben Graham’s times. But Ben Graham invested in simpler times.


Here are the times Ben Graham invested in: the 1910s through the 1950s. He invested during Two World Wars, the start of the Cold War, the atomic bombings of Nagasaki and Hiroshima by the U.S. and then the testing of nuclear weapons by other countries, The Great Depression, a big explosion (reportedly a terrorist bombing) on Wall Street, and the longest shut down of trading in Wall Street history that I can remember at least (right as World War One started). People talk about political risk today. Political risk in Ben Graham’s time meant Marxists and Fascists. Investors saw hyperinflation in Germany after the war and then they saw deflation after the 1929 crash. These were not simple times. If you go back and read the newspapers from the time – you can see how not simple they were.


Now, yes, they were different from today in some ways. Much of the period investors and economists in the U.S. study were more regulated than today. So, you either had the Gold Standard or Bretton Woods. You had much greater belief in planned and insular economies in a lot of countries. With the benefit of hindsight – and seeing the entire sweep of history – many of these decades seem simple to us. They rarely were. Try to find a decade without too much inflation, too much deflation, too much war, the mania of some bubble, or the bursting of that bubble. At any point in that past, people could have believed value investing was dead. And yet, buy and hold investors – business owners and the like – have been compounding fortunes in the U.S. from the 1800s through today. If there are companies that can make founders and their families billionaires – there are companies that can make shareholders very rich if they buy and hold.


It’s hard for me to address the specific issues you mention in your email, because I don’t think that’s the problem here. The problem is that you are looking at the entire investment landscape as a depressive would look at their own life. You are fixating on some negative things – some real headwinds – that are likely to be a drag on the performance of some investments for many years to come. Sure, those things exist. But, both good and bad things exist in all sorts of years. In 1946, an investor could have lamented the low yield on bonds, the inevitable depression that would come from demobilization (many people at the time believed there would be such a return to Depression as soon as the war was over) and then either another World War or a nuclear exchange. With hindsight, we can see that 70 years later, there never was another World War nor did anyone else use nuclear weapons. But, that would have been a hard sell in 1946. Try convincing people who had been through two World Wars in 30 years and now saw the invention of a weapon of mass destruction that there would be no war on that scale again in their countries and there would be no nuclear exchange.


Your question was not about geopolitics. And some value investors get tired of Warren Buffett often repeating that he first invested in 1942 when the U.S. was losing the war against Japan. But, it is worth remembering these things. Because to the people who were caught up in them at the time – the outcome was not clear. We may believe The Great Depression was some sort of one-off event and that while World War Two may have provided a great deal of stimulation to the economy that did not mean that the second it ended, the peacetime economy would again return to that Depression. But, people at the time did believe that. They were unsure. Just as we are unsure.


As far as things like mechanization – I understand your concern. And I don’t deny that over time you will see the substitution of capital for labor. But, that has already happened in the past. My grandparents all worked in jobs that are now done by machines. They either did factory work that is completely automated now or they did office work that is now performed by managers using computers instead of secretaries. There are still workers in those factories. But the tasks they themselves performed are not done by humans any more. There are still workers in those offices. But there are not secretarial pools typing up all the inter-office communications that is now done entirely by email. So, those jobs don’t exist. That’s not at all unusual.


And deflationary pressure from investment in capital like driverless cars is not unusual either. Driverless trucks aren’t really that different from railroads. Very little labor is involved in running railroads now. If you look at things like railroads and farms in the U.S. and how many people used to be involved in doing work at those sites and how much greater output there is now with far fewer people – you’ll see that these are not new trends.


Deflation is probably the natural state of an economy. Even if you look at economies like the U.S., you don’t have much in the way of inflation between about the end of the Revolutionary War and the start of the Second World War. The inflation you have is largely over the last 75 years. Now, obviously, the economy grew tremendously quickly before all of that inflation.


Debt problems are not new either. In the ancient world – the Roman Republic and Athenian Democracy – the most common call for reform was debt relief. There were occasional monetary crises and these were often discussed in terms of heavy debt loads that couldn’t be serviced. There was a push even in Ancient Athens to get farmers to stop investing in growing food crops and instead focus on a cash crop (olive oil) that the city could export. Olive trees take time to mature. So, they require an upfront commitment of capital with no immediate payback. Farmers didn’t want to do this. And it was only those who had ample capital – probably from trade – who were eager to make the investment. It is not an unusual problem to see those with heavy debt loads unable to make the necessary investments in capital and falling behind in society. Back in ancient Rome and Athens this was investment in large scale farms. It was investment in slaves, and implements, and land improvement, and focus on cash crops instead of food crops. Doing those things took savings. Today, it can be the cost of tuition. Education is critical to future earnings. So, a parent in the U.S. may feel they have to buy a home – taking out a huge mortgage to do so – to raise their kids in the right town with the right schools. And those kids may – when they reach college age – feel they need to take out student loans and pursue graduate degrees and so on. Most people don’t have the savings to do this. So, they borrow. They have to borrow to invest in their own human capital. People who have only their labor – and no saved up “human capital” in the form of education and specialized skills – fall behind relative to others. That’s the kind of story you are telling me now. It’s a sad story. But, it’s not a new story. Likewise, cyclical debt problems aren’t new. They aren’t new for households, for businesses, or for governments. Historically, governments defaulted all the time. The conclusions in the book “This Time Is Different” might not be right. But the list of defaults they have for governments going back centuries isn’t wrong. Those governments really did default. And some of these government defaults happened during periods we now consider “normal” and “stable” and “simple” compared to today.


There are a lot of changes happening in the economy right now. There are a lot of risks. I just wrote a post about the possibility of negative interest rates. Now, in the 1970s and 1980s, what would an investor say about such a post? They’d think I was crazy to even write such a post. And they wouldn’t necessarily think that sounded like such a bad place. A place without inflation? The concern back then was that inflation would destroy an investor’s returns even if he picked the right stock. And you know what – they were right.


As a buy and hold investor, the risks posed by depression, deflation, and negative interest rates aren’t as bad as the risk posed by persistently high inflation. It’s easy to forget that now. You look back at Berkshire Hathaway’s results through the 1970s and you think they look pretty good. But, as Warren Buffett wrote in one of his letter to shareholders – the truth is that an investor could have done about as well simply by investing in a barrel of crude oil or an ounce of gold instead of Berkshire Hathaway stock. That’s not because Buffett wasn’t making great decisions. Buffett’s own record has gotten progressively worse each decade in terms of the value his decisions have added. His best decade as an investor was the 1950s, his best decade at Berkshire was the 1960s, then the 1970s and so on. But, during the 1970s and into the 1980s – it was very hard for an investor buying and holding high quality businesses to outperform assets like land, gold, and oil. Low amounts of inflation might be good for some businesses. For example, Grainger (GWW) has said that it benefits from inflation because its own business is deflationary. So, it can take costs out of its own distribution centers before it passes those savings on to customers. There is a time lag. And that lag can benefit the company by as much as 2% a year. Customers will eventually see the benefit of the company’s cost savings. But, the company will see them first and then only update catalog prices later. But, most businesses can really only insulate you from inflation. They can’t benefit from it. So, I’m not even sure that too much debt is a worse problem for investors to have than too much inflation. If you look at the real return on equity (nominal ROE less inflation) at companies, it has obviously been good recently. It was terrible at times in the 1970s and 1980s. There were large U.S. companies that weren’t creating any real – inflation adjusted – value for shareholders. You could buy the Dow near book value and it would just manage to preserve your real purchasing power – not help grow your actual wealth.


The problem here is not with the world economy. It’s with your framing of your situation. Even if there was a problem with the world economy – and there is always some problem – you need to frame your behavior in terms of your own problems and your own opportunities. What can you do today to make your situation better? It’s not enough to have an opinion about what is or what isn’t true about the world. You need to have an opinion that’s useful to you as an investor. You need an idea about how you can get to work doing something to improve your own situation.