Table of Contents: 1. AI-generated summary 2. Transcript (AI-edited) (auto-generated transcript which follows audio only available in browser)
AI-generated summary:
Key points on value investing's differentiated approach:
Focus on capital preservation and adequate long-term returns (15% annual average).
Mindset akin to private market investors, not influenced by short-term price movements.
Seek significant margins of safety to minimize capital loss risk.
Upside driven by improving earnings yields, not speculative appreciation.
Avoid "fear of missing out" on price gains; focus on sustainable returns.
This differentiation, centered on prudent capital allocation, is value investing's edge.
Transcript (AI-edited):
Hi everyone, this is Aaron from Value Investing Substack. I'm starting a new podcast series called Value Investing Insights, and the reason I'm doing this is because I've always faced a hurdle in getting my thoughts on value investing out when I'm writing articles, mainly due to editing time constraints.
I thought that if I could do it in a podcast format instead, where the editorial requirements are not as high, I could actually express more of my insights about value investing, of which I have many, to the rest of you. This way, you can benefit from it without me having to spend time on less value-adding editing tasks.
If you enjoy this kind of content, please remember to subscribe to this channel - or follow it if you're on Spotify. Hopefully, I can provide more benefit to you with the years of experience I've had thinking about what value investing means to me.
Without further ado, let's jump straight into today's episode. Today's episode is going to be about where value investing gets its edge, or what sets it apart. The context here is that there are many styles of investing in stock markets, and one common question we, as value investors, get is: how are you guys better?
Here's how I would describe it. Whether or not it's immediately visible to everyone that value investing is actually better than other styles, I can make a very strong case for how we approach things differently. i.e. How value investing fulfills one of Porter's Five Forces, Differentiation, which is where we get our edge.
To boil it down to its essence, we choose very different types of stocks. To borrow a quote from Benjamin Graham, the father of value investing, he says that the definition of an investment is one which promises the safety of principle as well as providing an adequate return. That's really the genesis of where the differentiation of value investing comes from. If you're interested to learn more, I've gone to great lengths to expound on it in the article linked below:
I can only speak for myself and my own personal interpretation of that quote – but what I look for in my own investment decisions, in line with this quote, is twofold. Firstly, I'm looking for the preservation of my capital, which aligns with Graham's criteria in his aforementioned quote of “safety of principal”. Secondly, I'm looking for a 15% long-term return. That's my definition of an “adequate return” in Graham's quote.
The context for this is that I'm really approaching my stock decisions from the framework of a private market investment. Think about M&A activity. Let's say a firm wants to merge or acquire another firm, or consider if a PE firm is trying to assess a potential candidate for acquisition. The way they'd approach the acquisition logic is intuitively very different as compared to how most market participants approach stock picking. You'll agree with me that private market investors rarely describes risk as “downside”, correct?
In contrast, consider how risk is usually described in markets. It's described as either downside volatility or the permanent loss of capital. Both imply a slide in the share price. Whereas the way a PE firm might think about it, or the way a company that is thinking about merger would is more like, is the capital that I'm going to allocate going to remain safe? Is there capital preservation? What's the likelihood of me losing all of it?
Just to give an example, let's say McDonald's is trying to acquire Chipotle. How does that factor from an operational standpoint into my capital risk? Does it affect my ability to get it back? Maybe it's marketing spend, maybe it's CAPEX.
I think marketing spend might be a good example to demonstrate this phenomenon, because it's ethereal in nature given its uncertain payback. The way most large companies like McDonald's think about marketing spend is to benchmark it against the lifetime value (LTV) of the customer. Because of that, they're willing to take a loss upfront on any given marketing project, as long as it helps contribute toward the longer-term strategy, which is to acquire the lifetime value of the customer.
So, they don't really need to make a profit on any given marketing spend – which would naturally represent a risk or potential loss of capital at the project level. That's the capital preservation consideration - you might not get that marketing spend back, since once you spend it, it's gone. And whether you get it back or not, there's no real causal link to the return of marketing spend.
That's how a private market participant or a private investor would think about the safety of their principal. It's not represented by share price trajectory, but rather the safe return of capital. Do you see where I'm coming from? That's the same kind of approach I use when thinking about my own stocks.
For instance, about six months ago, or even a year ago, I was drawn to INTC 0.00%↑ - because as you probably already know, Intel’s valuation has only recently recovered from narrative weakness. For most of the past two years, it was pretty much the dog of the market. But from my perspective, I felt that it was a very good candidate for capital preservation. Why? Because given more recent news, we now know what Intel's fair value is actually likely to be; but at the time, there wasn't this perspective amidst market consensus.
Since I felt very strongly at the time that Intel’s fair value was what markets recognize it as today, I was very comfortable with the level of capital risk I was assuming when Intel was still trading at then much lower levels. And since you’re giving yourself that margin of safety, that represents safety of principal.
If you think about it, I'm behaving the way a private market investor would when looking at capital preservation, the way I described earlier – i.e. how McDonald's might perceive its own marketing spend when trying to acquire Chipotle.
Notably, it's very different from how most market participants think about risk, isn't it? It's not about downward share price trajectory (i.e. “downside”). It's about allocating your capital like a businessman would, and asking what's the likelihood of you getting it back. That likelihood needs to be as close to 100% as possible. The only way you're going to do that is by only partaking in opportunities which are significantly below fair value, i.e. have a large margin of safety.
Now, of course, that does not mean that value investors don't care about upside, right? Personally, I have a very defined benchmark of a 15% yield on an annual average basis. It can be realized over the long term, but it has to be 15% on an average annual basis. From that perspective, I've actually gone to lengths in the article linked below — click here to jump straight to the relevant section) to explain why I think this metric is accurately represented by earnings yield. But at the end of the day, I'm looking for a 15% normalized earnings yield:
As value investors, we’re really looking at earnings yield from a capital investment perspective in the same way that a private market investor looks at it. We're not looking at share price trajectory, where the intention is to flip it for a profit later. And because the upside incentive is so different, we are also driven by very different incentives. We're looking at different things. We want different things.
One example of this might be, we're not too concerned by FOMO — whereas most market participants would readily admit that they are. We don't really care about the fear of missing out, because we're not driven by “the flip”. We're driven by earnings and earnings yield. In fact, it's the things which encourage earnings yield that create our FOMO, the “value investing FOMO”. We're not chasing FOMO in markets the way most market participants do.
Hence, I have explained what my differentiation as a value investor looks like. Basically, one, I'm looking for very safe investments where I don't actually risk any capital — much in the same way that McDonald's might approach a private market investment. Two, I'm looking for upside, or rather my upside incentives (as defined by a 15% earnings yield) are driven by things which encourage the earnings yield to go up; rather than things which may cause the share price to go up.
Of course, there's a whole other discussion about how do we reconcile this new baseline with, say, your clients or third parties from an accountability standpoint. But that's for a completely different discussion. The point of today's podcast is to show how value investors have an edge by being different. They have differentiation. They have a real edge by virtue of doing something completely different, being incentivized by completely different incentives and just chasing very different things. That brings us back to the title of our episode, “Where do value investors get their edge, and how are they different”?
I hope this podcast was helpful. As I said earlier in the podcast, I am planning to provide more value investing insights in podcast format going forward. So if you like this kind of content and you find it valuable to you, please subscribe and like the channel so that you can get more such insights in your inbox. Till the next episode.
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Disclaimer: This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the authors. To the best of the authors’ abilities and beliefs, all information contained herein is accurate and reliable. The authors may hold or be short any shares or derivative positions in any company discussed in this document at any time, and may benefit from any change in the valuation of any other companies, securities, or commodities discussed in this document. The content of this document is not intended to constitute individual investment advice, and are merely the personal views of the author which may be subject to change without notice. This is not a recommendation to buy or sell stocks, and readers are advised to consult with their financial advisor before taking any action pertaining to the contents of this document. The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties and other factors, most of which are beyond the authors’ control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
Where Does Value Investing Get Its Edge?