The changing face of investing - Part 2

In July last year my eldest son's unprotected head was introduced to concrete - by way of an electric bike travelling at over 40kmh. The result was a traumatic brain injury that required four days in intensive care and some skilled Swiss doctors. Assuming he avoids another bang on the head, he should make a full recovery.

Currently, this seem unlikely. Teenagers are hard-wired to miscalculate risk but, in my son's case, unless he's pouring boiling water on two-minute pot noodles, there's often no calculation at all. Riding in the dark with no lights or helmet? No problem.

In a few months he'll be in Canada where he can be senseless beyond my remonstrations. I might worry about that, but I won't have any control over it.

So it is with some of the shifts in the investing landscape over the past 20 years, described last week in The changing face of investing - Part 1.

Instead of agonising over more efficient markets, the death of the business cycle or the rise of passive investing, we should instead focus on what we can control - how our analytical activities might adapt to the changing environment. There are three primary areas of consideration:

1. Creative destruction is speeding up

Depending on which historian you read, the first industrial revolution, from labour-intensive production to mechanisation, ran from around 1760 for 80-odd years. The owners of a Roberts Loom, which turned textile production from a skilled craft to an industrial process, the disruption of its day, had decades to recoup the capital cost of their investment.

The business model was clear; the success of the venture determined by access to capital, labour and dealing with burgeoning competition. In 1803, there were 2,400 looms in the UK. Thirty years later that number had increased 40-fold. Thus began the fashion industry.

Financial analysts would have had little trouble comprehending the source of value creation in the textile industry of the 1800s, and it remained that way for almost 200 years. Had you invested in a state-of-the-art factory in the 1980s, the skills required of the financial analyst wouldn't have been that different.

The third industrial revolution - digitisation, renewable energy, robotics, the internet etc - requires us to update the playbook, with footnotes and addendums rather than a rewrite. Where once the value of a product was in the making of it, nowadays value is more frequently derived from the intellectual property embedded in it. Labour is now more a function of brain activity than physical activity.

In many sectors, the internet has lowered barriers to entry while globalisation has reduced transport and production costs, opening up global markets. The disruption is causing businesses to rise and fail more quickly. For anecdotal evidence, see how the companies in the Dow Jones Industrial Index have changed from 1884 to 2018.

Unconvinced? How about the Cray-2 supercomputer, which came to market in 1985 at a cost of US$30m? On almost every measure it is outperformed by the phone in your pocket. In fact, your smartphone is millions of times more powerful than all of NASA's combined computing in 1969.

The impact of technology has had even more indirect impacts. In the consumer realm, a 2015 study by Catalina, a digital and consumer loyalty firm, showed that 90% of the top US household goods brands are losing market share. Via Instagram, Facebook and other internet-enabled channels, niche brands can grow without mass media marketing, which explains why Woolies now stocks kombucha.

As product life cycles shrink, businesses are having to reinvent themselves more frequently. For analysts like us, this demands a deeper understanding of a company's business model.

Warren Buffett popularised the concept of an 'economic moat' in his 1993 shareholder letter, where he wrote of Coca-Cola and Gillette: 'The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles.  The average company, in contrast, does battle daily without any such means of protection.'

These words form a key part of the value investing canon - but moats aren't much use when the enemy arrives in a helicopter gunship.

Gillette is now facing competition from subscription services like the Dollar Shave Club, while Woolies is shifting shelf space from Coca-Cola to a legion of cannily marketed alternatives, not least the aforementioned kombucha.

All of which means enduring competitive advantages can no longer be taken for granted.

2. The softer side of analysis is more important than ever

Darwin famously said that: 'It is not the strongest of the species that survives but the most adaptable'. Nowadays, the ability of a business to adapt has less to do with physical capital than more esoteric, human qualities.

This makes things much more challenging for investors. There are no line items for culture, intelligence, energy and ethics on a balance sheet. That's the trouble with intangible assets - you can't bloody see 'em.

The horror stories emerging from Amazon in 2015 illustrate the complexity. Former employee Bo Olson told the New York Times: 'Nearly every person I worked with, I saw cry at their desk.' Liz Pearce, who worked on Amazon's wedding registry told the Times that she 'would see people practically combust.'

From the outside, an analyst comparing the spartan, punishing workplaces of Amazon with the gyms, masseurs and organic snacks of Google, might conclude it was doomed. 

And yet the opposite has been true. Amazon employees have a love/hate relationship with the company; many that leave because of the punishing, hyper-competitive culture end up missing it and return.

'It's the greatest place I hate to work,' said John Rossman, former Amazon executive and author of The Amazon Way (you know where that link goes). 

Assessing management and culture is tricky, especially for those with a numerate bias, which of course includes most analysts. One might start by looking for success - unsuccessful companies don't tend to have a great culture - but there's more to it than that. Analysts need to assess management and culture on a deeper level than 20 years ago, but not get waylaid by it.

Had we delved a little deeper into these issues in the cases of GBST and IOOF, maybe we would have avoided some of the losses incurred. Both were waving red flags before their heaviest falls. Not only do we need to be quicker to respond to them; we need to find a way to express concerns without sounding like we're going soft.

3. Margin of safety 2.0

The most sacred cow of value investing, though, is the concept of margin of safety. Ben Graham in The Intelligent Investorcalled it 'the distillation of the secret of sound investment into three words'. That might need some revision, not of the core concepts but in how one finds and establishes value.

As noted in Part 1, sharemarkets are now more efficient. That means stocks that appear to offer a margin of safety in terms of common valuation metrics, and even their current competitive position, are generally those that face the greatest long-term threats. Nowadays, cheap-looking stocks are usually cheap with good reason.

There's another problem, outlined by research director James Carlisle: 'If we now live in a world where a large chunk of the market's returns come from a handful of stocks that achieve enormous success - and are often highly priced for years as they deliver it - then insisting on a margin of safety will mean you miss out.'

James argues that you might try and value such stocks on a probabilistic basis and give, say, a 5% weighting to the chance of a $1 trillion valuation. You might then say that on that basis said stock might be undervalued by 50%. But as James says, 'it would be a stretch to call that a margin of safety when more than half your scenarios involve losing money'.

Buying expensive stocks with no margin of safety in 1999 would have probably worked out well, as long as you fell upon Amazon. But that's for venture capitalists, not value investors.

Perhaps we need to take a broader view of things, still focusing on companies we believe can offer competitive advantages (at least in the future), but being more flexible about the concept of 'margin of safety' and how it mixes with value. If intangibles are now more important to the future success of a business, we need to weight them accordingly.

Cards up our sleeve

There are other changes that require a modification of approach. Senior analyst James Greenhalgh believes the market is more bifurcated than it used to be: 'While quality still tends to be underpriced, high quality businesses can rapidly become very highly priced (as we are seeing now). Conversely, the dogs tend to be recognised as such and priced accordingly.'

Gaurav Sodhi believes investing is changing from 'a hunting exercise to an "insiders-outsiders" problem', which is a nice way of summing up the issue. Strong businesses have intangible moats that are hard to assess from the outside whilst new moats need more nuance to recognise. This is what the changing nature of analysis asks of us.

We do, however, have a few cards up our sleeve. Fear and greed will always lead human behaviour where money is concerned, and the herding instinct is as strong as ever. The market has lost none of its short-termism, and that's great news for independent thinkers who can focus on the things that really affect value over the long term.

Despite the need to build on the value investing approach to account for the growing importance of intangibles like culture, this remains a core advantage. You can rest assured we intend to ride it for all it's worth. 

Read Part 3

Further reading (and listening)

- Gaurav Sodhi recently wrote that 'value is sometimes better found with imagination rather than a spreadsheet'. Hunting for value in break-ups - Part 1 examined one well-known stock that fits that description. Part 2, to be published shortly, will offer two more examples.

 - For a podcast discussion on the issue of culture, with Gaurav Sodhi, James Carlisle and yours truly, pin back your ears and click here. Warning: GBST gets a mention.