The Five Elements of Value

Many people will say that they are either Value Investors or Growth Investors. Many of the greatest investors are both (and in a sense they are two sides of the same coin). Being a great investor often involves changing a winning game. What has worked in investing in the recent past will not necessarily work in the future. So it may be important (especially for very large investors) to reevaluate strategies.

Where I differ from many investors is that I consider Margins of Safety to be more than just a discounted purchase price. I like to incorporate all the ways that an investor can reduce risk and increase returns into my investment strategy. There are five Elements of Value that I have identified. The more elements of value the better off the investor is. No one element is necessarily better than the other.

When investing in companies there are Five Elements of Value or five ways to establish Margins of Safety:

  • Cheapness

  • Growth

  • Quality

  • Control

  • Catalysts/Liquidity

Cheapness

This, along with growth, is one of the easiest ways to conceptually think about reducing risk. Buying a company at 2x earnings is way less risky than buying a company at 20x earnings almost regardless of growth. If you purchased an entire company at 2x earnings the per year returns assuming no growth would be 50% on the investment. If you purchased an entire company at 20x eanings the company would need to grow earnings by 1000% in the first year in order to equal the returns for the company bought at 2x which for all but a handful of companies is impossible. Of course in the long term if the company bought at 20x earnings continues to grow the returns may eventually be larger than the company bought at 2x earnings.

Growth

Buy a company and get the growth for free. A company that sums up this strategy fairly well is Alphabet. You could have bought the company in the recent past at prices that approximate the value of the company’s search division alone and got all the other “moonshots” for free.

Growth investing is probably the area where most new investors swarm to when they first start investing. It can be a very difficult path to follow with many investments in this category often becoming massive losers (depending on the strategy). A key to the more aggressive growth approach is to diversify more heavily than one would a regular portfolio so that the losers are more than taken care of by the winners. For the growth category it is also important to have the potential for astronomical returns. In other words whereas in the typical investment in value might require a 20-50% margin of safety an investment in a growth investment may require that the company has the potential to become 10-100x larger as a company.

Another way to reduce risk in this category would be to focus only on higher quality investments.

Quality

Quality means many things to many people. It could mean the quality of a companies balance sheet or it could be the moat and defensive characteristics of a security. In the bond realm it is the creditworthiness of the issue. In the stock market it may be the makeup of the companies underlying assets such as a great brand or the location of owned real estate. The highest quality asset of a company to the deep value investor is cash. The highest quality asset to a growth investor is something that gives the company a competitive advantage.

A company that has a return on invested capital of 20% and can maintain that for a period of 20 years is much better than a company with a return on capital of 10% for the same period of time. Even if the purchase price is substantially less for the company with lower Returns on Capital the company that has the higher return will eventually be a better investment in the long run.

A quality company may be able to grow or at least hold ground during a recession. Certain quality companies even welcome a recession so that they can take advantage of former competitors that are in a weakened position.

Control

Control is a fairly apparent way to achieve safety in an investment. The trouble is outside of real estate or startup businesses most people will never exercise this element of value. An activist investor with a large enough stake can effectively reduce his or her risk by attempting to influence the companies board of directors. If an activist buys into a turnaround situation and the company fails to perform the activist can change management or even sell the company.

Another aspect of control is that if an appropriate management team is in charge then the investment may have additional aspects of safety. For example Buffett has put in place a policy to purchase Berkshire stock if the stock runs under a certain multiple of book value. If one were to purchase stock slightly above that multiple then the downside is effectively limited by a put option. If an outstanding CEO/capital allocator steps into a dire situation at a struggling company then there is an added level of safety to the investment over a crappy CEO/capital allocator.

Catalysts/Liquidity

Catalysts are important to any investment. They are particularly important, however, to investments in bargain issues. Catalysts can be anything from an up-listing to spin-offs and mergers to liquidations.

Liquidity is meant to account for how quickly you can get out of an investment but also how quickly an investment is returned. If you invest in a merger arbitrage deal you should account for how quickly you can get your money back. Obviously a 5% return in 1 month is better than a 20% return in one year and in a sense less risky because money will be returned to you more quickly.

Illiquid investments are often referred to negatively. But most of the time illiquidity is more than made up for with a lower stock or bond price. If the returns are the same for both an illiquid and a liquid investment then one should obviously choose the liquid investment but that is seldom ever the case when comparing very similar situations.

Private business ownership is a different story. I have heard many stories of people running into trouble and not being able to save their businesses or sell them before they went under. Private business ownership is probably not more inherently risky than owning a smaller piece of a similar publicly traded company BUT they do have different risks. Illiquidity discounts can be more than made up for with control premiums.

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