The Price of Everything and the Value of Nothing: Recognizing Intangible Value in a Business

I am a Maruti vehicle owner, and a highly satisfied one at that. The overall cost efficiency of their vehicles and the tremendous value they provide is legendary. It is aptly shown in that funny ad in which a rich man is being sold a luxury ship by a sophisticated salesman, and at the end of it he coolly asks – “Kitna deti hai?” Maruti can take the credit for (or is guilty of – based on how you look at it!) making Indian car owners used to a certain minimum standard of fuel efficiency. And that sort of dependability (and many other benefits that car owners attribute value to and which Maruti has mastered) tends to tilt the car buyer’s decision in favor of Maruti more often than its competitors – at least on Indian roads. In a very conscious or unconscious way, customers assign a value to their purchase, and compare it to the price at which it is being offered, and if the gap is there – they seem to go for the purchase.

In my profession (technology and management consulting) often I am required to sell our offerings to other companies using what is commonly known as “Preparing a Business Case”. In most cases, the approach taken to create a business case is what I broadly like to refer to as the ‘route of efficiency’ rather than the ‘path of effectiveness’. And the reason for it is simple: it is easier to quantify efficiency, and very tough to quantify effectiveness. So for whatever it is worth, one goes about getting some numbers around how much time will be saved due to automation, or how many man hours will be saved due to process time reduction, or how much material will be saved due to lesser turnaround time. Despite that exercise (which has its own value), I have often experienced that companies that finally end up buying do not do so, only because of the price justification in the business case, but due to some additional value perception that they see. That value perception often means different things to different customers in different circumstances, but unless that happens, the business case alone is not enough and the sale does not happen. And in a competitive environment, that value perception is the ‘thing’ that tilts the customer to choose a seller.

price-value-compete_on_valueIt is easy to offer a price, but very difficult to quantify that value perception. Companies that can consistently offer this value relevant to their markets, and whose customers choose them for this intangible value perception are themselves candidates for outstanding long term value.

As customers of various products, we are exposed to offers on multiple things at multiple prices everyday. As prospective customers, most of us are smart enough to evaluate the value in what is offered, then check the price, and if there is a gap, we grab it with both hands. A lot of ‘up to 30% off’ offers are simply stripped down products at slightly lesser prices, and most of us, after checking on them – reject those kind of offers. Some of them are genuine ‘sale’ offers or turn out to be great bargains, and we are smart enough to recognize those too.

But as investors, a lot of us are not that smart when choosing company stocks to buy. We forget that price is one factor, but whether the company is of value is the important one. A new promoter tries to sell part of his company which has just started making profits (an IPO is just that!), but we still buy it even when an established company is available for purchase every day – perhaps because “it is cheaper”. We see on business channels, the reporter routinely making statements like “retail investors seem to have come back  to the market as there is more action seen in mid and small cap stocks” – thereby meaning that they buy the stocks that have lower price. A friend of mine ‘invests’ in penny stocks because “it is 12 rupees, so even if it moves by 10 rupees my money will almost double”. Another acquaintance never understands why buying a 10-year-old mutual fund unit costing Rs.200 per unit is better than buying in a new fund offer for Rs.10 – “I am getting 500 units for Rs.5000 in the new fund”. It is almost like going to a grocery store and asking for a soap for under Rs.5 – well you may get a soap, but it is not going to wash anything much!

That is not to say that there is no value in low-priced stocks. Like bargains for any other product, there could be, but price cannot be the sole reason of purchase. It is best if the starting point of any purchase is at least a broad evaluation of what constitutes value for you. When the value seen is reasonably close or under the price at which it is offered – be it for someone buying cars, software or company stock – it results in a good purchase. But a great purchase is perhaps made, when you not only get some of these quantifiable measures of value, but also know that there is some more value offered that is pretty certain and perceived, maybe not easily quantifiable and replaceable. The kind of value you have when you know that customers in India prefer Maruti cars for some reason. Or that it is almost impossible for someone even with a lot of money to replace Cadbury or Disney from a child’s mind. Or Americans for some reason love Coke. That is when you know that when such value is available cheap, it is not a “up to 20% off, conditions apply” kind of sale, but a genuine bargain on a quality product.

Buffett said that price is what you pay, value is what you get. The ability to get this difference is critical. Else like Oscar Wilde said we will “know the price of everything and the value of nothing”.

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Are Markets Efficient and does it matter?

A lot of investing debate and styles of investing are supposed to emanate from this question. The roots of this debate are in an old financial theory called the Efficient Market Hypothesis – which says that all that is to know about a stock is reflected in its price at any point in time, so it is futile to analyze stocks as no one can do it. The very theory challenges human nature so much that it is no surprise that, depending on who you are and what your place is in the financial services industry, you are almost compelled to take a view on it – one way or the other.

marketefficient-garfield_dont_care_black_shirtBut for an individual investor, is it really relevant? Does it matter whether markets are efficient or not, or is it just another debate to confuse him? Again – like so many other things in investing, this may be a great question for experts to debate on, but for an individual investor, a wrong question with many right answers. For an individual investor, letting go on this debate on whether markets are efficient is the best choice. “I don’t know” and “It doesn’t matter” are the best responses. The answer to this question is said to determine whether you as an individual or a fund manager who manages your money can beat the market or not. Again – this is perhaps the wrong question. What if I decide that the markets are efficient and hence invest in Index funds, and then later (at the end of  a year or two) realize that there are lots of funds beating the Index? On the other hand, what if I decide the market are not efficient and hence invest in an Actively Managed fund or decide to manage my money myself, and then later realize that it has not beaten the Index? In other words, the market turned out to be not efficient, but so did my fund manager and my investing techniques!

So actually the prudent answer for an individual investor to the question on whether the markets are efficient or whether I or my fund manager can beat the Index is “I don’t know and it doesn’t matter”. Because the reality is, irrespective of whether they are efficient or not, it is practically impossible to predict in advance whether and/or which stock or which fund manager will beat an Index. Hence – “I don’t know and it doesn’t matter”. Well – I don’t know is fine, but an individual investor may ask why “it doesn’t matter”? It doesn’t matter because what matters more is to have an investment plan, asset allocation and re-balancing strategy in place. What forms part of those assets once you have a plan in place does not matter that much. So whether you choose an Index fund, or an individual stock or an actively managed fund within that asset allocation and re-balancing plan based on your answer to the question “Are markets efficient” may not matter much, at least if you are broadly close to market averages, and in so far as reaching your financial goals are concerned.

So – leave the debate of whether market are efficient to the experts to fight over and resolve. Post that, let them decide whether to focus on large caps versus mid caps; or to use fundamental analysis or technical analysis. For you as an individual investor, what matters more is a proper investment plan to reach your goals that is in line with risk profile, has the right asset allocation and re-balancing strategy in place, and the discipline to stick to it. Post that, you are free to keep deciding what assets to put into that plan, based on performance every year or every couple of years. If the markets turn out be efficient, you are free to move the actively managed fund and individual stocks out of that plan, and hold an Index fund.  If the markets are not efficient and you end up with a good fund manager (or if you yourself are able to beat the market) , good for you, as the stocks and funds you hold may beat the Index. And finally, if you realize that markets are not efficient, but your investment style or fund manager turn out to be equally inefficient :-), you are free to move that money to an Index fund!

So let the debate on Market Efficiency continue, and let the experts argue and make a case for your money. You as an individual investor are in an enviable position, because when asked your view, you can continue saying – “I don’t know and it doesn’t matter.”

Guru Speak: Walter Schloss, Truly conservative value investing

Among the famous investors of Graham-and-Doddsville that Warren Buffett refers to as ‘super-investors’, the most conservative yet in no small measure less successful was Walter Schloss. He was perhaps the closest to what was commonly referred to as ‘cigar-butt’ investing, and someone who perhaps followed the bargain hunting principles in stock picking perfectly and over the longest period of time with highly successful results.

“Over the entire 45-year period from 1956-2000, Schloss and his son Edwin, who joined him in 1973, have provided their investors a compounded return of 15.3% per year…Every dollar a fortunate investor entrusted with Schloss at the start of 1956 has grown to $662 by the end of 2000, including all charges for management.  A dollar investing in the S&P Index would have been worth $118.”*

walter-schlossA lot has been said about the legend and his style of investing – a very simple style based on buying depressed stocks trading close to book value, of companies with some record of reasonable performance and with little or no debt. His famous lack of interaction with management because “I am not a good judge of people” and dependence on buying something that is so cheap that “something good will happen” are largely responsible for his success. The sheer conviction and high degree of comfort that Schloss had on this approach that he consistently followed with his son for over 40 years to give results surpassing most traditional investors is almost ascetic.

“Their office – Castle Schloss has one room – is spare; they don’t visit companies; they rarely speak to management; they don’t speak to analysts; and they don’t use the Internet. Not wanting to be swayed to do something they shouldn’t, they limit their conversation.  There is an abundance of articulate and intelligent people in the investment world, most of whom can cite persuasive reasons for buying this stock or that bond.  The Schlosses would rather trust their own analysis and their long standing commitment to buying cheap stocks.  This approach leads them to focus almost exclusively on the public financial statements that public firms must produce each quarter.”*

* from the book “Value Investing: From Graham to Buffett and beyond” by Greenwald

Their approach to investing is something that any individual investor with conviction in it can follow with reasonable effort and study – with no need to predict the future or understand businesses beyond a point; but with only a single objective of weeding out companies to find price less than value.

Here is a valuable document that Walter Schloss shared a few years ago, when asked about how he goes about making his investing choices –  a clear and simple set of golden rules of the Walter Schloss style of truly conservative investing.

Walter Schloss and 16 golden rules of investment

Buffett’s style can’t be implemented by Mutual funds fully, but it does not matter

It is structurally not possible for mutual funds to implement value investing, in its completeness.

Mutual funds are essentially slaves of their investors and their temperament. Simply because of the structure of mutual funds and the need to beat an index on a monthly, quarterly, annual basis, it is almost impossible for mutual funds to replicate the ‘buy value and hold long term as long as the business stays great’ approach of Buffett in toto. And there is no reason honestly for individual investors to put their money in actively managed mutual funds if they cannot beat the index. That in itself is a structural constraint on why mutual funds will never be able to fully implement Buffett’s value investing style.

But nevertheless, I think individual investors may be in a position of advantage here, if they manage their portfolio well,  simply because of the situation that mutual funds find themselves structurally in.

One option for value oriented individual investors is clearly by not investing using mutual funds and doing value investing in a full fledged manner by directly buying stocks of great businesses at good prices and holding them, aka Buffett. But that may work for only a select few who want to do investing full-time, and may not be feasible for most individual investors. But even though most individual investors may not be able to do this, the second option for value-oriented individual investors may actually be to treat mutual funds as ‘diversified value buckets’, use them as useful stock selection mechanisms, and buy (more or less) mutual fund units based on their general assessment of value existing the market at various times.

That’s one way that individual investors can perhaps be value investors in a partial sense, without having to dabble directly in stocks – but by using funds as proxy value buckets. The need of funds to constantly beat indexes will make sure that they get at least reasonable performance (else use index funds), and treating funds as value buckets will ensure that investors can practice value investing, though to a lesser extent than Buffett, and buy general market value by timing their purchase of fund units.

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