The Value of Value Investing

When I used to visit India as a kid, the contrast between it and the US was striking. Back then, India did not yet have the economy and modernization that it is known for today. There were five black and white television channels with limited programming, women who only wore saris, men who eve-teased, cloth bags brought to market when shopping, and recycled newspaper bags given by vendors to hold purchases when the cloth bags were already full. The garbage cans were minis­cule, a quarter of the size of a typical US garbage can, because very little was thrown away and almost everything was reused.

Money was tight, people did not have a lot of disposable income. There were many young graduates who could not find jobs despite their college education or masters degrees. There were no professions like interior designing or counseling. It was hard enough to get a job even in solid fields like accounting or science or engineering — no one would have spent good money and time on a “cotton-candy” career.

In some ways the environment was drab and restrictive, throttling the dreams of those who might be different or creative. In some ways, however, there were benefits to that culture that need to be brought to the US today. Those benefits involve the concepts of value and substance.

Because people didn’t have extra money, because there was no security through unemployment or social security or medicare, because people — especially women — didn’t have a lot of options, every decision taken in life, and every penny spent was evaluated for core value and the return it would bring. People did not have extra money to pay for pet rocks or bottled water or cyber gifts on a social media site. They did not have money to pay for a bachelors degree in Philosophy. If the money being spent was going to bring value in the way of food, shelter, clothing, education, transportation, or other basics, it was invested, otherwise it was not.

That is the kind of system that we need to bring back to the stock market today.

I am an admirer of Warren Buffet. It might be trendy to dismiss him and talk about why other philo­sophies are better, but I don’t think his common sense will ever go out of style. That is because Warren Buffet is a man who believes in fundamentals. If a company offers a need - based, proven product or service, and if it shows prudent management and a consistent, profi­table history, that’s when it’s smart to invest. And only if the price is right.

When is the price right? Well, let’s go back to the original point of the stock market. Way back in the 1700s, when the stock market and investing first began, what was its purpose?

The purpose was to enable investors to share in the profits of a company in return for their investment in the company. A company would receive capital to increase its operations and produce more revenue. In return, the investors would share in that revenue as it was generated. Usually an investor paid an amount for the stock that was equivalent to about ten years of projected earnings (a price per earnings, or P/E ratio of 10). In other words, the investor expec­ted to get his stock price back over no more than ten years. The payment to an investor out of a company’s earnings is what we would call a dividend.

Instead, something akin to the Dutch tulip market has taken precedence. Capital appre­ciation is based on the assumption that the money an investor makes will come out of the increase in share price. The investor may not keep his shares for ten years, or even receive a dividend. Many companies do not pay any. However, the next investor to buy the shares from the first investor will hopefully pay a much higher price for those ten years of earnings. So the first investor makes his money from selling the shares, rather than participating in the earnings of the company.

Now, why would subsequent investors buy shares at higher prices than the first investor paid? Well, the first logical assumption would be that the earnings of the company have increased more than expected. In other words, maybe the new investor is still paying for ten years of revenue payback, but the projected revenue is much more than originally calculated. So he is willing to pay more for the shares.

Unfortunately, this is not usually the case. Most investors buy shares at price-per-earnings that are twenty or even forty times revenue. Facebook was valued at a PE ratio of 95 (yes, 95!!!) when it went public. The thinking was that the company was so hot, and growing so fast, that paying ninety-five times current earnings was fine. As of today, Facebook’s stock price has fallen 33%. Personally, given its uncertain revenue prospects, I consider even that price too high. Actually I seem to be skeptical when it comes to investing in web companies. Overall, I’m in love with, and a big believer in the web in terms of what it’s done for the world. It’s simply amazing. Most of my companies as an entrepreneur were websites or web-related. However, I don’t think the brilliance of the web should be a cause to throw fundamentals out the window. And unfortunately most web companies today are priced way too high.

Warren Buffet believed in owning stocks of companies with sound business models, profitability, and reasonable expectation of return on investment.

I believe these are the reasons he is so successful today. Money does not appear out of thin air. It has to be EARNED somehow. Sometimes anomalies will occur and we’ll have a sudden boom in one sector, or a trend or craze will jack-up the price of one company’s stock. But these are unpredictable and unsustainable. The increases in price cannot last forever if there is no revenue or sales to back them up. Investors have to be paid back somehow, and at some point, people are going to realize that they can’t always count on selling their shares to the next bigger fool. It’s like a game of hot potato — who is going to be left holding it when the music stops?

Invest wisely and carefully, with value, substance, and fundamentals as your guide, and hopefully . . . it won’t be you.