Over the past 35 years, the global economy has moved from a manufacturing-driven economy to a service-led economy. Given that value investing has underperformed growth investing for the last 15 years, does value investing have a role to play in a service-led economy?
Herro: Yes, it certainly does. First of all – let there be no mistake – the global economy will continue to evolve. A couple hundred years ago, we were mostly an agrarian economy. That is, people worked for subsistence. Then, as we entered the Industrial Revolution, we became a manufacturing economy. As we become more advanced as people – and more efficient at producing the goods we need – we have very different demands, from entertainment, to recreation, to travel, etc. So it is not unnatural that the economy has evolved.
When you’re investing in businesses, you are buying a financial asset. Like any asset, it has a price, and it has something that it returns to you. If it’s a car, you pay a price for transport utility. If it’s food, you satisfy your hunger utility, etc. Value is the price you pay for what you get. It is in essence a fraction. Whether you are buying a bag of apples, a refrigerator, an automobile, or whether you are buying a company, the same concept comes into play – the price you pay for what you get.
What’s important for value investors is that there are periods of time when the fundamentals of price and value are divorced from reality. Take the dot-com bubble of ’98, ’99, early 2000 or the natural resource bubble of 2006–2007. We see periods of time where the laws of supply and demand – or what is value – become divorced from reality. Ultimately, fundamentals assert themselves and value becomes an important factor in equity investment. Despite the fact that the global economy continues to evolve, I don’t think value investing will ever go away, unless you think that the price you pay for an asset doesn’t matter into perpetuity.
What does economist Ben Graham’s “margin of safety” mean to you?
Herro: Well, Graham’s “margin of safety” – and value investing in general – is centered on two concepts. The first concept is, as an investor, you aim to buy something at a low price. The second is you buy something that has a very strong financial balance sheet and very strong financial protection. For Harris Associates, this doesn’t encompass the full 360 degrees of value investing. It does focus on one aspect of value investing: price. You have to ensure that you pay a low price for whatever you are buying or investing in. This is good economic math – you want to get the most for the least. While Graham focuses on typical valuation measures such as low price-to-book value, low price-to-earnings, low price-to-cash flow, he doesn’t quite give enough attention to what you’re getting in return.
At Harris Associates, we incorporate the notion of quality. In other words, what we want to buy is a business that proactively builds shareholder value per share over time, or free cashflow-per-share over time. This means you have a management team that operates the assets of the business in a way which seeks to grow revenues in as efficient a manner as possible. Simply put, we judge quality by the stream of cash flow that management generates from the asset base of the company. The more efficiently management can do that – and the stronger the cash flow stream they produce – the higher the price we are willing to pay. So to us, Graham in many instances does remain very important, but on the other hand, we don’t think he went quite far enough. You have to consider the other side of that equation – what you are getting for the price you are paying.
How do you seek to avoid “value traps” – investments that look like value opportunities, but are ultimately misleading?
Herro: You have to look for the signs of a value trap. That means looking for value-per-share which actually declines over time, instead of goes up over time, which is usually caused by management not generating cash in an efficient manner from the revenue base, or not investing in their assets to create a revenue base. They are also not likely redeploying cash in a way which is conducive to growing value per share. Think about it – when a company generates free cash, there’s just a few things they can do with that free cash. They can invest it into their business, they can pay down debt, they can undertake an M&A activity, and they can give it back to the owners via dividends or share buybacks. Choosing the right route for capital allocation is very important to creating value. For instance, if you have a high internal rate of return, then you should be putting that money back into the business. If you have a low internal rate of return and lots of cash and no debt, you should either be looking at M&A, or giving it back to shareholders. The reason why I bring this up, capital allocation, is because this is one of the ways in which management teams can destroy value. If they don’t allocate capital in an economic manner, they can destroy value.
Can you speak to the difference between an investor and a trader and how it relates to value investing?
Herro: An investor is someone who has analyzed the pluses and minuses of a business and has a method of assessing the attractiveness of that business. As a value investor, the attractiveness of a business is the cash flow stream which it produces. A trader, on the other hand, guesses on price movements. They speculate about what will impact price, usually over a short period of time. They’re momentum players. They don’t care about what a business is worth, because they’re trying to predict price movement. As value investors, what we try to do is take advantage of the trader’s short-termism. We believe in investing in businesses with long durations, not trading them like coins or baseball cards.
Upward and downward price movements, irrespective of fundamentals, are part of the system. This is just human behavior moving share prices because short-termism is natural. To me, what has changed over the past 35 years has been the size of these price swings and the amount of volatility. When you have more big players who are traders, there’s a lot less long-only pension funds – more factor investing, more rotations, more people playing geographies and industries, more speculation. To us, this actually translates into more opportunity.
As value investors, how does Harris Associates avoid “groupthink” within their investment teams?
Herro: “Groupthink” is another word for liking a stock that goes up, and disliking a stock that goes down. Everyone moves into one sector – irrespective of price – it’s like getting on a train because it’s moving, but not knowing where it’s going. Avoiding this is a key part of the job we have as the investment leaders of our firm. We have been through numerous cycles and have seen the perils of groupthink. I’ve seen colleagues in this industry, value investors who at the very last moment caved in right at the wrong time. And all of a sudden, they become inconsequential. As value investors, we like to ask, where is that train going? For us, the object of investing is to outperform the group. Of course, in the short term, it becomes very hard to differ from the group. But it becomes critically important to long-term investment to be different, or you’ll never beat them.
How do you incorporate ESG and sustainable investing considerations into your investment thinking?
Herro: Good corporate citizens are good value creators. What is a good corporate citizen? We know all the things that lead to value creation in terms of being able to grow your sales – the mechanical things that improve value stream. But a subset of this is behaving in a responsible manner – not being a discriminator, not being a polluter, recognizing that diversity within your business is a way to strengthen your business, that if you have groupthink, it’s going to lead to mediocrity. We want to make sure that companies we invest in aren’t exploiting, aren’t polluting, aren’t discriminating – all these things which to us would absolutely be detrimental to value creation.
In light of the Covid-19 pandemic, there’s been a lot of central bank intervention in markets. How hard is it to structure a portfolio in an environment?
Herro: I don’t think that it’s necessarily difficult, but you have to be constantly aware and alert, because these changes cause rapid changes in price. I would argue that you have to keep your portfolios forward-positioned. When policy changes are impacting price – positively or negatively – you have to be prepared to move. Some of these policy changes cause this additional volatility, and this inherently means you have to be prepared to act. Covid-19 macro policy switches and what we are seeing in monetary policy certainly have had an impact on the price of businesses, and to a more minor degree, on the value of businesses. But for us, they’ve also provided opportunity.
How have you been able to continue to ascertain the value of businesses during Covid-19?
Herro: During the first six weeks of the pandemic, we spent a lot of time with management and anyone doing business with our companies. First and foremost, it’s important when you’re going through a situation where you have a severe drop in revenues to make sure you have a healthy balance sheet and access to liquidity. That’s number one. Number two, you look at the second-order condition. How is this going to reverberate through the down period? And how is the recovery going to look? There was this tendency to go back to the Global Financial Crisis of ’08 and ’09, but there have been huge differences with that time period. Look at the recreation market as an example – boats, athletic equipment, campers. During the Great Recession, they couldn’t give that stuff away. This time around, people actually spent money, savings rates exploded, and people who were working were looking for things to spend money on. Of course, there were people who weren’t working – but this is another big difference. Governments were far nimbler and fast-acting in terms of fiscal and monetary policy than they were in ’08 and ’09.
As it relates to European financials, if interest rates stay “lower for longer” in Europe, how does that change your thinking about portfolio positioning?
Herro: We’re already positioned for that. We assume that rates in Europe stay lower for longer, but at some point, there will be interest rate normalization. It won’t likely be in the next year or two, but at some point over the longer term. In my view, one of the reasons why monetary policy has been so ineffective is that the velocity of money has been low – it has not perked up since the Global Financial Crisis. There’s really two simple explanations for this. Immediately after the crisis, there was a propensity to hoard money. Secondly, for regulatory reasons, banks spent the better part of the 2010-to-2020 decade hoarding capital. They were told to do so – they were told to strengthen their balance sheets. At the very same time that monetary policy was opening the floodgates, they were telling banks, “Don’t lend money, build reserves.” This has been a ten-year project, ten years of trillions and trillions and trillions of dollars going into reserves. Now we’re at more than adequate. One could argue perhaps these banks are over-reserved. This is why I think at some point this will come to an end and you will see the velocity of money pick up, followed by some interest rate normalization.
Lastly, how do you think about greed and fear when looking at companies and the market?
Herro: Greed and fear are a natural part of our environment. These are natural emotions. It will always be the case, and this is something that an investor can take advantage of because these emotions cause extremes in price and extremes in valuation. I’m thankful they’re there. In fact, if fear and greed were not there, I would probably be out of a job. Fear and greed is what sources value investing opportunities. Every morning we should wake up and be happy for fear and greed and natural human emotion – it causes opportunity in financial markets.