At Oldfield Partners we invest in businesses which we can understand, are unlikely to be disrupted in a way that they cannot cope with and trade at a significant discount to our conservative estimate of intrinsic value. This usually means companies where their valuations are lower than that of the general market and lower than their own history. Some might say we are biased to ‘old economy’ businesses which we think oversimplifies our approach, but we admit that our focus on sticking to what we understand and going where we find attractive valuations is unusual in a world that is seemingly obsessed by growth.
In 1999, Warren Buffett said at the Berkshire Hathaway annual meeting, “A dollar earned from a horseshoe company is the same as a dollar earned from an internet company, in terms of the dollar. So it is not worth more, [if] it comes from somebody named dot-com, or somebody named, the Old-Fashioned Horseshoe Company. The dollars are equal.”
We think investors get misled into thinking that a dollar from a growth company is worth more than a dollar from a stable or even a declining company. At Oldfield Partners, we have no biases towards one or the other; we go where valuations take us. We believe we can derive more value from a lowly rated company than a highly rated growth company.
To illustrate how investors can get it wrong, consider the following three companies:
- Company A: Growth company which reinvests all its earnings to grow 15% p.a. for five years trading at 30x P/E. As dictated by the laws of economics, growth eventually slows down so let’s say after five years the business derates to 20x on the lower future growth prospects.
- Company B: Stable company without any growth trading at 10x P/E. Over the next five years, it uses all its earnings to repurchase shares which continue to trade at 10x.
- Company C: Declining company with earnings falling 5% p.a. for five years trading at 5x earnings because of its poor prospects. Over the next five years, it uses all its earnings to repurchase shares which continue to trade at 5x.
Which company is the most attractive investment over the five-year holding period?
Many (if not most) investors today would say Company A because it has better growth prospects, because of hope that the abnormal growth can be sustained for longer or a belief that the exit multiple will be the same as the entry multiple (even though the growth prospects after five years of abnormal growth have clearly worsened).
As it turns out, the annualised return of Company A would be 6%, that of Company B would be 10% and Company C would be 13%. The valuation of Company C was so low that buybacks more than offset its poor growth prospects. If Company A had not derated from 30x to 20x it would have been the better investment (15% annualised return). However, the growth (and hence the valuation) of all companies eventually mean-revert, although in some cases it may take longer because of impossible-to-predict factors such as a once-in-a-generation business (e.g. Apple or Google) or macro-economic factors (e.g. record-low interest rates).
At Oldfield Partners, we do not steer away from stable or even declining companies just because their growth prospects are poor. On the contrary, when these companies can be bought below a conservative estimate of intrinsic value (typically because the market has given up on them), we tend to get enthusiastic. We recognise that growth is just one factor of the valuation equation, even though to many investors it is the only factor. After all, a dollar is a dollar whether it comes from a high-growth tech company or a declining ‘old economy’ company.
As we look ahead to 2023, we see significant opportunities for value in our portfolios which are full of companies that are fundamentally sound and trade at low valuations.
https://buffett.cnbc.com/1999-berkshire-hathaway-annual-meeting/, Berkshire Hathaway AGM (1999).