Value Investing: From Graham to Buffett and Beyond, Edition 2

I really enjoyed the first edition of this book, which I read almost 20 years ago. The two approaches to valuation prescribed in that edition were refreshingly straightforward. The most conservative approach was the asset-based valuation. Estimate a company’s asset reproduction value and buy at a discount. The next-most conservative approach was the earnings power-based valuation. Calculate normalized earnings (assuming no growth) and divide by the cost of capital. Both approaches were to-the-point and practically-applicable. I was therefore quite surprised when Bruce Greenwald recently stated in an interview that he thought the first edition of the book wasn’t very good, and that this second edition, 20 years later, was better. The second edition would apparently incorporate a “returns-based” framework for analyzing growth stocks -- going far beyond the two methods described above. Intrigued, I bought a copy. Long story short -- I think this second edition -- in particular Chapter 8, the new chapter on valuing growth stocks -- completely loses the plot. In fact, I think that the “returns-based” model ruins the entire book. At the very least, it serves to remind the reader that the (five!) authors have limited real-world investing experience (on any real scale). What follows is a (very) long review. I’d usually refrain from writing a review at all, but given that this book is supposed to be one of the seminal texts in the field of value investing (and given that I am an avid value investor), I felt that its shortcomings should be highlighted. Let me get straight to the point: no one who actually runs money for a living evaluates growth stocks in the manner prescribed in Chapter 8. The authors pitch their “returns-based” approach as a superior alternative to the DCF, because, as they note, the DCF is sensitive to assumptions and results in a much greater variance of outcomes. The authors contend that, as a result of these variances, calculating the intrinsic value of a rapidly growing company is “impossible”. I find this to be ridiculous. Any attempt at valuation will be subject to a significant degree of error. The idea is not total precision. The DCF is king because it is the literal definition of valuation: a company is worth the sum of its future free cash flows, discounted back to the present. Full stop. The earnings power value approach prescribed earlier in the book IS a DCF -- just one that assumes no growth! Moreover, the earnings power value approach suffers from huge variances depending on the discount rate chosen. Yet the authors are OK endorsing it. Just because a rapidly growing company will result in a wider range of DCF outcomes doesn’t mean that you throw the whole methodology away! Sadly, the proposed replacement methodology is limited to the point of being useless. The authors’ recommended process for analyzing growth stocks is as follows: take a company’s current distributable earnings yield, and add to it your estimate of that company’s long-run organic growth rate. That’s it. The combination of these two things is your expected return. If this return is higher than your cost of capital, then invest in said growth stock! If it is lower, then don’t. The authors then distinguish between “market-based” organic growth, and organic growth driven by “active investment”. I have no qualms with this distinction, and the “active investment” piece speaks to the importance of return on capital exceeding cost of capital. But then there is a needlessly complex further digression highlighting the fact that the organic growth component of the total return equation above doesn’t actually equate to the “real” return that an investor should expect if a company’s market value is above its intrinsic value. There is also an appendix to Chapter 8 that will only serve to confuse readers. The second part of this appendix (or maybe the entire appendix) is written by someone who I'd bet has never managed real money.

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