How I Became a Bad Investor

After being told, early on in my investing career, that stocks have intrinsic values (what they are “really worth”), I spent a lot of time trying to learn how to calculate them. The book that helped me the most in that direction was “Valuation” by McKinsey & Company.

In retrospect, however, that effort seems to have made me a worse investor, one less likely to buy the companies with the best returns. Below, I will describe how Valuation turned me into a bad investor.

The Path to Classic Value Investing

After presenting the standard formulas for intrinsic value in terms of cash flow, return on invested capital (ROIC), growth, and cost of capital, Valuation goes on to demonstrate that ROIC is a fairly stable property of a company, while growth is highly mean reverting. As a result, the conservative investor is advised to assume all companies have the same growth rate going forward.

Furthermore, if we going to use assume a constant growth rate forever, then it is not sensible to assume a growth rate above the rate of GDP growth as the company would otherwise grow to engulf the entire economy. And while earnings have grown at 5–6% for many decades, GDP had an annualized nominal growth rate below 4% over the last 25 years.

As growth rates decrease, ROIC becomes less important. (What good is the ability to earn a high return on invested capital if you can’t actually invest more capital?) At a 4% growth rate, companies in the top quintile of ROIC are worth maybe 10–15% more than average companies. We should be willing to pay a premium for such companies, but only a fairly small one.

If we ignore those small differences as well, then the intrinsic value of any company is proportional to its P/E ratio. Hence, buying companies for less than they are worth amounts to just buying companies with low P/Es.

This strategy worked well through most of the 20th century, but two problems come to mind now. First, it has high turnover: once a company is priced at intrinsic value, you will only get average returns for holding it going forward, so in order to outperform, you need to sell it and buy something cheaper. Second, the strategy hasn’t worked well for the last decade (at least).

Suspicion Mounts

The recent underperformance of the classic value approach understandably leads one to start questioning assumptions. In particular, for me, it is the assumption that all companies have the same expected future growth that has looked more suspicious as time has passed.

McKinsey’s chart says that the top quintile of stocks by prior year growth, which start out by growing over 30% in the prior year, regress to 8% growth, only slightly above the long term median of 5% per year, within 4 years.

One reason I became suspicious of this is how often the returns of great investors came from companies that grew much faster than this. Many of Warren Buffett’s great investments had double digit growth for over a decade after their purchase. Peter Lynch required at least 10% growth out of even his investments in steady, “stalwart” companies. (His “high growth” investments were expected to grow much faster than that.)

The story of the last 10 years is dominated by the FAANG stocks, nearly all of which had double-digit growth throughout the decade. Since I lived through this period, I can say that it was clear at the time that their growth was going to continue for many years to come.

These examples do not invalidate McKinsey’s chart. To me, they clarify that the chart is describing typical companies, whereas high returns often come from finding atypical companies, the outliers. It is a mistake to assume that, because sustained double digit growth is not typical, that it is impossible. Finding those companies that can defy the chart — usually because of a sustainable competitive advantage — is a viable investment strategy.

Indeed, the perpetuity formulas show us just how sensitive intrinsic value is to future growth. In fact, a company that could grow double digits in perpetuity would have infinite value. (Personally, I’d be happy with even half of that.)

Revisiting the McKinsey Charts

Given my suspicions, I thought it would be worthwhile to rebuild the McKinsey charts myself to make sure that they hold up. I used data from OSAM Research covering large cap US companies from 1965 – 2019.

Here are the results:

Those readers familiar with McKinsey’s versions of these charts will note that these are very similar. In particular, we do see that ROIC regresses to the mean much more slowly than growth.

However, one difference does stand out to me: in this version, the top quintile of large caps by prior year growth continue to see double digit growth for 8 years following portfolio formation. Furthermore, the median company in that portfolio sees annualized growth of 14% per year for the first 5 years.

With long-term median growth of 6%, this is 8% excess growth. As I described in my earlier article on adjusting P/E ratios for growth, that justifies a P/E ratio that is 8 points higher than the market’s P/E. In other words, the base rates from the chart tell us that an average company in the top quintile by prior year growth would give average market returns even if we bought it when its P/E was 8 points higher than the market’s. If we bought it with a P/E only, say, 6 times above the market’s, then we would expect to outperform.

As we saw earlier, the best returns often come from buying great companies. Unfortunately, those companies rarely have below average P/Es. The prior analysis points out, however, that we are still getting a “fair price” if we buy at a multiple that is 5–8 points above the market’s P/E: a randomly chosen high growth company would be expected to at least match the market’s returns at that price, so if we believe this is a truly great company (one likely to sustain its advantage beyond 5 years), then the odds are still in our favor even if we buy it when its multiple is a few points higher than the market‘s.

Some Great Companies

Let me conclude by pointing out some examples of companies that could have been purchased in the manner just described, held while they maintained above unusually strong growth, and produced unusually great returns.

Throughout most of 2010, Google’s P/E was 0–4 points above the market’s. During that same period, it was in the top quintile by prior year growth. It stayed in the top third by growth through the end of 2019 (the end of this data set). From March 2010 to 2019, Google outperformed by 5.6% per year.

Immediately upon entering the large cap universe in 2011, Transdigm was in the top quintile by prior year growth. It stayed there throughout 2012, and in the latter half of the year, its P/E was 4–8 points above the market’s. If you bought then and held until late 2017, while it stayed in the top third by growth, you outperformed by 12.1% per year. If you saw through that dip in growth and held through the end of 2019, you outperformed by 20.9%.

Disney moved into the top quintile by prior year growth in mid-1983. They continued to be in the top third by growth, with only a few small dips, through the end of 1997. In late 1983, Disney’s P/E was 4–6 points above the market’s P/E. If you bought in mid-late 1983 and held through 1997, you outperformed by 10.2% per year.

At the end of 1975, Capital Cities was in the top quintile by prior year growth, and like Google, its P/E was only a few points above the market’s. It stayed in the top third of the market by growth into 1979. If you held for those four years, you outperformed by 10.4% per year. If you saw through the slight dip in growth in late 1979 and held through 1988, you outperformed by 9.4% per year for a full decade.

I could go on with more examples — Altria, Waste Management, Intel, Precision Castparts, etc. — but you get the point. While great businesses rarely trade at below average P/Es, they do frequently trade with P/Es that are 2–8 points above the market’s. The base rates in the McKinsey chart tell us that those are fair prices for companies in the top quintile by prior year growth. And as Warren Buffett taught us, buying great businesses at fair prices usually turns out to be a great decision.