Graham or Growth? Part 3 - Examples Not Theory

May 2019
James Anderson
JOINT MANAGER, SCOTTISH MORTGAGE INVESTMENT TRUST

When we first attempted to explore and explain our enthusiasm for Growth Investing 15 years ago it was natural to try to learn from our predecessors. The problem was that there was very little literature to guide us. The only text in the canon of investment that espoused Growth Investing was Phillip Fisher’s ‘Common Stocks and Uncommon Profits’. It dates from 1958. What follows is James’s musings after he reread Ben Graham’s value bible, ‘The Intelligent Investor’.

Examples Not Theory

One of Ben Graham’s communication gifts lay in his simplicity. A classic instance of this lay in his gentle but pointed use of extended company comparisons. Glamour was punctured and persistence extolled. So Chapter 13 of Intelligent Investor is ‘A comparison of four listed companies’. The four chosen are ELTRA, Emery Air, Emhart and Emerson Electric. Only the last survives in its own right. Then Graham gets even keener on this technique: Chapter 17 offered the guidance of ‘Four Extremely Instructive Case Histories’ but didn’t exhaust the theme as Chapter 18 comprises ‘A Comparison of Eight Pairs of Companies’. Jason Zweig modernised the examples in homage. I can’t manage either the style or the number of companies that either provide but how would this exercise look now? The purpose isn’t to preach growth but to try to elucidate how the structure of corporate returns, their rewards and disasters may reflect the structural changes that may have occurred over the last 35 years.

Coca-Cola versus Facebook

Choosing Coke as an example is an easy choice. For many decades it has been an essential ingredient in the Berkshire Hathaway portfolio. Moreover it is the focus of one of the great discussions of investing vision as propounded by Charlie Munger. It begins:

“Imagine it’s January of 1884 in Atlanta, Georgia...You and twenty others are invited to present a plan to start a business that will turn a $2 million investment into a business worth $2 trillion by 2034”.

Munger sketched his plan for Coca-Cola back in 1996. It required only simple principles and simpler maths. The calculation is what less elegant speakers would describe as that of a Total Addressable Market. Munger then inverts as so often – in order to be worth $2 trillion the world population of 8 billion in 2034 will need 64 ounces of water a day. If a quarter of this comes from cleaner and tastier drinks and your company garners a half of that then you have a market of 2.92 trillion eight ounce servings. With a modest 4 cents a time net he envisages $117 billion of earnings (still growing) by 2034. Then you need practical stimulators and psychological imperatives to come together to give a Pavlovian response that in Munger’s terms represents a “lollapalooza” multiplication of motivations and rewards.

There’s no doubting that such an approach generated a fabulous business for Coke and terrific returns for Berkshire Hathaway. But is it going to attain the $2 trillion by 2034? In the late 1990s the capital value of the company was already over $175 billion and Munger’s targets with reinvested dividends might have seemed feasible if demanding. But over the last 20 years the equity value has only gained 12 per cent in aggregate – $2 trillion looks far off.

Is this just the toll of demanding valuation? After all Graham, who captured stocks in Price Earnings (PE) multiples even though he naturally knew that long-term cash flows were more meaningful, was perennially suspicious of anything over 20x.[1] Before final results, Coca-Cola sells for 23x likely 2018 earnings with a presumed growth rate of 6–8 per cent for the long term. Graham might not have appreciated the double digit Price to Book.[2]

But whether this is a classical Value stock or not, the most perturbing feature is that there is a clear possibility that the lollapalooza of mutual reinforcement of advantages might be reversing. If it was a vision of wealth, health and modernity in 1884 then by 2019 it seems rather tarnished. As Coca-Cola records in its 10K listing of risk factors “Obesity and other health-related concerns may reduce demand” and separately but additionally “Public debate about perceived negative health consequences of certain ingredients” may reduce demand.

Therefore Coke has diversified into water, juices and buying Costa Coffee as its own confidence in the original vision diminishes. I confess that there seems to me to be more scope for a negative lollapalooza here.

Coca Cola advert

Facebook

So here we have a quintessential high growth company and until recently a noted momentum stock as the initial letter in ‘FAANG’. Anything part of a Jim Cramer acronym can hardly be other than likely to make Mr Graham shudder. But if we blind ourselves to the name how does it compare to Coke as a Value investment or an investment for the long term from here which is essentially what Graham was trying to elucidate in his pairs.

Facebook went public on May 18 2012 at $38 per share. This represented an historic PE multiple of 88x. With a peak market value that day of $45 it was capitalised at over $100 billion. Where are we at the start of February 2019? Facebook trades at 22x historic earnings for 2018. It is forecast to grow 15–25 per cent per annum over the next five years according to NASDAQ.

If we venture beyond PE towards periods of greater longevity then uncertainty comes more strongly into play. But Graham offers his own formula for assessing medium-term growth. It is sufficiently simple that he felt it important to introduce caveats and a degree of caution later but since what we are considering is the relative values it throws up then we do not have to worry too greatly. The formula is:

Value = Current (Normal) Earnings x (8.5 plus twice the expected growth rate).

So what does this suggest about Coca-Cola and Facebook? For Coke the formula would suggest that the market believes the analyst forecast company is set to grow at a little more than 7.5 per cent over the next 7–10 years. For Facebook the answer appears to be much more at odds with the analysts. In fact Facebook discounts growth just lower than Coca-Cola at a little below 7 per cent. It may be convenient to my suspicions but Coke has since suggested that earnings are likely to be flat in 2019 in its year-end statements.

What would Graham have said about this? For sure he might have felt that Facebook was an evil fad and that analysts are ever seduced by aggressive growth. Yet isn’t there another possibility here? It’s hard to say which company relies more on continuing addiction. Yet it’s close to indisputable that the Margin of Safety for Facebook is higher on Graham’s metrics. Which is the Value stock therefore? Which is more attractive? As Orwell wrote in Animal Farm it’s eventually hard to distinguish which is human and which animal.

Margin of…Upside?

Let’s pause though and try to put the systemic economic complexity musings back into the stock equation. What they tell us is that we can’t know about earnings progress over the next decade – let alone beyond that – but that confessing to deep uncertainty does not prevent us coming to all conclusions. We can formulate different scenarios. We can factor in the possibility of asymmetrically high returns. We can, if with even more openness to doubt, give these visions of the possible future different probabilities. This enables us to form a quite educated sense of whether the upside is substantially higher than the downside. I confess to finding the Margin of Potential Upside more alluring than the classic Margin of Safety.

The balance of the potential asymmetries matters to Coke as much as Facebook and to Value as much as Growth investing. I’m not at all sure that there is any business about which one can be confident enough – even with the famed Margin of Safety – that losing money can be excluded as beyond the bounds of credibility. In both these cases it would seem far from improbable that the capital loss may be substantial. As we know both Coca-Cola and Facebook operate close to the frontiers of addiction. Their power is therefore also their vulnerability. In both cases there are forceful arguments that consumers would be better off without the product.

But what about the reverse situation? Which of the two companies offers the better opportunities for substantial upside? Even without a ‘lower’ starting multiple and higher returns it’s considerably easier to construct a scenario, or an associated discounted cash flow analysis, that is more alluring for Facebook than Coca-Cola. Put another way Instagram and WhatsApp appear much stronger subsidiaries in both competitive and growth metrics than Dasani and Costa Coffee.

[1] Price earnings - The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS).

[2] Price to Book - Companies use the price-to-book ratio to compare a firm's market to book value by dividing price per share by book value per share.

The views expressed in this article are those of the author. Its express purpose is to highlight areas of intellectual thought and debate which inform the investment philosophy that underpins Scottish Mortgage, in the hope that they may be of wider interest. The author(s) therefore make(s) no suggestion that this article constitutes independent investment research and it is not subject to the protections afforded to such.

Further, it is not intended to be considered as advice or a recommendation to buy, sell or hold any particular investment. Those considering investing in any of the areas highlighted in the article should undertake their own research, seek advice if unsure, and be aware that the value of any investment and any related income, can fall as well as rise, meaning that investors may not get back the amount invested. For those looking for information on Scottish Mortgage specifically, please visit www.scottishmortgageit.com for a Key Information Document.