The Problem With Value Investing (Buffett's $1 Trillion Lie)

If you're a stock investor, you've no doubt read thousands of bloody Buffett quotes, maybe even The Intelligent Investor. And what you've probably picked up is that value investing is the only safe way to pick stocks. But what if I told you that was a complete myth and that a low P/E ratio isn't any safer than chasing a high one? I'm James Helliwell, I'm a former fund manager turned financial educator, and in this video I'm going to show you why value investing no longer works, how you can come up with better stock ideas, and build a portfolio that actually beats the market. And to do this, I want to begin with a story about one of the greatest investors of all time, Warren Buffett. Now, Buffett originally employed this so-called cigar butt investing strategy where he purchased seemingly mediocre companies but at rock bottom prices to try and get one last puff of value out of them. And that method was taught by his mentor Benjamin Graham. He's the guy who wrote the book The Intelligent Investor. What a lot of people don't realize is that Charlie Munger actually steered Buffett away from this approach entirely, instead urging him to buy wonderful companies at fair prices instead. And it was that shift that transformed Berkshire Hathaway into the most famous fund on the planet. And that misunderstanding is one of the main reasons why value investors never get close to his results. Most people are looking for what's cheap according to either the PE or maybe the price-to-book ratio, and that often leads them to capital-intensive companies in these very cyclical sectors. And no matter how cheap they might be, a turnaround is unlikely without getting the right catalyst, which means you're otherwise left holding a company that's bleeding cash while you wait. And hence, value investing has underperformed the S&P 500 and other investing styles like quality, which ultimately comprise better businesses. So you can see the example here of the so-called Russell 2000 Value Index. Look at the distribution by sector and you'll see that it's massively overweight financials, industrials, and other highly interest rate sensitive sectors compared to the likes of the MSCI World or regular S&P 500 ETF, which is overweight quality tech companies that generate shitloads of free cash flow. So how is value investing still popular? Think of it as the TK Maxx effect, or TJ Maxx if you're in the US. We as human beings are wired to get a buzz from bargain hunting, and this effect that we feel tends to overvalue the things that we feel we've worked to discover ourselves. And that's what makes the potential return feel earned and therefore more rewarding than making a similar amount even in the consensus idea. And that psychology is a big part of the reason why value investing has remained so popular, even as Buffett himself has evolved away from it. But that only explains why people keep doing it, and what I'm going to show you next explains what's actually driving these returns and what value investors often miss behind it all. The people think that by looking at company fundamentals, they're investing bottom-up, as it's known, and that means that some management decisions, some corporate event, we'll surely see earnings improve and the share price go up. But that's only part of the picture because the performance of value as a style is determined by something much bigger. So let me show you what value investors are really trading. Here we have the 10-year government bond yield compared to the performance of value stocks versus growth stocks. What you can see is that the two tend to follow a very similar pattern. In other words, they're correlated. So as bond yields, which you can think of as interest rates, rise, value stocks tend to outperform growth stocks and vice versa. So in other words, the performance of value stocks is tied to interest rates, which ultimately move in lockstep with the business cycle. So this is the ISM PMI here, a lead indicator of the US economy. So value investors aren't just betting on the company, they're betting on the broader earnings cycle, they're betting on inflation, and they're also betting on interest rates here. So whilst they might see themselves as bottom-up fundamental investors, what they're really doing is trading global macro. And with that comes a risk of market timing, which Buffett himself is famously against. And just to be clear, there are moments where value can indeed outperform, and it's usually at very specific points of the cycle. But if you're going to do that, you'll need to be sure that you get this next part right so that you don't end up buying the wrong company thinking you found a bargain. Fundamental analysis can be pretty daunting, and if I'm honest, it took me quite a while, even as a professional, to fully understand financial statements. And that's one of the reasons why People don't look beyond the basics of things like earnings per share and the PE ratio when it comes to valuing stocks. But what people don't realize is how easily these numbers can be manipulated, not because earnings suddenly improve, but because the denominator changes. And it's one of the reasons why share buybacks have become so popular over the last decade or so, because by reducing the share count in buying the shares back, companies can increase their per-share earnings even if the underlying business hasn't grown. That deliberately lower share count can make a stock appear cheaper than it really is. So IBM is actually a really good example of this because they've spent something like $200 billion on buybacks over the last 10 or so years. So this is the PE ratio, so price divided by earnings per share. Looking at this trend, it might appear as though the stock is becoming cheaper because the PE ratio is falling. But when we look at an alternative measure, this time in the free cash flow, which is less easily manipulated, this has actually been rising. So on an earnings per share basis, the stock is looking like better value, but considering the cash that the company's actually generating and is left over here, that suggests that this part of the rally has seen it become really quite expensive now, but that wouldn't show up in the PE ratio. Free cash flow is still measured per share, so it's not completely immune to buybacks distorting it. The crucial difference is that whilst earnings can be engineered through clever accounting, cash cannot. So when it comes to valuation, the lesson here is that whether you call yourself a growth investor or a value investor or anything in between, free cash flow is a far more reliable starting point than earnings. But even armed with the right tool, it won't help you much if you don't know how to use it properly. So now I want to show you the next mistake that people make when looking at valuation ratios like the free cash flow. Now the problem here is that numbers have no meaning on their own. Even if you think that a free cash flow yield of 10% sounds amazing, which it does to me, I'm using a frame of reference that's anchored to a comparative investment, whether it's the S&P 500, or it might be the yield on government bonds as an alternative, or another stock that you happen to be comparing it to. And this is where investors get caught comparing apples and oranges, as I say, because two companies even in the same sector can have very different profiles. So the same valuation can mean two very different things. So you can get around this by looking at a stock relative to its historical valuation range. So again, we're going to look at price to free cash flow as an alternative to price to earnings. And we can see here how at the beginning of 2024 it was trading at 23 times free cash flow. If we were to compare that to another tech company, whilst it's not a direct comparison, in IBM, we might think that Google looks really expensive, trading almost double the valuation of IBM. But when we view things in the context of Google's own historical range, all of a sudden the 24 times that it was at begins to look like a bit of a bargain. From there, Google never looked back, and it absolutely trounced the S&P's return of about 70%. Now I just want to leave you with this example of Nvidia, which trades at 60 times free cash flow, which compared to Google and certainly compared to IBM seems crazy. But when you look at its historical median, it is very similar. And that's why valuation only makes sense in context. Free cash flow tells you whether a business is legit in terms of what it's actually producing, its value. And relative valuation tells you how optimistic or pessimistic the market currently is, is its rating. But the key point is that even when investors get both of these right, they can still make the biggest mistake of all. And I'm going to show you now how to avoid that. It's not about choosing the wrong ratio, but rather putting the valuation before the business and then asking whether a company is actually worth owning. And what this can lead to are these mistakes of omission. You miss out on owning the best businesses because of the valuation at the time. And this goes back to what Munger was so keen to impress on Buffett in the early days of Berkshire. So let's take Pepsi as an example. So back in the early to mid-'90s, it was basically the new kid on the block. Every investor owned Coca-Cola, and they were nervous about abandoning it for Pepsi. So back then, you can see that earnings per share was around $1, and the share price was in a range of sort of $30 to $40. So the price relative to the earnings per share, to get the PE ratio, was sort of 30 to 40 times, and that's why many investors walked away. But Pepsi just continued to grow. So what happened is that it grew into its valuation. It compounded earnings, and it also was able to produce incredible dividend growth all the way through to present day. So back in 1995, '96, I think it was, when everybody was worried about the valuation being too expensive, it had earnings per share of $1 and dividends per share of $0.50. Those have increased tenfold. And if you were to add up all of the dividends that you would've received over that period as a shareholder, from the point that people thought it was just too expensive to buy, despite seeing very clearly that it was a great company with great prospects, it would've amounted to about $40. The dividends alone would've repaid your initial investment in full, regardless of the initial valuation. And you can see the effect this has had on the share price from that point where it was considered just too expensive to touch. It's outperformed by more than double. And the lesson in this is that great businesses usually do trade at a premium because they deserve one. When you focus on valuation first, you bias yourself towards these weaker businesses and maybe even end up in value traps. But when you focus on the business first, valuation just becomes a tool to help you choose between your best ideas, not a reason to abandon them. And that's the difference between buying cigar butts and owning companies that compound shareholder value, ideally at a reasonable price. So now you understand the mistake that so many value investors make, you might want to check out this video next, which explains the 5 biggest mistakes that I've made in 15 years of investing. If you don't want to watch it, that's fine. Value and chill. I'm not your dad. See you in the next one.