Ideal businesses are increasingly found among a new breed of asset-light "platform" companies.
Warren Buffett has shifted his views to better reflect changing realities, although many value investors lag behind him.
This article describes the advantages of "Value 3.0" companies and suggests several names to watch.
When business historians look back on the 2010s many years from now, they will likely pinpoint this time as marking a seminal shift in the investing landscape.
For the past 60 years, the biggest winners of the stock market have been consumer products companies, with the likes of Coca-Cola (KO), Philip Morris (MO), (PM), and General Mills (GIS) crushing the broader market. When value investors go hunting for bargains, they typically default to these well-known consumer brands and dominant players in commodity businesses such as ExxonMobil (XOM). It is becoming increasingly clear, though, that the best value plays belong to a new breed of asset-light compounding machines with huge network effects.
The four largest companies today by market value do not need any net tangible assets. They are not like AT&T, GM, or Exxon Mobil, requiring lots of capital to produce earnings. We have become an asset-light economy.
Buffett's comments received only passing mention in the press. As Adam Seessel wrote last year, Buffett's acolytes mostly ignored this incredible proclamation from the master.
At the cocktail parties afterward, however, all the talk I heard was about insurance companies—traditional value plays, and the very kind of mature, capital-intensive businesses that Buffett had just said were receding in the rearview mirror. As a professional money manager and a Berkshire shareholder myself, it struck me: Had anyone heard their guru suggesting that they look forward rather than behind?
The next day, Buffett repeated his view in a CNBC interview and noted the lack of attention they had received.
I did mention one thing at the meeting, which I don’t think people appreciated at all...so you have close to 10 percent of the market value perhaps of the United States in five extremely good businesses that essentially take no capital. Now that was not the case in the past.
Those five businesses are, of course, Amazon (AMZN), Apple (AAPL), Microsoft (MSFT), Alphabet (GOOG), and Facebook (FB). Buffett went on to say that he would "love it" if Berkshire's business portfolio could be reformulated to better reflect changing realities.
This is not the first time Buffett has adjusted his thinking to better suit changing times. Benjamin Graham, the father of value investing who mentored a young Buffett, is best known for articulating a strategy that involved buying stocks below a measure of per share liquidation value. The years following the Great Depression abounded with these "cigar butt" opportunities, and Buffett made a fortune pursuing them.
By the early 1970s, though, Buffett had largely abandoned the approach of hunting for statistical bargains. Influenced by Charlie Munger and the writings of Phil Fisher, Buffett started focusing on great businesses that could reinvest earnings at high returns.
In 1972, Buffett and Munger bought See's Candies, a well-known brand in California, for $25 million. At the time, See's earned $2 million after taxes. Buffett and Munger believed that the company charged too little for its products and instituted annual price increases. By 2007, See's earned $60 million after tax on just double the volume sold. Over the preceding 35 years, Berkshire had taken out $1.35 billion before taxes while investing just $32 million to maintain the business.
The See's experience provided the blueprint for Berkshire's purchase of Coca-Cola stock and other similar investments. In 2003, Buffett described the "ideal business" as "one that earns very high returns on capital and that keeps using lots of capital at those high returns."
The ideal businesses that Buffett had in mind generally existed in capital-intensive industries such as insurance and railroads, or they produced a widely advertised consumer products. Throughout his career, Buffett famously eschewed technology stocks, explaining that he did not understand them. That would change in a big way less than 15 years later.
A Stunning About-Face
In 2017, the famously technology-phobic Buffett floored the investment world by revealing an enormous Berkshire stake in Apple. He had previously purchased stock in the 100-year old IBM (IBM), but Apple represented his first real foray into modern Silicon Valley. Today Berkshire owns $40 billion of Apple stock - far and away its single biggest holding.
Despite the company's technological nature, the Apple of today more closely resembles the branded consumer products that dominated the 20th century corporate landscape. Buffett justified his purchase by pointing out the stickiness of Apple's products among consumers and its strong management.
Meanwhile, Buffett's enthusiasm for packaged goods - the previous kings of consumer products - has waned. The Oracle stated in a recent interview that he was "wrong in a couple of ways on Kraft Heinz (KHC)," admitting that Berkshire "overpaid."
These "Value 3.0" companies, as Seessel calls them, differ from the old behemoths in several important ways. The first is that they are extremely asset-light. Never in the history of capitalism has no much wealth been created using so little capital.
The second is how they build and maintain market share. During the 20th century, brands established dominance through advertising at a time when media consumption was highly concentrated. Today, with audiences fragmented across many forms of media and retailers like Walmart (WMT) and Amazon gaining leverage, branded products are becoming increasingly irrelevant.
The Value 3.0 "moat" usually comes back to network effects - the tendency of a "platform" company to become more valuable as more people use its products and services. Facebook is valuable because, well, everyone uses Facebook. The model is self-reinforcing.
Besides the high-profile names, there are other public companies that have benefited from the asset-light/platform model. Ansys (ANSS), a longtime holding of value investor Joel Tillinghast, sells - among other things - aircraft simulation software. Standardization is critical in industries where safety is a major factor. The stock went from $10 in 2004 to $175 today.
Over the last two years, my own portfolio has come to more closely resemble this new investing paradigm. Copart (CPRT) runs the world's largest online auction site for salvage vehicles, and Match Group (MTCH) owns a portfolio of dating apps and websites. Although these two companies exist in entirely different industries, they both grew large and powerful through significant network effects.
Stocks Worth Watching
The early riches of Value 3.0, I believe, have already been created. Match Group gained over 30 percent in 2018; the company is now up 277 percent since its 2015 IPO. Between February 2009 to February 2019, Copart shot up 760 percent. Since January 2016, the stock has increased by a factor of three.
Copart, Match Group, and Facebook are among the few strong platform stocks that could have been had at reasonable valuations last year; most sport sky-high price-to-earnings ratios. The elevated expectations occasionally create buying opportunities, however, when Wall Street gets jittery. In late 2018, Copart and Match Group shed one-third of their value, although by now both have mostly recovered to previous highs.
Although Facebook is up 30 percent from its December low, it is still down almost 25 percent from the high of $218 set last summer. With a P/E in the low 20s, shares do not look too overvalued, although sources of future growth for the $472 billion social media giant remain uncertain.
eBay (EBAY) and KAR Auction Services (KAR), the latter of which owns Copart's rival Insurance Auto Auctions, both have P/E ratios in the teens. KAR also intends to spin off IAA into its own publicly-traded company. It will be interesting to watch how that transaction unfolds.
I try to look forward as much as possible when examining investment opportunities. The natural tendency, of course, is to look back on what worked before, which leads investors to focus too much on storied companies whose peak growth has come and gone. What worked in the past often does not work in the future. I want companies built for the future.
We should note, though, that the core value investing philosophy has not changed - merely the environment. From the 1930s to the 1960s, value investing was centered around cigar butt stocks. Over the next half century, it shifted toward advertised consumer brands and capital-intensive commodity businesses. Now the best value investing opportunities can be found in asset-light compounders with huge network effects.
At age 88, Buffett is charging boldly into a new era for value investing. The younger folk would do well to follow.
Disclosure: I am/we are long MTCH, CPRT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.