“One of the most important pillars of value investing is the idea of margin of safety. But where does margin of safety come from? For a Graham-and-Dodd value investor, it comes from asset value, or from earning power over the purchase price, which is high in relation to a AAA bond yield. There is far less focus on the quality of the business or the management.

For a Charlie Munger/Philip Fisher type of value investor, the margin of safety comes from the ability of a business to deliver high returns on invested capital over time, and that comes from durable competitive advantage usually created by exceptional people. This type of investor does not hesitate in paying up for quality. But, by no means does this have to mean that he or she is overpaying. And the way to figure out whether this type of investor has overpaid or underpaid is not by focusing on P/E multiples based on historical earnings. The way to figure it out is by comparing the price paid by him or her with the earnings delivered by the business many years later. To be sure, paying high multiples of near-term earnings will make sense only if future earnings will be significantly higher than at present. So, the focus should be on long-term earning power and not current or past earnings.

In a sense, the classic Graham-and-Dodd investor believes in mean reversion. For him or her, bad things will happen to good businesses, and good things will happen to bad businesses. For a Charlie Munger/Philip Fisher kind of investor, the kinds of businesses he or she invests into have fundamental momentum — that is, a probabilistic tendency to continue to deliver exceptional performance. In other words, these businesses do not conform to the principle of mean reversion — at least not for a very long time — long enough for them to become great investment candidates at the right price.

Now, momentum is a dirty word in value investing, but it need not be because I am talking about momentum in fundamental performance of businesses and not momentum in stock prices (although the former tends to create the latter). The Charlie Munger/Philip Fisher type of investor does not completely disagree with the idea of mean reversion that Graham-and-Dodd investors cling to. Rather, the Charlie Munger/Philip Fisher type of investor knows that there are some businesses that prove to be truly exceptional, where there is a persistence of high quality for long periods of time. And he or she chooses to focus on those and those alone. And when she finds them, she does not hesitate in paying up a bit for such outstanding businesses.

So, in a sense, among value investors, there is sort of a clash between two different ideologies in value investing — mean reversion and momentum. And both ideologies are correct in my view. For most businesses, mean reversion applies, but for some exceptional ones, it applies after a long long time, and until then, momentum applies.”

Sanjay Bakshi

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