Where the Money Is

1. Value Investing Must Adapt to the Digital Age

To continue as I had would have been to ignore economic reality and to consign myself and my clients to a future of dismal performance.

The world has changed. Traditional value investing principles, focused on asset values and reversion to the mean, are failing to capture the wealth created by digital companies. The rise of tech has been so rapid and transformative that old metrics no longer accurately reflect the value and potential of these businesses.

Tech's dominance. A significant portion of the U.S. market's gains in recent years has come from the information technology sector. Digital companies are creating most of the incremental wealth in the world today, while simultaneously hollowing out large parts of the legacy economy. Examples:

• The fossil fuel sector has shrunk dramatically as a percentage of the U.S. stock market's value.
• Amazon is now significantly more valuable than traditional blue-chip companies like Exxon Mobil and Wells Fargo.

A new approach is needed. To succeed in the Digital Age, investors must understand how tech companies function, the source of their competitive advantages, and how to value them. This requires a recalibration of traditional tools and intellectual constructs.

2. Ben Graham's Value 1.0: Asset-Based Investing

As a newcomer—uninfluenced by the distorting traditions of the old regime—I could respond readily to the new forces that were beginning to enter the financial scene.

Graham's framework. Ben Graham, the father of modern security analysis, developed a disciplined approach to investing focused on asset values and liquidation potential. His Value 1.0 strategy involved buying stocks at or below their liquidation value, emphasizing tangible assets over future earnings potential.

Key principles:

• Rigorous research and analysis
• Discipline in price paid
• Scorn for randomness and speculation

Limitations:

• Short-term focus requiring constant portfolio recycling
• Overemphasis on asset prices, ignoring qualitative factors
• Inability to capture the value of businesses with high growth potential

Value 1.0's decline. As the world emerged from the Great Depression, Graham's asset-based system became increasingly ill-fitted to the American economy. The United States became more stable and prosperous, and Graham's system didn't identify businesses whose value resided in their ability to generate large and growing income streams rather than in their net assets.

3. Warren Buffett's Value 2.0: Quality and Brands

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.

Shifting focus. Warren Buffett, Graham's student, evolved value investing by emphasizing business quality and sustainable competitive advantages. His Value 2.0 strategy focused on identifying companies with strong brands, moats, and the ability to generate growing income streams over time.

Key elements:

• Emphasis on business quality over price
• Focus on competitive advantages (moats)
• Qualitative analysis of management and business models

Brand/TV ecosystem. Buffett capitalized on the brand/TV ecosystem, investing in companies like Coca-Cola and Capital Cities that benefited from strong brand loyalty and the power of mass media. However, this ecosystem is now weakening due to the rise of digital media and changing consumer preferences.

Value 2.0's limitations. The old television network ecosystem is dying, mass brands are moribund, and legacy financial companies have exposed themselves to digital competition through their own bad behavior. Many of these companies, however, look cheap when viewed through the lens of their current price/earnings multiple. But they aren’t cheap because they’re attractive; they’re cheap because their future is bleak.

4. Value 3.0: Moats, Growth, and Management

Ironically enough, the aggregate of profits accruing from this single investment decision far exceed the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.

HEICO as a catalyst. The author's discovery of HEICO, a generic spare parts manufacturer, led to the articulation of Value 3.0. This approach combines the best of Value 1.0 and Value 2.0, emphasizing both business quality and price discipline.

Key criteria:

• Low market share of a large and growing market
• Clearly identifiable competitive advantage (moat)
• Management team that thinks and acts like owners
• Understanding of what drives business value
• A price that gets you under twenty times earnings power, for a 5%+ earnings yield

BMP Checklist. The BMP (Business, Management, Price) checklist provides a framework for evaluating investment opportunities. It prioritizes business quality, management alignment, and price discipline.

5. Competitive Advantages in the Digital Age

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.

Beyond growth. Rapid growth alone does not constitute a competitive advantage. Many companies experience short-term growth spurts but lack the underlying moats to sustain their success.

Types of moats:

• Low-cost producer: The ability to produce goods or services at a lower cost than competitors (e.g., HEICO)
• Brands: Strong brand loyalty and recognition (e.g., Coca-Cola)
• Platforms and switching costs: Creating ecosystems that make it difficult for customers to switch (e.g., Apple)
• Network effects: The value of a product or service increases as more people use it (e.g., Facebook)
• First-mover or fast-mover advantage: Being the first or quickest to capture a new market

The most powerful moat. Network effects are the most powerful source of competitive advantage in the Digital Age. Companies with strong network effects tend to dominate their markets and generate significant wealth for their shareholders.

6. Management: The Human Element of Value

This is a different world than existed in the past, and I think it’s a world that’s likely to continue.

Management matters. A business's performance depends considerably on the executives who run it. The best managers think and act like owners, prioritizing long-term shareholder value over short-term gains.

Key qualities:

• Stewardship: Putting the owners' interests first
• Financial acumen: Understanding key metrics like return on capital
• Capital allocation skills: Making wise decisions about how to deploy company resources

Tom Murphy as an example. Tom Murphy, the former CEO of Capital Cities, embodies the qualities of an excellent manager. He was frugal, targeted his spending effectively, and understood how to create long-term value for shareholders.

The Mendelson's at HEICO. The Mendelson family, who run HEICO, also exemplify the owner-operator mindset. They have a long-term vision for the company and are deeply invested in its success.

7. Earnings Power: A New Valuation Tool

The world has changed.

Current earnings are distorted. Traditional valuation metrics, like the price/earnings ratio, often fail to capture the true value of tech companies. This is because accounting rules require companies to immediately expense R&D and marketing costs, which depresses reported earnings.

Earnings power defined. Earnings power is an attempt to quantify a digital company's latent, underlying ability to generate profits. It involves adjusting reported earnings to reflect a more realistic picture of a company's long-term potential.

Adjusting the income statement:

• Projecting revenues several years into the future
• Recasting reported earnings to estimate earnings power
• Using comparable companies to triangulate between conjecture and economic reality

Benefits of using earnings power:

• Puts tech companies on a comparable basis with mature companies
• Removes accounting distortions
• Serves as a proxy for a digital enterprise's ultimate ability to produce wealth

8. Navigating the Investment Landscape

The world has changed.

The importance of process. Successful investing requires a disciplined and methodical approach. This involves establishing solid habits, reading widely, and using Mr. Market to your advantage.

Key habits:

• Be quick, but don't hurry
• Extend your circle of competence
• Read widely and consistently
• Use Mr. Market to your advantage
• Invest for the long run and invest incremental dollars regularly over time

Avoiding distractions. It's important to avoid distractions like meme stocks and socially responsible investing, which can lead to subpar returns. Instead, focus on identifying superior businesses and applying the BMP checklist.

The future of investing. The investment landscape is constantly evolving, and investors must be prepared to adapt to new trends and technologies. This requires a willingness to learn, experiment, and challenge conventional wisdom.

Last updated: February 27, 2025