By Lauren R. Rublin
As 2014 was drawing to a close, money manager Adam Seessel faced a reckoning: It was time to rethink his devotion to value stocks and view investing through a more growth-tinged lens. Seessel's portfolio, stuffed with "old economy" names, had lost 4% to 5% that year, while the broad market had rallied 13% to 14%. The digital revolution was on, and Seessel had missed it.
Not any more. Seessel loaded up on technology stocks, and today his New York investment firm, Gravity Capital Management, owns companies such as Amazon.com [ticker: AMZN] and Alphabet [GOOGL] -- neither one cheap (at least, not until recently) based on value-investing metrics such as price-to-book value or price-to-current earnings. Last year's tech-sector selloff was no picnic for these stocks or Gravity, which directly manages about $100 million and advises on assets of roughly $8 billion. The Nasdaq Composite fell 33%, while Seessel's portfolio declined 21%, net of fees. But that loss followed two years in which Gravity gained well above 20%, net of fees.
Seessel, a former journalist and sometime contributor to Barron's , described his evolution into a "value 3.0" investor in Where the Money Is: Value Investing in the Digital Age, published last year by an imprint of Simon & Schuster. He also paid tribute in the book to the late Benjamin Graham, considered the father of value investing (1.0), and Graham's student, Warren Buffett (2.0), chairman and CEO of Berkshire Hathaway [BRK.A, BRK.B].
Seessel provided an update in a March 1 interview with Barron's, and discussed some of his favorite stocks. An edited version follows.
Barron's: How did you come to realize that the tools of value investing had failed to capture the value of emerging tech companies?
Adam Seessel: My portfolio was full of classic value names: an oil-services company that was cheap based on earnings, a railcar company that was cheap based on net asset value. I also owned Avon Products and Tribune Media. All these businesses were cheap, yet their shares weren't appreciating. I took a good, hard look and realized their best days were behind them. It occurred to me that I was barking up the wrong tree and needed to re-evaluate my approach.
So, what did you do?
I took a deep dive into tech. Like most value investors, I had sniffed at tech companies' lofty valuations. But two things occurred to me. The tech companies of the 2010s weren't the tech companies of the dot-com era. Google [now Alphabet] and Amazon.com had become battleships. They were durable, branded franchises with strong businesses. Second, while they were optically expensive, if I loosened up the rigid value framework I had adhered to for my entire investment career, these companies started to look cheaper.
These and smaller companies, whether Adobe [ADBE] or Intuit [INTU], have looked expensive from a value perspective since their initial public offerings. Yet, they have massively outperformed since then, notwithstanding last year's market correction. And, they have a bright future; they have a small market share in large markets. Either the market was wrong and we were in for a tech-stock reckoning that would make the dot-com bust look trivial, or something about value investing wasn't capturing the value these companies were creating.
Didn't a multiyear decline in interest rates have a lot to do with these companies' impressive valuations?
That's a popular narrative. But did the shares of all these digital businesses go up just because rates were low, or because these companies were serving huge markets with a long growth path ahead? It seems pretty clear the latter was true.
Do you consider yourself a growth-stock investor now?
I wouldn't say I'm a growth investor. I'm a new value investor. Buffett himself has said there is no distinction between value and growth. The higher a company's growth rate, the higher its terminal value. Buffett has gotten more comfortable paying higher valuations for businesses because he understands that business quality is the main driver of value. My three variables are business, management, and then price. If you start with price, you tend to be looking at subpar businesses. That's why they're cheap, and that's why value investors so often succumb to "value traps."
How did you "loosen up" your value framework?
When I started researching Google in early 2016, it was trading for $37 a share. It had $5 a share of cash, so it was effectively a $32 stock after its 20-for-1 split. The company had earned about $1.15 a share in 2015, so it was trading for 28 times earrings. It was showing an operating profit margin of 25%.
Facebook [now Meta Platforms $(META)$] and Alibaba Group Holding [BABA] were smaller companies but in the same sort of asset-light, software-driven business, and reporting margins of 40% to 50%. This meant either Google was an inferior business or spending more through its P&L [profit and loss statement] to grow. I concluded the latter was true, and that its earnings power implied a 40% margin.
How do you define earnings power?
Earnings power attempts to quantify a company's latent, underlying ability to generate profits. It tries to get at not what a company is reporting in its GAAP [general accepted accounting principles] financials, but what it could report if it were run as a mature business like Coca-Cola [KO]. Buffett's holdings, like Coke and American Express [AXP], don't have to spend billions of dollars trying to find a new frontier. It wasn't fair to compare tech companies' earnings to those of mature companies. So, I made an adjustment.
Assuming Google's earnings power allowed for 40% margins, earnings were close to $2 a share, which meant I was paying more like 16 to 17 times earnings for the stock. People might say my adjustment was magical thinking, but guess who made a similar adjustment when his company bought Geico? The Oracle of Omaha himself. It is an instructive example.
But not of magical thinking.
Berkshire owned 51% of Geico and agreed in 1995 to buy the rest. In the last year in which it published financials, Geico had $250 million of net income and spent $30 million marketing its products. Within a few years of the acquisition, reading between the lines, Geico was spending $250 million on marketing. Accounting rules forced the company to run 100% of these expenses through the P&L, which depressed earnings. It couldn't capitalize them, unlike a manufacturer.
Yet, functionally, the marketing was a factory in the sense that it had a long life. Geico had to spend up front to acquire customers, and then they would stay with the company, generating more revenue. As Buffett said in his 1999 annual report, he was investing today for tomorrow. And this is exactly what Amazon, Alphabet, and Intuit are doing -- investing to grow. It isn't crazy math. But GAAP accounting, codified in the 1930s when industrial companies ruled the roost, wasn't designed for today's tech companies. It penalizes outlays for marketing and research and development by forcing such long-term investments to be accounted for as one-year expense items.
What excites you now about Amazon?
It dominates two huge markets: e-commerce and cloud computing. It has moats around its brand and infrastructure in both businesses. Amazon is so huge that people think its business must be mature. Yet, online shopping accounts for only 15% of U.S. retail sales. Amazon has a 40% to 50% market share, and delivers more packages than FedEx [FDX].
Reported earnings don't look great, but again, if you look through the investments made to build out that infrastructure, the earnings power is huge. In 2021, ex-Amazon Web Services, the cloud-computing business, Amazon's reported operating margins were 1.5%. It's absurd to think this company's margins would be a third of Walmart's. When you work through what Amazon could earn if it went into "harvest mode," I calculate that margins are around 15%. The company's earnings power is 16 times reported earnings. The valuation looks much more reasonable on that basis.
Same question for Alphabet: What excites you now?
Alphabet's stock is so cheap and out of favor that it trades for 16 times consensus 2023 earnings estimates without any earnings-power adjustments. Management has been buying back stock.
To me, Alphabet has a bit of a culture problem. It has 10 or 12 platforms with more than a billion users each. Its engineers are geniuses at creating great applications that people love, but management just isn't as mercenary as Amazon's Jeff Bezos or Meta's Mark Zuckerberg in monetizing them. The non-search businesses collectively break even or lose money.
Sundar Pichai, the CEO, is trying to make the company's non-Google "other bets" businesses more disciplined. An activist investor is making some of the same points as me. I said in my book that it would be good if Alphabet were broken up by regulators. The non-Google franchises would be forced to make money.
Texas Instruments [TXN] is another of your favorite stocks. Why?
Texas Instruments is the only vertically integrated producer of analog chips, which regulate physical sensations such as temperature and motion, as opposed to digital semiconductors that are used for memory and storage. TI has an advantage in product depth, and is a great capital allocator.
I also like Intuit. Its QuickBooks Online product has about a 2% share of the addressable market in small-business accounting software, so there is a long way to go. Intuit spends about 10 times more than its nearest competitor on marketing and product development. It has a moat in terms of brand recognition and those expenditures.
Tech stocks account for about half your portfolio. Where else have you made big bets?
(MORE TO FOLLOW) Dow Jones Newswires
March 09, 2023 14:33 ET (19:33 GMT)
Copyright (c) 2023 Dow Jones & Company, Inc.