To The Moon

In his book, “Warren Buffett: Inside the Ultimate Money Mind,” Robert Hagstrom describes how value investing has evolved through three stages.

“Warren Buffett: Inside the Ultimate Money Mind” by Robert Hagstrom

Stage 1: Classic Value Investing

This is the style of investing espoused by Benjamin Graham in his 1934 classic, “Security Analysis.” It seeks to buy stocks at low prices in relation to their current earnings, current dividends and current assets. Buffett used this strategy when he ran his partnership and when initially picking businesses for Berkshire Hathaway.

Stage 2: Valuing a Business, Not a Stock

See's Candies

Whereas stage 1 focuses on present value instead of future value, stage 2 is forward-looking. It has its origins in the work of John Burr Williams who argued that stocks are worth the future value of their dividends. Stage 2 value investors seek to buy better businesses with low capital-intensive needs that generate high cash and high returns on capital. Buffett transitioned to stage 2 in the early 1970s after Charlie Munger introduced him to See’s Candies. Stage two of value investing is about buying companies that are selling at prices below the discounted present value of their future cash flows.

Stage 3: The Value of Network Economics

Companies benefiting from high switching costs attributed to network effects, positive feedback loops, lock-in of customers and path dependency are viewed as being more valuable. Desirable business models are low capital intensive and have high returns on capital. Bill Miller brought this strategy to the forefront of value investing. It is a forward-looking approach that considers the future cash flow that can be generated from intangible assets. This is how Warren Buffett got a hold of $Apple(AAPL)$ in 2016, although it was actually Ted Weschler who made the initial purchase for $Berkshire Hathaway(BRK.B)$.

Apple Logo

The App Store was growing double-digits and had low capital-intensive needs, had network effects. The moats were all there. Ultimately, it was well understood even back in 2016 and 2017 that Apple was going to become almost 50% service and 50% hardware. The service business was worth much more than people were discounting. Buffett put in a big chunk of Berkshire Hathaway money, ultimately $36 billion. So, Buffett finally got to the third stage of value investing. But it was Bill Miller who certainly was the trailblazer for that.

Source : The American Association of Individual Investors