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Investors are always looking for a simple method to try and beat the market. Unfortunately, these don't exist. Beating the market is hard, and finding high-quality businesses to buy is even more challenging.
Due to the desire to find easy ways to value securities, it's no surprise book value is so widely regarded as a yardstick for measuring value. Indeed, this is a mistake I made when I first started investing. I looked at Warren Buffett (Trades, Portfolio)'s success and thought I'd try to copy his method. One of the easiest ways to do that, it appeared, was to buy stocks trading at a discount to book value.
This was a mistake. I made some terrible investments when following this mentality of trying to use an easy shortcut.
The mistake I made was not realizing that while Buffett had made a tremendous amount of money in the 1950s and 1960s buying stocks that looked cheap compared to the value of their assets, he had long since moved on.
The Oracle of Omaha was able to do so well using this approach because the rest of the market was unaware of the valuation disconnect. By extracting these market inefficiencies, he was able to generate an almost risk-free profit.
But as the financial market has grown and developed, these inefficiencies have become harder to find. I know of at least 10 different websites that list the cheapest stocks on a book value or net basis.
Further, I know of value investor forums that have thousands of investors. Back in the 1960s, Buffett was often the only investor chasing the stock of a deeply undervalued business. Today there is a range of websites broadcasting these opportunities to thousands of investors worldwide who can buy the stock at a click of a button. The market no longer has that kind of inefficiency - cheap stocks today are almost always cheap for a good reason.
Book value vs. earnings power
Buffett realized the market was changing in the 1970s, and he changed his strategy as a result. Instead of focusing on book value, he shifted to earnings power.
At Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) 1998 annual meeting, when responding to a question about how to value Japanese equities, the Oracle explained why he no longer focused on book value and why doing so could lead to poor investment returns:
"Earnings are what determine value, not book value. Book value is not a factor we consider. Future earnings are a factor we consider. And as we mentioned earlier this morning, earnings have been poor for a great many Japanese companies. Now, if you think that the return on equity of Japanese business is going to increase dramatically...and you're correct, you're going to make a lot of money in Japanese stocks...if a company's earning 5% on book value, I don't want to buy it at book value if I think it's going to keep earning 5% on book value. So a low price-book ratio means nothing to us. It does not intrigue us."
Buffett went on to add that rather than being attracted to a stock trading at a low price-book ratio, he would likely see it as a sign to avoid the business:
"In fact, if anything, we are less likely to look at something that sells at a low relationship to book than something that sells at a high relationship to book, because the chances are we're looking at a poor business in the first case and a good business in the second case."
This is an often-overlooked change in the investor's style that took place decades ago. Buffett has been focusing on a company's earnings growth potential since the 1970s. During this time, he's made some of his most successful investments. Deep value and net-net investing served him well while it worked, but Buffett moved on to the growth at a reasonable price (GARP) style of investing decades ago.
This article first appeared on GuruFocus.