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A great dichotomy

March 22, 2017

Wal-Mart is probably the most famous low-cost retailer in the world. It’s also one of the most successful. The ability of its founders and executive management team to consistently provide products at prices that millions of Americans can afford has made the proprietors and shareholders extremely rich. The Walton family is by far and away the wealthiest family in America with a combined net worth of nearly $150 billion. The Waltons knew that by controlling costs, they could maintain affordable prices for everyday goods that millions of people would purchase. With a 24.5% gross margin rate in 2014, Wal-Mart earns its enormous profits by literally turning pennies into billions. The company is so successful that its annual revenue exceeds the nominal GDP of Hong Kong.1

 

So what does this have to do with investing? Other than the obvious fact that investing in Wal-Mart at its inception would’ve paid large sums thereafter, this example highlights a division between what something costs and what consumers value, above and beyond the price of a good or service.

 

A great dichotomy exists between cost and value, not only in the retail space, but also in many other industries. Consumers shop at places like Wal-Mart not because everything they offer is cheap or on sale for a dollar or two, but it’s due to the value—perceived or otherwise—that these companies offer. It’s the same reason shoppers pay an annual membership fee to use Costco’s services and obtain price discounts based on volume and overall economies of scale. The membership sees value in the company, despite not having the lowest prices among its peer group.

 

Value investing

 

Almost everyone is in search of value. Both shoppers and investors alike want to believe they’re getting more than what they view is a fair price. One of the most prominent of all investment authors is Benjamin Graham, who penned his magnum opus in 1949 which would later serve as Warren Buffett’s guide to value investing. The Intelligent Investor is probably the most famous investment book of all time, and Buffett used it to lay the foundation for his success, as he would later go on to become the best value investor of all time.

 

Value investing is basically the idea that certain assets may be intrinsically less than what the market, or a subset of investors, is pricing that particular asset, whether it’s a private company, a public stock, or a piece of real estate. In other words, investors are actively trying to determine which assets are undervalued and they’re buying in anticipation of either the market realizing their higher intrinsic value or, in the case of Buffett, they’re actively working to improve the companies, to subsequently increase the inherent value of the company.

 

This investing philosophy is a very popular strategy for money managers and individual investors because behind the idea is the notion that a certain skill set is required to make money, unlike more speculative methods like technical analysis, whereby traders try to predict future price movements of a stock based on historical chart formations. The prerequisite knowledge to value a company is reflective of how financially viable the company is, whereas the know-how to trade stocks based on charting is more of a lesson in human behavior than anything.

 

We’re not discounting the fact that there have been many traders who have made lots of money buying and selling equities. Over one, two, or even three years, it’s very possible that Joe Trader sitting at his home computer could choose a handful of stocks that could outperform the S&P 500, even after transaction costs and taxes. It’s when you’re taking a longer time horizon that the odds of beating a simple index fund will tend to favor the computer tracking the benchmark rather than the trader tracking line formations.

 

In the vanguard

 

Just as Wal-Mart is in the vanguard as a leader in retail, there’s a fund company headquartered in Valley Forge, Pennsylvania which recognized that by controlling their cost structure they could pass on savings to their customers in the form of higher returns on their investment. The Vanguard Group operates at cost, which in the words of its founder Jack Bogle, made it the very first “mutually owned” mutual fund. The investors who invest in the funds actually own those very same funds, not a third-party management company, like the majority of other investment companies. This structure has led to the entrustment of more than $3.5 trillion of investors’ capital with the organization, making it among the largest companies by assets under management (AUM) in the world.

 

Vanguard’s AUM grew exponentially when the overwhelming research pointed to an overall inability of the average money manager to beat a basic benchmark index, leading to a passive investing revolution of sorts. But Vanguard still recognizes the importance of offering investors actively managed funds as well; they just do it in a way that almost ensures higher yields to their customers. Because with lower cost structures like that of Wal-Mart, they’re providing value without compromising on the quality of the funds they offer. The results are telling. Since 2007, 92% of Vanguard funds have outperformed their peer-group averages. Over one-, three-, and five-year periods ending December 31, 2015, at least 81% of active funds offered by the company have beaten other actively managed funds.2 It doesn’t get much clearer than that.

 

Cost and value are not synonymous. If cost mattered more than value, price would be king, not the overall experience and mutually beneficial paradigm that has shaped how companies now view their proposition to the public. Adam Smith wrote in the Wealth of Nations that the sole role of the producer is to serve the consumer. For companies like Wal-Mart and Vanguard, they’ve perfected the art of servicing the client, and the value of their offering is evident.

 

 

 

 

1.https://www.fool.com/investing/general/2014/01/21/wal-mart-and-target-have-the-worst-gross-profit-ma.aspx

2.https://vanguardinstitutionalblog.com/2016/06/09/the-cost-value-paradox/?refer=iigweb_researchcommentary

 

 

 

 

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