Where the Money Is: Value Investing in the Digital Age

By Adam Seessel, 2022 (272p.)

This was a fantastic book that I read in one sitting. Seessel is a fund manager who does frequent appearances in the media, yet I had never heard of him until a friend asked me yesterday if I had read his book. Seessel tells us of his pilgrimage from hard core value investor (disciple of Graham & Dodd, Buffett & Munger), to a state of enlightenment and harmony in a world where only high-multiple, durable growth stocks make any sense for the long term. To me its clear that Seessel still struggles with valuation, or he wouldn’t bother with writing this book, nor the mental accounting contortions he describes in Part II, my least favorite part of the book.  I agree with Bill Ackman, who commented that this was one of the best investment books he has read in a while, but the reason I liked it so much is that Seessel does a fine job of pitching three of our favorite holdings: Alphabet, Intuit, and Heico.

Here is a 4 minute interview on CNBC where Adam Seessel is introduced as “the founder of Gravity Capital Management, advisers on roughly $8 billion.” I was unable to pull up Gravity Capital’s portfolio on the Bloomberg, which suggests they aren’t really that big by SEC standards.  I searched through SEC.gov and saw that in fact, they filed as an “exempt reporting advisor” in March 2022, with regulatory assets of $25-100m – but its common in this business for people to count assets that the SEC doesn’t, so nothing against Seessel.  With a quick Google search, I discovered that “Gravity Capital Management manages money in both a partnership and a separate-account format.  It has a long-term record of beating the market after fees, with special focus on capital preservation. In 2008, for example, the Gravity Long-Biased Fund lost only 5.5% of capital and returned 27% in 2009.” (link).  I also learned that Seessel and his wife, an artist, live in Manhattan, and that they have a grown son who is a software engineer. Adam graduated summa cum laude from Dartmouth College in 1985, with a BA in Religion.  Google also revealed that he runs Clear Mind at Work Program for the Kadampa Meditation Center of New York (link), which is a charitable entity with ties to the International Kadampa Buddhist Union – a global religious movement founded by Kelsang Gyatso in England in 1991 (Wikipedia). He mentions meditation once in his book (next to parenting), but doesn’t elaborate.

I loved the book and would recommend it as a top 10 on investing, but that doesn’t mean I wasn’t disappointed by a detail or two. Seessel never even mentions Phil Fisher, for example, yet he devotes a lot of attention to Ben Graham. Buffett even gives Fisher credit for helping him see the light on growth, but Seessel doesn’t acknowledge it.  But then, as if trying to win sympathy with the “value” school, Seessel goes and throws Jesse Livermore, the boy plunger, under the bus. “In 1940, rather than face another personal financial crisis, Livermore took a Colt pistol and shot himself in the head,” he reminds us before he utters: “Don’t be this guy.” I didn’t like that line. Jesse Livermore was a genius who was said to suffer from clinical depression, so the fact that he shot himself at 63 doesn’t mean he was a bad investor with the wrong ideas. In fact, he was known to put much weight on the quality of the people and the durability of the narratives that he invested in.  While he was famous for his trading, he recognized, like Seessel, that the big money was not made by trading, but by sitting.  Edwin Lefevre told Livermore’s story in Reminiscences of a Stock Operator (1923), and Livermore published his own book, How to Trade in Stocks (1940), seventeen years later. It remains to be seen is Seessel’s book will age as well as those two classics.

Adam Seessel and I have some friends in common so I need to take my jabs carefully.  But it would be impossible for me to read a book like his without finding some flaws.  When describing Intuit, for instance, Seessel portrays Turbotax as being “largely mature” – which is a dated view, in my opinion.  After Intuit acquired Credit Karma in Dec 2020, which Seessel doesn’t mention, they pivoted the Consumer Group (which houses TurboTax), towards a much larger total addressable market (TAM) than just tax filers. Seessell also fails to mention the acquisition of MailChimp in 2021, which significantly expanded Quickbooks’ growth opportunities. While about a third of QBO subscribers are global, international subscribers account for less than 10% of QBO revenues.  Seessel doesn’t mention this, probably because he wanted to keep it simple.  But then he suggests that Intuit overstates their TAM, which I don’t agree with.  Seessel also claims in Chapter 9 that Intuit “invented and brought to market TurboTax,” which I know isn’t true.  Turbotax was developed by Michael Chipman, founder of Chipsoft, not by Intuit.  Intuit agreed to acquire Chipsoft in September 1993, the same year it had come public. As the 1993 press release announcing the deal explained (link), Chipsoft shareholders ended up holding 39% of the merged company. I also believed TurboTax was “largely mature” when we started buying Intuit in our accounts in Q2-2017, but today we disagree with that view.  The opportunity to go up-market is enormous, and indeed, management expects half of the Consumer Group growth will come from upselling their premium offerings, including TurboTax Live and TurboTax Full Service (link).

Below I share some of my highlights from the book, but only up to Chapter 4, which is as much as the publisher allowed me to export from the Kindle. That Adam Seessel and I don’t agree on everything, is what makes a market.  I do think, though, that his book is a masterpiece.  And hats off to Professor Chris Begg of Columbia Business School, for giving Seessel the idea of framing the evolution of value investing as a series of software releases. That’s an interesting way to think about it, but beware the Value 3.0 release, since in the era of cloud computing, such launches can become obsolete quickly.

Best,
Adriano


HIGHLIGHTED EXCERPTS

Introduction: So Big, So Fast

Apple’s wonderful ascent, however, obscures the fact that four times over the last fifteen years, Apple’s stock lost 30% of its market value. Once every three to four years, Alex saw his life savings decline by almost a third. As anyone who has ever invested in the stock market can tell you, that does not feel good. But Alex didn’t lose his head, or his lunch, or his conviction in the logic for owning Apple, and he has become wealthy simply by identifying a single, superior business and sticking with it. A $10,000 investment in Apple when the iPhone came out is today worth nearly $500,000, about fifteen times what he would have made if he’d invested in the S&P 500 index.

Contrary to what many people believe, the market is neither a hall of mirrors nor the Emerald City, where the Wizard of Oz hides behind the curtain pulling the strings. The stock market is nothing more than a collection of American companies whose profits grow over time. As their profits grow, so does their market value. If you believe that the United States will continue to grow and prosper, you should own a piece of that action.

Because 5% annual appreciation is decent, putting $10,000 to work in the American real estate market over fifty years will net you slightly more than $100,000. But investing that same amount at the average stock market return will generate more than $700,000.

Even if you’re, say, forty years old, I believe you shouldn’t have much at all in bonds, which barely pay more than a three-year CD. Some so-called 2045 target date funds have as much as 15% bond exposure in them, which is 15% too much for me. With more than twenty years ahead of you to smooth out returns, you should be letting the growth of American business work for you.

Like Alex with his Apple, I want to find businesses that are going to do better than the market’s average of roughly 9% annual growth. In this book, I am going to suggest that you do the same, and I’m going to give you techniques to do so.

The magic of compounding will see to that: $10,000 invested at the market average of 9% will give you more than $700,000 after fifty years, but that same amount invested at a 12% rate will give you almost $3 million.

Lynch’s words remain as true as ever, but the problem is that over the last generation technological change has altered the economy so much that the nature and character of what constitutes a superior business has also dramatically changed. The internet, the cell phone, and social media didn’t exist when Lynch wrote. Many of the everyday examples that he used to illustrate superior businesses—Toys “R” Us, Subaru, and Hanes, the maker of L’eggs pantyhose—are now laughably out of date. That’s no knock on Peter Lynch—the world changes—but we must acknowledge that the same common sense that led him to those stocks now tells us to go nowhere near them. The internal-combustion automobile today faces threats from both driverless and electric cars; most women stopped wearing pantyhose a long time ago; and as for Toys “R” Us, squeezed between the giant pincers of Walmart and e-commerce, it filed for bankruptcy protection in 2017.

Tech dominates our daily lives so thoroughly that it’s natural to think the digital revolution is largely complete, but that’s not true. In many ways, it’s just beginning. Even after a generation of growth, Amazon’s annual retail sales volume only now matches Walmart’s. Cloud computing, which today accounts for roughly 10% to 15% of all spending on information technology, will one day likely account for more than two-thirds. Intuit, the world’s leading provider of small-business accounting software, reaches only 1% to 2% of its ultimate addressable market. The list goes on, and as computing power compounds, the list gets longer every year.

Tech’s dramatic rise has been accompanied by an astonishing fall in the old economy’s market value. Over the last decade, the fossil fuel sector has shrunk from 13% of the U.S. stock market’s value to less than 3%. During the same period, the financial services industry has shrunk from 15% of the market to 10%. As recently as 2015, Exxon Mobil and Wells Fargo, two reliable blue-chip investments for generations, were each two to three times more valuable than Amazon. Today, as the chart below shows, Amazon is four times more valuable than Exxon Mobil and Wells Fargo combined.

Big tech gets most of the headlines, but hundreds of smaller, lesser-known tech companies have also continued to appreciate. Adobe in document productivity and digital marketing; Ansys in design-simulation software; and Autodesk in digital construction tools are only a few examples, and I’ve not yet exhausted the list of companies beginning with the letter A. Most people know Adobe because of its PDF functionality; fewer know that in 2020 Adobe earned roughly $3.5 billion, about the same as Kraft Heinz, whose brands like Oscar Mayer hot dogs and Philadelphia cream cheese have been around since the 1800s.

Pessimists are wrong, however, to suggest that we’re in for another bust. Today’s tech companies have put down powerful and profitable roots in ways that the first wave of dot-com companies never did. Two decades ago, businesses such as Pets.com IPO’d at multi-hundred-million-dollar valuations on the dubious proposition that they were somehow valuable because they attracted lots of “eyeballs.” At its peak, however, Pets.com never turned a profit and never generated more than $50 million a year in sales despite spending more than twice that in marketing. Today’s online companies don’t look anything like Pets.com. Adobe’s annual revenues are nearly $16 billion, from which it makes $5 billion in profit. Facebook has 3.5 billion users, and its annual earnings approach $40 billion, which is roughly four times what Disney makes.

Some also believe that, given all the concern over big tech’s sudden influence over our lives, government intervention will soon check tech’s power and, with it, its ability to generate wealth for shareholders. Governments may well move to curb the influence of the digital giants. They may even succeed in breaking them up altogether—but it’s impossible for regulation or legislation to undo a generation of daily, habit-forming usage of the world’s largest tech applications. How is any government going to regulate away the fact that, every day, people around the world search on Google 5.5 billion times? Are politicians going to outlaw Facebook from serving its billions of regular monthly users? These companies’ applications are woven into the fabric of daily life around the world, and every year the weave gets tighter and stronger. As such, companies like Google and Facebook can rightly be regarded as the Coca-Cola and the General Motors of our generation.

When technologists introduced the field-effect transistor, a basic semiconductor that’s become the most manufactured artifact in human history, it could hold only a single chip and it cost more than $1. Today, each field-effect transistor contains millions of chips and costs $0.000000001, or one billionth of a dollar. This price/performance explosion became known as Moore’s law, and it’s been in force now for more than sixty years. Engineers have been predicting the death of Moore’s law for at least a decade, but so far it hasn’t happened.

At the turn of the millennium, only 1% of the world’s population had a broadband internet connection, as the venture capitalist Marc Andreessen pointed out in a seminal essay a decade ago. Cell phones were so expensive then that only 15% of the world’s population owned one. Such facts help explain why the dot-com boom busted: the technological backbone wasn’t strong enough yet to support it.I

Today, more than half the world’s population has both broadband access and a powerful smartphone. As a result, much of the world searches, shops, chats, banks, and performs many other everyday activities online.

Before Google Search, you had to go to the library or invest in a set of encyclopedias, which were bulky, went quickly out of date, and were hardly interactive. Before digital maps, you needed paper maps, which often ripped, never folded properly, and didn’t give you alternate routes or reports on traffic accidents along the way.

A recent MIT study led by Erik Brynjolfsson quantified how much consumers value their everyday tech applications. He and his team asked consumers how much money it would take to get them to forsake their accounts at Facebook, Google, and others. On average, the study found, it would take $550 in annual payments to make a Facebook user quit Facebook. The number was much higher, nearly ten times so, for WhatsApp. Almost unbelievably, the study found that to go without Google, the average user would require a $17,500 annual payment. That’s almost one-third the average American citizen’s income.

Intuit, the small-business software provider, has profit margins twice that of Campbell’s, the soup maker, even though Intuit spends roughly four times as much in marketing, sales, and research and development. How can that be? Campbell’s raw materials are tomatoes and chicken and noodles, which cost a lot; Intuit’s raw materials are nonphysical and therefore cost almost nothing. Moreover, software-based enterprises like Intuit have no major capital or manufacturing needs. When Campbell’s wants to make more soup, it must build a new production line or a new plant. Even Coca-Cola, which sells sugar water, must have its subsidiaries build a bottling plant and invest in trucks and vending machines to expand. Software companies don’t require factories or production lines; they require laptops manned by intelligent engineers. When a software company wants to enter a new geographic market, its engineers write new code, hit “deploy,” and their software is available around the globe, instantaneously and with almost no incremental costs. Even a software company’s major capital requirement, giant servers that process and store data, can now be rented rather than bought. That’s the essence of cloud computing. Higher profitability + lower asset intensity = the highest return on capital businesses ever seen. When Ford wants to grow its business, it must invest $10 in assets to generate $1 in profit. Coke requires roughly $6. Facebook, only $2.

Stock market speculators have always been with us, but they now can place their bets wherever they have cell reception. Recently, they banded together on social media and used new trading platforms to cripple professional short sellers. Given such turbulence and confusion, an inexperienced investor might reasonably ask: Why should we invest in the stock market at all? The answer is not complicated. We invest our money because, while it would be nice to spend all of it today, we know that we’ll require some down the road. We will need money to put our kids through college, to help our parents get long-term care, and to make sure we ourselves can live comfortably during retirement. We forgo the pleasure of spending $1 in the present to transform that $1 into $5 and then $10 to use at some time in the future. And as I laid out earlier, for the last one hundred years the U.S. stock market has been the best place to do that.

Peter Lynch told us to “invest in what you know,” and this is generally good advice. Like hunters, investors do best when they understand the terrain. Many older investors, however, today find themselves in an unfamiliar landscape. What do companies with nonsensical names such as Chegg, Splunk, and Pinduoduo do, anyway?

Younger and less experienced investors have the opposite problem. They grew up in the digital ecosystem, and they know the territory in that intuitive, born-with-it way that positions them to hunt and track today’s investment opportunities. On the other hand, many younger investors mistrust the markets and “the system” in general. They have legitimate reasons. Young investors have already endured three major market meltdowns—the dot-com bust in 2000–2001, the financial crisis in 2008–2009, and the coronavirus pandemic in 2020—and they have entered adulthood with lower incomes and more debt than their parents. No wonder that, rather than turning to reliable investments to build wealth as their elders did, the younger generation has turned to newer, more experimental asset classes like cryptocurrency, socially responsible stocks, and speculations promoted on Reddit message boards. Don’t get me wrong: I dislike crypto as an investment not because it’s young and I’m not. I dislike cryptocurrency for the same reason I dislike gold. Neither crypto nor gold are living, dynamic businesses that can expand over time. Bitcoin may be a new storehouse of value, but in the end it’s just a currency. It has no customers, no revenues, and no profits to grow.

We must remind ourselves that the stock market is nothing more than a collection of businesses and that investing in them has historically been the best way to build wealth. We should acknowledge that the world’s economy is increasingly digital, so we must learn how digital companies create wealth. We should invest in the best such companies, then let compounding do its job.

No subset of investors has had a harder time adapting to the changes brought on by the Digital Age than value investors, an investment discipline of which I’m proud to be part. Although the term is often used, “value investing” is rather hard to define. Just as there are many sects of Christianity, so are there many branches of value investing.

Value investing does, however, revolve around a few central principles. Chief among these is an insistence upon discipline, rigor, and study. Value investors approach the stock market not as a betting parlor or a bodega where we can buy a lottery ticket but as a place where we can systematically attempt to build wealth. We are not traders or speculators. We are bookish and analytical, and we love metrics, yardsticks, and ratios—anything that can help us make sense of the public markets. Above all, we seek to codify our approach to investing through a set of rules. We use a framework that we impose on the stock market so that when we beat it, it’s not a matter of luck, but rather of a system. Value investors are also notorious cheapskates who hate to pay a high price for an investment. That’s why we’re called “value” investors and that’s why we look down on other methods that give price less weight in the decision-making process. We disdain so-called growth investors, who are interested mainly in companies with steep sales and earnings trajectories. We are even more disgusted by momentum investors, who do in fact treat the market like a casino, seeking to ride their luck by following short-term trends. Because of value investing’s disciplined approach, study after academic study has shown that a value-based discipline has led to long-term, market-beating results.II Faced with technology’s radically new and alien business models, however, value investing’s frameworks have begun to break down. Reliable value-based metrics like price to book value, which measures how expensive a company is relative to its assets, and price to current earnings, which measures expensiveness in relation to how much profit a company is generating, have failed to capture tech’s enormous value creation. As a result, these same academic studies are now beginning to show that value investing hasn’t been working the way that it once did. Even Warren Buffett, the high priest of value investing and widely considered the most successful investor of all time, has struggled to navigate the new economic landscape. While Buffett’s long-term returns remain awesome in the original sense of the word, they have been diminishing. As the following chart shows, his market-beating performance peaked in the 1980s, lessened in the 1990s, and since 2017 has turned into underperformance.

As a Wall Street investment analyst since 1995, I’ve watched as tech stocks have grown from gawky adolescents into some of the most powerful economic specimens the world has ever seen. For the last several years, I’ve been wrestling with these issues as both a full-time money manager and as a contributor to Barron’s and Fortune. In this book, I do my best to resolve them.

Honestly, I’d rather not have had to investigate “tech” at all. Only a half dozen years ago, I was a stodgy value investor who was comfortable with the old orthodoxies. I’d have been happy to spend the next twenty-five years of my investing career in the same way I’d spent the first twenty-five. I have no innate interest in technology, I dislike gadgets, and I barely understand how electricity works. If it weren’t so financially dangerous to do so, I’d stay set in my ways—but old industries are dying and new ones are being born at a rate not seen in more than a century. 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. I arrived at this conclusion only after several years of struggle, research, and contemplation. I came to it unwillingly, with the same reluctance that a true believer gives up his faith. But as a student of business, and as someone devoted to what might be grandiosely called Truth, I had to admit that something important had happened. So I recalibrated my instruments and focused my attention on the digital economy. I did this not because tech is sexy, or interesting, or beneficial to society. I did it for the same reason Willie Sutton robbed banks: it’s where the money is.

Anyone interested in this subject would enjoy reading Andreessen’s “Why Software Is Eating the World,” first published in the Wall Street Journal in 2011. Likewise, you should read Gordon Moore’s less elegantly titled “Cramming More Components onto Integrated Circuits,” a 1965 essay that laid out the price/performance dynamics of computing power. The former is five pages long and the latter is four pages. Why are all the most important papers so short?

See for example Eugene F. Fama and Kenneth R. French, “Value Versus Growth: The International Evidence,” Journal of Finance 53, no. 6 (1998): 1975–99, http://www.jstor.org/stable/117458. “Long term” here means a decade or more.

See for example Baruch Lev and Anup Srivastava, “Explaining the Recent Failure of Value Investing,” New York University, Stern School of Business, October 2019, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3442539.

Part I: Preparing to Invest

My first job was at Sanford C. Bernstein, a firm known for the thoroughness of its investment research, and its halls were as quiet as a monastery’s.

Good investors do not live by testosterone or adrenaline; they ignore them. Peter Lynch said that his most valuable course in college had nothing to do with finance—it was a course on logic. To relax, Warren Buffett reads the philosopher Bertrand Russell and plays bridge.

This slow, incremental approach especially characterizes long-term investors, who don’t see the stock exchange as a gambling hall in which we “play the market.” Instead, we see it as a place where, over time, value is found out.

As Peter Lynch has said, superior businesses win in the stock market over time. Inferior ones either languish or die.

All value investors do their research. All value investors are disciplined about the price they pay. Above all, all value investors scorn randomness; instead, like Graham, we impose a framework onto the markets. We invest using a set of rules that we rarely alter, trusting that our discipline will help us outperform the market averages over time.

The reversion to the mean framework measures stocks as Buffett does, comparing a business’s current quoted price to its profits, and the essence of the discipline can be summed up by value investor Sir John Templeton’s dictum, “The four most dangerous words in the English language are ‘this time it’s different.’” At Bernstein, this phrase was our Apostle’s Creed. Don’t try to predict wholesale change, we were taught, because it’s not going to happen. Simply buy the companies that are historically cheap and sell the ones that are historically expensive. Eventually, life will return to normal.

I was the junior oil and gas analyst apprenticed to the senior one, and it was our job, along with all the other analysts, to feed data about the companies we covered into what we called “the black box.” This wasn’t a box at all, but rather a sophisticated computer model Bernstein used to determine statistical cheapness using mean reversion calculations. In would go data on projected sales, estimated earnings, debt ratios, and so forth, and out would come the stocks and the sectors that the black box deemed expensive and the ones it deemed cheap.

Because in the late twentieth century everything did eventually return to normal, the black box generated large gains for the firm and its clients. At its peak, Bernstein managed $800 billion, making us one of the largest money management firms in the world.

The man who presided over the black box when I was there was Lew Sanders, Bernstein’s chief investment officer. Lew was slim and quiet, and he moved through Bernstein’s corridors with the quiet grace of an abbot in his priory. Lew embodied the kind of cerebral, tide-mapping investor I wanted to be.

When I felt my apprenticeship at Bernstein was done, I left to become a more senior analyst at first one and then another firm, Baron Capital and Davis Selected Advisors. In 2000, I began co-managing a mutual fund for Davis, and by 2003 I felt experienced enough as a value investor to start my own firm.

Then, in the middle of the last decade, my system rather suddenly stopped working.

Sitting at my desk that dark December evening, however, I had the uncomfortable feeling that the market had finished weighing my stocks and found them wanting.

What if the businesses I owned were not cheap because they were on sale—what if they were cheap because their futures were bleak?

Software companies have few tangible assets and cannot therefore be valued using Graham’s original asset-based analysis.

When tech stocks collapsed in the dot-com bust, it confirmed to value investors that the four most dangerous words in the English language were indeed “this time it’s different.” If there was any reversion to the mean in the tech sector, it was to the mean of chaos, and no serious value investor was interested in that. Fifteen years later, however, something unusual happened. In 2016, Buffett, the guiding light of value investors and the keeper of the flame passed down to him by Ben Graham, bought $7 billion worth of shares in Apple. To say that this move mystified the investment community is like saying Catholics would be confused by a pope who opened the priesthood to women. Apple was a hardware technology company so historically brutalized by competition that in the late 1990s it was ninety days away from declaring bankruptcy. What, the value investing community asked itself, was the Oracle of Omaha doing? Fortunately, I had a plane ticket to hear Buffett explain himself. Every spring, 40,000 of value investing’s faithful gather in Omaha, Buffett’s hometown, to hear him and Charlie Munger expound on the state of their holding company, Berkshire Hathaway, and the world at large. Anyone interested in investing should make the pilgrimage to Omaha at least once: Buffett and Munger sit on a dais in a basketball arena and answer a full day of questions, laying out what they invested in over the past year and why. Even though Buffett is ninety-one years old and Munger’s well past that, they remain committed to transmitting the lineage of value investing the old-fashioned way: orally and in person.

By the time I went to Omaha, I’d sold Avon, Tribune, and the other stocks whose best days were behind them. I’d concluded that these companies were, in Wall Street parlance, value traps: cheap, but not valuable. My largest position was now Alphabet, my performance had improved, and my conversion to a new way of looking at the world was deepening. But it was still new, and I wanted to hear from Buffett why he’d bought Apple. Misery loves company, but so does conviction, especially when it’s recently discovered.

“I didn’t go into Apple because it was a tech stock in the least,” he would later say. “I went into Apple because I came to certain conclusions about the value of its ecosystem, and how permanent that ecosystem could be.”

Munger, who is almost always more direct than Buffett, chided both himself and his partner for not buying Alphabet, the parent company of Google. “If you ask me in retrospect what was our worst mistake in the tech field, I think we were smart enough to figure out Google,” Munger told the crowd. “So I would say we failed you there. We were smart enough to do it and didn’t do it.” Buffett agreed, recalling how Google had first appeared on his radar screen a decade earlier when GEICO, Berkshire’s auto insurance subsidiary, began to buy Google Search ads on a per-click basis. “We were paying them $10 or $11 a click or something like that,” Buffett said. “Any time you’re paying $10 or $11 every time someone just punches a little thing where you’ve got no incremental cost at all, that’s a good business.”

Aha, I thought. Buffett and I are on to the same idea, and the word is getting out. As the meeting ended, I found myself looking forward to talking about it with my peers at the dinners and cocktail parties that followed the gathering. At these events, however, I found that nobody wanted to talk about Apple. Nobody, in fact, wanted to talk about tech in general or the new world that Buffett had just described. Instead, everyone continued to chatter away about the same old old-economy businesses they’d been chattering away about for years. They talked about Buffett’s recent airline investments, even though these investments represented a smaller dollar commitment than the one he’d made to Apple. People also spent lots of time unpacking tiny, incremental changes Buffett had made to Berkshire’s various insurance subsidiaries. This struck me as insane. Both airline and insurance companies were the very kind of mature, capital-intensive businesses that Buffett had just said were fading away. Had nobody heard our guru telling us it was time to look forward rather than back?

By late 2009, the market had recovered from the crisis and the S&P was on its way to its best year in decades; Bernstein’s flagship fund, however, remained down more than 50%. On another dark day in late December, Lew Sanders left his office at Bernstein for the last time. I lost track of Lew after that, but he resurfaced for me as I began to wrestle with the ascent of the Digital Age. He had started his own firm, Sanders Capital, and I was shocked when I read that his top holdings included several tech companies, including Alphabet and Microsoft. Neither of these stocks was even close to attractive when viewed through traditional value lenses. This made me very curious indeed. What had made the archbishop of reversion to the mean renounce it? “Lew,” I began, “over the last few years I’ve come to suspect that many of our old investing methods no longer work. Businesses like Alibaba, Facebook, and dozens of other, smaller companies are prospering. None look attractive when you look at them using conventional metrics—but maybe the conventional metrics are wrong. Maybe ‘this time it’s different’ aren’t the most dangerous words in the English language anymore; maybe it’s ‘life is going back to normal.’” Lew was silent, and his ice-blue eyes were downcast. So I continued. “I’ve begun to invest in such businesses,” I said, “and I notice you’re doing the same.” Still nothing. “So, Lew, I have to ask you,” I finally said. “What the hell is going on?” Lew smiled, raised his glacial eyes to mine, and uttered four words that will remain with me for some time. “The world,” he said, “has changed.”

Chapter 2: Value 1.0: Ben Graham and the Age of Asset Values

Although Graham became known as the father of modern security analysis, he was at heart an intellectual. He knew seven languages and routinely quoted Corneille in French, Kafka in German, and Homer in ancient Greek. Graham is likely the only financial analyst in history who, during a poor stretch of investment performance during the Great Depression, composed a poem about it. (“Where shall he sleep whose soul knows no rest,” the poem concludes. “Poor hunted stag in wild woods of care?”) Like many thinkers, Graham was known in equal measure for his brilliance and his absentmindedness. He invented a new version of the slide rule, but he would also often show up at work wearing two different-colored shoes.

In 1923, Graham quit Newburger, Henderson & Loeb to start his own investment operation. He was only twenty-nine but he had an edge, and he knew it.

“To old Wall Street hands it seemed silly to pore over dry statistics when the determiners of price change were thought to be an entirely different set of factors—all of them very human,” Graham later wrote in his memoirs. But “[a]s 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. I learned to distinguish between what was important and unimportant, dependable and undependable, even what was honest and dishonest, with a clearer eye and better judgment than many of my seniors, whose intelligence had been corrupted by their experience” (emphasis added).

Graham’s reputation, his bank account, and his self-confidence all grew. His asset-based approach was working well—so well that he used the securities he owned as collateral to borrow money and buy even more stocks with it. He leveraged up, as we say on Wall Street, or “went on margin,” and he did this right into the Crash of 1929. All stocks sank, and Graham’s borrowings amplified his losses. By 1932, his investment partnership was down 70% from its peak. It would not be until five years after the crash that Graham’s fund recovered to pre-1929 levels.

Graham moved his family to a smaller apartment, and his wife found work as a dance instructor. He abandoned the car and chauffeur he’d kept for his mother, but he did not abandon his investment discipline. While other investors despaired, Graham continued to invest using his asset-based system.

While Graham’s full performance records do not survive, it appears that by using this system he outperformed the larger market by a comfortable margin from the 1930s until he retired in 1956. Graham estimated his returns to be 20% per year, roughly double the market averages over that period.

There are deeper problems with Graham’s system, however. Value 1.0 is largely a short-term strategy, one that requires a constant portfolio recycling as inexpensive stocks appreciate to fair value. Graham’s approach came to be known as “cigar butt investing,” because the stocks in a Graham portfolio are like cheap stogies picked up off the sidewalk. Good for only one or two puffs, they must be quickly discarded, then new ones found. It’s time-intensive to find such stocks, track them, and decide on entry and exit points for each one. Because the recycling is rapid, gains in cigar butt investing are also often taxed at ordinary-income rates, which are higher than long-term capital gains rates. In the upper tax brackets, a 20% short-term investment gain becomes a 10% gain after paying 50% taxes on it. Finally, and most importantly, Value 1.0 is rigid, rote, and monomaniacal in its focus on asset prices. As a result, the biggest fish routinely slip through its net. Value 1.0 was well-suited to its times; its strict adherence to numerical formulas kept investors away from speculating. It’s a simple system with easy, binary answers: either a stock meets Graham’s liquidation criteria, or it does not. Finding a company you can invest in with a margin of safety, Graham wrote in The Intelligent Investor, “rests upon simple and definite arithmetical reasoning from statistical data.”

Obsessed with formulas, Graham ignored any sort of qualitative analysis; one of his assistants recalled that he would get bored and look out the window if anyone started talking about what a company actually did.

Walter Schloss, who worked for Graham and later became a legendary value investor in his own right, once pitched Graham on a company that wasn’t selling for a fire sale price but owned a promising new technology: Haloid, which would later commercialize the Xerox machine. “Walter, I’m not interested,” Graham told Schloss. “It’s not cheap enough.”

Graham retired early for a portfolio manager, at sixty-two. A wealthy man, he could afford to return to his earlier, more intellectual interests. He translated a novel from Spanish, published a volume of poetry, and began to split his time among the United States, Portugal, and Aix-en-Provence. Shortly before he died, however, Graham made a bizarre, indirect confession about the limitations of the discipline he had created. The confession came in a two-page postscript from the final edition of The Intelligent Investor, published in 1973. Graham apparently felt so sheepish about the matter that he wrote of himself in the third person. He describes what transpired as if it had happened to someone else, whereas in fact it happened to him and his longtime business partner, Jerome Newman. “We know very well two partners who spent a good part of their lives handling their own and other people’s funds in Wall Street,” Graham begins in the postscript. “Some hard experience taught them it was better to be safe and careful rather than to try to make all the money in the world…. In this way they did quite well through many years of ups and downs in the general market…” Graham goes on to say that in 1948 he put 20% of his partnership’s assets into a single stock. The stock was cheap relative to both assets and earnings, and, Graham writes, he and his partner were “impressed by the company’s possibilities.” Almost soon after Graham bought it, the stock took off and continued to appreciate—so much so that over time, it made Graham and his partners two hundred times their initial investment. This appreciation quickly made it look expensive on Graham’s asset-based metrics, but he decided to keep it because, as he says in his memoirs, he regarded the company as “sort of a family business.” “Ironically enough,” Graham concludes in The Intelligent Investor, “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” (emphasis added). In other words, a single investment in one great business made Graham more money than a generation’s worth of cigar butts combined. The company was GEICO, the automobile insurer. Yet in Graham’s memoirs, he mentions GEICO only twice, once in relation to an insurance claim he filed with them. Northern Pipe Line, on the other hand, receives a whole chapter. “Are there morals to this story of value to the intelligent investor?” Graham asks in the conclusion to his postscript. “An obvious one is that there are several different ways to make and keep money on Wall Street. Another, not so obvious, is that one lucky break, or one supremely shrewd decision—can we tell them apart?—may count for more than a lifetime of journeyman efforts.” Here, Graham was dissembling. By the time he wrote this postscript, he knew that identifying great businesses like GEICO did not involve a lucky break. He knew that the identification of great businesses could be systemized, just as he had systematized asset-based investing. One of his former Columbia students—his star pupil, in fact, the only one he ever awarded an A+—was proving it through his own investment track record.

End of Chapter FootnoteI am indebted to my friend and colleague Chris Begg, cofounder and chief investment officer of East Coast Asset Management, who gave me the terms Value 1.0, Value 2.0, and Value 3.0, which I use throughout the book.

Chapter 3: Value 2.0: Warren Buffett and the Brand-TV Ecosystem

Buffett was heavily influenced in his thinking by John Burr Williams, an economist who had written a book called The Theory of Investment Value. Like Graham’s Security Analysis, Williams’s book had been written in the depths of the Depression, but it was as optimistic and as forward-looking as Graham’s was cautious.

“The key to investing,” Buffett said in a 1999 speech that was later published in Fortune, “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.”

In both its general worldview and its specific tools, Value 2.0 is beginning to fail us. As the economy changes, the moats that protect many of Buffett’s classic postwar franchises are weakening. At the same time, Buffett’s valuation framework, with its focus on mature companies generating lots of current earnings, hasn’t captured the enormous value being created in the Digital Age. While Value 2.0 was exquisite in capturing where the money was, it’s not capturing where the money is.

the pair have been slower to recognize the secondary effects that media’s decline has had on mass brands: Coca-Cola and Kraft Heinz remain large Berkshire positions.

A third of Buffett’s top fifteen publicly traded stocks are financial-services companies, including American Express, Bank of America, and, until recently, Wells Fargo. This is a real problem, because digital companies are looking at legacy banks the way a lion sizes up an aging zebra. Like GEICO, a bank’s competitive advantages arises from its low-cost position. Unlike GEICO, however, which offers its customers better deals, banks have offered customers worse deals, betting—correctly, so far—that customers would put up with them. However, those days may soon be over.

While it’s true that it’s hard to change banks when you have so many accounts with them, banks have abused their customers’ trust for so long that they are all but inviting customers to leave. Not only do banks offer below-market rates, but they also routinely ding their customers with fees. Account-opening fees, account maintenance fees, fees for using another bank’s ATM, fees for failing to maintain a minimum balance, overdraft fees—as anyone who has seen them on their monthly statement knows, the list is long. The average American pays roughly $20 in banking fees every month, more than they pay for a Netflix subscription. But at least, with Netflix, people get something.

Why is that? What is it about value investing as currently constructed that lets most tech companies slip through its net? The answer is complex, but I think it begins with Buffett’s worldview. Buffett’s career coincided with a time when the American economy was unusually stable and homogenous.

Unlike many other tech companies, Apple is relatively unambitious in terms of trying to attack new markets; as a percentage of sales, Apple spends only about one-third of what Alphabet, Microsoft, and Facebook spend on R & D. Over the last decade, the company has acted like an old-fashioned capital allocator, using much of its cash flow to repurchase its own shares in the open market.

Experience has taught them to look for steady, persistent economic farmers, safe behind their moats and castle walls. The blitzkrieg success of companies like Alphabet, Facebook, and Netflix is alien to them, and little wonder. They’d never seen anything like it until they were more than seventy years old.

Alternatively, read Berkshire Hathaway’s 1992 annual report, in which Buffett gives a condensed version of Williams’s ideas.

Chapter 4: Value 3.0 and the BMP Checklist

This company makes generic spare parts for airplanes. Like GEICO in 1951, it has a small share of a huge addressable market. Like GEICO, its competitive advantage stems from being the low-cost provider of an essential product. Even its name resembles GEICO’s: It’s HEICO, a company I came across during my wretched period of underperformance in the mid-2010s.

At the time, I was working with a talented analyst named Clint Leman. I asked Clint to write a simple computer program that used different metrics from the “look for cheap stocks” criteria I’d been using. No longer would I put price ahead of business quality as I had with Avon, Tribune Media, and the rest. Instead, I would search for businesses with superior economic characteristics, then see about price later. I also asked Clint to screen for management quality using a single simple yardstick: whether executives owned a lot of stock in the company they were running. Clint’s screen turned up a dozen names, the most interesting of which was HEICO. The company was founded in 1957 as Heinicke Instruments Company, but the story really begins in the late 1980s, when one of Larry Mendelson’s kids stumbled upon it. Larry Mendelson was a New Yorker who, while attending Columbia Business School a decade after Buffett, took the same security analysis course Buffett had. After graduation, Mendelson moved to Florida and made a lot of money in real estate, but he put his value-investing skills to work in the stock market as well. In the 1980s, his sons Eric and Victor attended Columbia as undergraduates; while they were there, Larry asked them to look for undervalued securities in their spare time. Interest rates were falling, stocks were modestly priced, and Larry was looking for a business he and his sons could take over and run. In keeping with Ben Graham’s tradition, the Mendelsons didn’t particularly care what the business did. It just needed to be cheap, poorly managed, and located in Florida, where the family wanted to stay. One day, while doing research in the Columbia law school library, Victor found HEICO, which appeared to meet the family’s criteria. The company specialized in making medical-laboratory equipment, but it had made a series of acquisitions, including one in the aerospace business. By the time Victor found HEICO, it had been public for nearly thirty years but barely made any money. Like Graham with Northern Pipe Line and Buffett with Sanborn Map, the Mendelsons saw HEICO as a company whose shares they could buy in the open market and then agitate for change. Unlike Northern Pipe Line and Sanborn Map, however, HEICO’s appeal lay not in the liquidation value of its assets, but in the latent earnings potential of its aerospace subsidiary.

As they learned more about airline spare parts, the Mendelsons discovered that HEICO could produce and sell a generic option at a 30% to 40% discount and still make healthy profits and returns on capital. The Mendelsons also found that there were few patents or intellectual-property rights attached to aerospace replacement parts. Moreover, the market for spares was huge—it’s roughly $50 billion a year today—and the aerospace industry was growing. Like American Express, investing in airline travel is a classic call on rising worldwide prosperity, which leads to a rising demand for travel.

In 1989, the Mendelsons and their allies bought 15% of HEICO’s stock in the open market. After a proxy fight almost as ludicrous as Graham’s Northern Pipe Line contest, they secured four seats on the board and named Larry Mendelson the new CEO.

He immediately sold HEICO’s lab business and focused on the market for airplane spares.

When Clint’s screen led me to HEICO in 2015, it had shipped 68 million parts without a single adverse incident, and nineteen of the world’s top twenty airlines bought parts from the company.

Part II: Tools for Picking Winners

Chapter 5: Competitive Advantage Then and Now

Go to Intuit’s site and you will see that Intuit now has 5 million online subscribers to QuickBooks, its small-business accounting product. Intuit says that the worldwide addressable market for QuickBooks is 800 million customers. Five million divided by 800 million equals less than a 1% share—I’m interested.

Chapter 6: Management: Some Things Never Change

Chapter 7: Price and Value 3.0 Toolbox

Chapter 8: Earnings Power

Chapter 9: BMP Case Studies: Alphabet and Intuit

Chapter 10: Investing in Non-Tech Companies

Part III:  Putting it All Together

Chapter 11: Buy What You Know – With a Twist

Chapter 12: Thoughts on Process and Priorities

Chapter 13: Regulation, Innovation, and Second Half of the Chessboard