A Review of the Value Strategies that Work
When Ben Graham began documenting his theories back in the 1930s, he was doing so against a backdrop of a massive stock market crash and a US economy that was on its knees. His was not just a new strategy; it was a new way of thinking about how stocks ought to be valued and how investors could capitalise on opportunities left in the wake of the Great Depression. Unsurprisingly, his unpicking of conventional stock market wisdom led him to develop some hugely demanding approaches for finding bargain stocks.
But while Graham continues to exert major influence on investors, his techniques have been tweaked and adapted over decades by a new generation of Value Investors. In a way, these approaches can be thought of as a spectrum of strategies spanning the value range from bargains to quality stocks, adding new ingredients to the mix along the way. Very often, these approaches not only offer fresh thinking on ways of valuing and selecting stocks and improving the timing of buys and sells, but they also present additional ways of mitigating the risk of failure.
In the coming Chapters, we will look closely at how some of these approaches differ, starting with the ‘deep value’ strategies for which Graham and other investors like Walter Schloss became known and which primarily use diversification as a way to deal with risky investments. After that, we will travel up the curve towards quality by looking at the use of accounting-based filters like the Piotroski F-Score to weed out likely underperformers, the use of price momentum by Josef Lakonishok as a way to identify value catalysts, along with blended approaches that try to find better quality businesses, like Joel Greenblatt’s ‘cheap but good’ Magic Formula and finally the Buffett- esque notion of “quality at a fair price”.
What should emerge from this journey is a picture of value investing as a multi-faceted contrarian strategy that has largely carried on its inexorable march regardless of popular sentiment or academic thinking. Meanwhile, those that have persevered with it have become some of the most successful individuals in investing history.
Fortunately, there has never been a greater opportunity for individuals to access the information, guidance, screening tools and academic insight that, used together, can offer the best chance of making money from value stocks. But while individual investors can learn a great deal from the stock selection and buying techniques of these guru investors, it should be clear by now that there is much more to it than mimicry.
Buying deep bargains or “cigar butts”
“Come in here dear son, have a cigar you’re gonna go far…”, Pink Floyd
When it comes to buying stocks, few investors would dispute that finding a bargain is a seductive prospect. But while most investors are looking for an attractive price, some bargain – or deep value – investors are prepared to go to great lengths to find one. Warren Buffett calls this the ‘cigar butt’ approach to investing: “A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit”.
Bargain investing is often about having a very conservative measure of intrinsic value, essentially liquidation value, and a large margin of safety, in order to try to buy a pound for, say, 50p. In bull markets, true bargain investing can be arduous but in depressed and volatile conditions like 2009, the basket of potential stock candidates tends to swell. As we’ve seen, regardless of the conditions, some of the world’s most legendary investors like Ben Graham and Walter Schloss have made a mint out of this investment approach.
So how do you go about finding these kinds of deep value or bargain stocks?
1. Pay less than book value
Perhaps the most basic way to approximate liquidation value is by using the so-called price-to-book ratio. This involves comparing the current market value of a company’s shares with the book (accounting) value of the equity in its balance sheet, to figure out when a stock may be trading at a discount to its asset value. As discussed in a previous chapter, stocks trading on a discount to their assets are defined as being on a P/B Value of less than 1 and countless academic studies have shown that low price-to-book stocks tend to outperform over time.
True bargain investors would tend to be dismissive of any kind of intangible assets, usually calculating price-to-book on a tangible assets only basis, given the inherent difficulties in valuing intangibles and the scope for flexibility in accounting for them.
That’s fine for manufacturing companies but, of course, this makes it unlikely that they would invest in most service businesses (as the value in, say, a consultancy company, lies with the knowledge of its workforce – which is an intangible that isn’t even on the balance sheet).
However, even after adjusting for intangible assets, hardened bargain investors may be sceptical that price-to-book is a sufficiently robust measure of value. It may not give enough margin of safety to their investment in the event of a severe downturn if fixed assets may have been overvalued. As a result, a number of other (more extreme) metrics can be used by the deep Value Investors…
2. Pay less than liquidation value (NCAV)
Benjamin Graham is the absolute guru of bargain investing and took price-to-book investing to the limits with a serious twist. In essence he advocated buying stocks that, if they were to collapse tomorrow, should still produce a positive return because of the underlying asset backing.
Graham suggested ignoring fixed assets like property and equipment and solely valuing current assets (such as cash, stock and debtors) on the basis that only these assets could easily liquidated in the event of total failure, and then subtracting the total liabilities to arrive at the so called net current asset value. The idea was that a market valuation below that indicated that the market had totally mispriced the company, or that the company should be sold or liquidated.
To defend against the risk of individual failures, Graham also looked for a margin of safety of about 33% below that level and added the requirement to diversify the strategy to at least 30 stocks. However, his overarching belief was that a company with a market valuation that was less than its liquidation value indicated that the market had mispriced it or that the company should be sold or liquidated. In bull markets, NCAV stocks can be few and far between but in depressed conditions there are far more to look at.
In a study by Henry Oppenhemier in the Financial Analysts Journal, the mean return from discounted net current asset stocks over a 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index – an astonishing outperformance.
3. Pay even less than liquidation value (‘Net Nets’)
For investors that like the idea of liquidation value investing, it is worth noting that Graham pushed the formula a stage further. He reasoned that in a liquidation situation, cash due from debtors might not be collected and some inventories may have to be discounted, so he made allowances for this.
He called this even more conservative valuation as the Net Net Working Capital (NNWC) of the company - building in an even more extreme margin of safety.
Net Net Working Capital = cash and short-term investments + (75% * debtors) + (50% * inventory) – total liabilities.
This strategy is now very highly regarded by savvy bargain investors and qualifying stocks are known in the jargon as ‘net nets’.
4. Buy companies selling for less than their cash
A more modern version of the net nets and an alternative way of dealing with the “known unknown” of the true value of fixed assets in a liquidation situation is to deal simply with the cash in a business. Investors can look for companies whose cash is worth more than the total value of their shares plus their long-term debt!
This investment approach is known as buying stocks with a Negative Enterprise Value. Proponents argue that stocks in this position offer a potential arbitrage opportunity, whereby a buyer of the company could snap up the entire stock and use the cash to pay off the debt and still pocket a profit.
For the individual investor, this means buying into the cash at a discount and receiving a claim to the rest of the company for free. The argument goes that, in a reasonably efficient market, something would eventually have to give and the company would either be acquired, turned around or pay out a dividend.
James Altucher espoused a variant of this approach known as the ‘Cash Index’ in his book, Trade Like Warren Buffett. He suggested a multi-pronged approach to analysing potential bargain/arbitrage stocks trading below cash in times of market distress (in his case, post the 2001 bubble / Iraq War).
Our initial testing suggests that a Negative Enterprise Value type approach is far from free from downside risks. This may be because judging a company’s true current cash position, as opposed to its last reported cash position, is fraught with difficulty and there is also no guarantee that the company management will act in the best interest of shareholders in its use of these cash proceeds!
5. New opportunities with new lows
A final strategy for bargain investors blends the all-important book value with stocks that have fallen to new lows in terms of market price. This approach was taken by Schloss, another investor that studied under Graham and went on to refine his tutor’s theories into his own strategy.
Despite not using a computer (he preferred hard copy Value Line research) Schloss was interested in the financials behind a stock. More specifically, he was interested in stocks whose prices were at or near their 52-week lows. Without talking to the management (he was sceptical of his own ability to judge character) Schloss went on to assess the company based on its numbers.
The importance of identifying new lows is that Schloss saw this metric as an indicator of a possible bargain stock, although he stressed the importance of distinguishing between temporary and permanent problems. Beyond that, he would look for companies trading at a price that was less than the book value per share. He was also keen to see no long-term debt, stocks where management owned above-average stakes for the sector and, finally, a long financial history.
Schloss preferred to invest in sectors he understood, particularly old industries like manufacturing, although he successfully shorted Yahoo and Amazon before the markets collapsed in 2000. Like Graham, Schloss believed in significant diversification although his willingness to run up to 100 stocks would have many investors reeling. Nevertheless, over the 45 years from 1956 to 2000, his fund earned an astounding compound return of 15.7%, compared to the market’s return of 11.2% annually over the same period. In the words of Buffett, Schloss “doesn’t worry about whether it’s January…whether it’s Monday…whether it’s an election year. He simply says if a business is worth a dollar and I can buy it for 40 cents, something good may happen”.
Not for the faint-hearted
By definition, deep Value Investors do tend to get their hands dirty with some of the most unloved stocks in the market and that leaves a bargain strategy open to significant risk. While scrutinising the relationship between market price and underlying asset value (however you choose to do it) can prise open a basket of candidates that could offer substantial returns, investors should always back up their screening with detailed scrutiny as well.
Deep value investing is not an approach for the faint-hearted. Buffett argued against it as a strategy in his 1989 Chairman’s Letter to Shareholders, noting that the original ‘bargain’ price probably will not turn out to be such a steal after all because, “in a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.”
How do deep Value Investors mitigate the risk of cockroaches? For the most part, this is done through diversification. This is a sledgehammer approach that recognises that some stock purchases will fail but with a big enough basket, the thinking goes, the successes should outweigh the catastrophes. For Graham, the target was upwards of 30 stocks while for Schloss the number could be as heady as 100.
While certainly recognising the value of some diversification, the value investing strategies that we will discuss next have generally sought to approach the problem of downside risk in other ways.
Buying bargains on the mend
As we have discussed, one of the main challenges presented to an investor intent on buying value stocks is that cheap companies can often be troublesome, which goes some way to explaining why the strategy has occasionally earned the moniker “hold your nose and buy”.
While the principles of intrinsic value and margin of safety provide some protection, the risk remains that value stocks can go bust or simply fail to ever recover – and become ‘value traps’ from which there may be no escape.
But what if you could find a way to filter out the value traps from the recovery stocks to ensure that your portfolio contained only companies with the highest probability of turning around? Surely if such a method existed, you could significantly improve your odds and therefore your returns…
Spotting turnarounds fast with the Piotroski F-Score
This is exactly the conundrum that perplexed a certain Stanford accounting professor by the name of Joseph Piotroski. He was attracted to the long understood outperformance of cheap value stocks but found the variability in their returns startling. He noted that:
“Embedded in that mix of [value] companies, you have some that are just stellar. Their performance turns around. People become optimistic about the stock, and it really takes off [but] half of the firms languish; they continue to perform poorly and eventually de-list or enter bankruptcy.”
What he wondered was whether it was possible to weed out the poor performers and identify the winners in advance. He went on to develop a simple nine point checklist scoring system for evaluating the strength of a firm’s financial trend from one year to the next.
Piotroski first outlined his theory in an April 2000 paper entitled Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers[1]. His starting point is a list of companies that are, on paper, the most undervalued on the market. You arrive at a list of ‘value’ stocks by dividing what the market is pricing them at by what each company’s total assets are stated to be worth and concentrating on the cheapest 20% of companies. This price-to-book value list generally produces a collection of companies that, on a pure valuation basis, may be mispriced.
A quick scan of such a list will show that there may be very good reasons why investors won’t touch companies in this basket – they can often be financially stricken or even basket-cases. The overarching question is why each company is being undervalued and whether it is justified.
It could be any number of factors including long-term underperformance, financial calamity, investor ignorance, poor communications, an unsexy sector or an unappealing business model. Whatever it may be, these companies are out of favour and Piotroski’s theory seeks to pick the ones that offer the best chance of recovery as opposed to those that will continue to languish or fall further into distress.
To assess which companies are in the best financial shape Piotroski screens each stock using an accounting-based checklist – scoring one point for each ‘pass’. The criteria are broken into three sections starting with profitability signals followed by leverage, liquidity and source of funds and, finally, operating efficiency.
Piotroski’s approach essentially looks for companies that are profit-making, have improving margins, don’t employ any accounting tricks and have strengthening balance sheets.
By investing in companies scoring 8 or 9 by these measures, Piotroski showed that, over a 20-year test period through to 1996, the return earned by a value-focused investor could be increased by 7.5% each year. Since then the idea has won an army of followers and in the bear market of 2008 it was hailed by the American Association of Individual Investors as the only one of 56 screening tools to produce a positive return for investors.
Filter out financially risky stocks with the Z-Score
Alongside the F-Score, another interesting fundamental filter/ checklist is the Altman Z-Score. This is a metric that has been a part of the investor toolkit for more than 40 years but is not as well- known as it should be partly due to the difficulty in calculating it.
It was developed by New York University finance professor Edward I. Altman, who used a combination of five weighted business ratios to estimate the likelihood of financial distress. It was initially created to test the financial health of manufacturing companies; with later tweaks opening it up to non- manufacturing and even private companies. The basic idea is that any Z- Score above 2.99 is considered to be a safe company. Companies with a Z- Score < 1.8 have been shown to have at significant risk of financial distress within 2 years.
Some investors may question the idea of using a formula to predict bankruptcy – and to be fair it does produce some surprising results – but nevertheless tests have proved it to be highly effective. Its initial test found that it was 72% accurate in predicting bankruptcy two years prior to the event, while subsequent examination has shown 80-90% accuracy.
Filter out earnings manipulators with the M-Score
Another option for investors that want to screen companies for the risk of negative accounting practices is to use filters that are optimised to detect earnings manipulation rather than bankruptcy.
Glamour and growth are alluring not only to investors but also to company management whose compensation may be dependent on a continuing the trend! Accounting tricks such as booking sales early, changing asset depreciation rates and so on are all available for managers to massage earnings figure.
The Professor Messod Beneish created another scoring system to weed out these ‘manipulators’ - he called it the M-Score (which neatly parallels with the F-Score and Z-score!). It is an invaluable tool for Value Investors and offers even greater visibility and protection in marginal situations.
An M-Score above 2.22 highlights companies that may be inflating their earnings artificially increasing the likelihood they will have to report lower earnings in the future. In sample tests, Beneish found that he could correctly identify 76% of manipulators, whilst only incorrectly identifying 17.5% of non-manipulators. Interestingly, students from Cornell University using the M score correctly identified Enron as an earnings manipulator, while experienced financial analysts failed to do so.
In a similar vein, Value Investor, analyst and author James Montier has developed useful system called the C-Score (C stands for cheating or cooking the books). The test focuses on identifying tell-tale signs which accompany bad accounting practice (e.g. is asset growth high or is DSO increasing?), which are scored in a simple binary fashion, 1 for yes, 0 for no. The idea is that, the more flags that are present, the more likely it is that something may be going on below the surface of the accounts.
Montier found that in the US, stocks with high C-scores underperformed the market by around 8% p.a. while in Europe, high C-score stocks underperformed the market by around 5% p.a. Although developed as a short-selling technique, this can also be useful as a way of filtering lists of value stocks.
Diamonds in the dirt
Fundamental-based techniques to try to filter out value-trap companies and focus on those that could be poised for a recovery present an interesting new layer of analysis over the fundamental principles of intrinsic value and margin of safety. Of all of these techniques, the Piotroski F-Score is perhaps the best performing in that it was specifically designed to tackle the cheapest stocks in the market. This approach offers a new twist on investing in the cheapest stocks and news ways of thinking about managing risk.
Buying bargains on the move
“A rolling stone gathers no moss, but gains a certain polish”, Oliver Herford
Among the most prolific academic writers on the subject of value investing is US-based finance professor Josef Lakonishok. Together with fellow academics Shleifer and Vishny, his work in a 1994 paper entitled Contrarian Investment, Extrapolation, And Risk[2] was seminal. It concluded that there were many reasons why investing in value, rather than historically well performing glamour stocks, was more successful.
For individual investors, the preference for glamour stocks derives from poor judgment and too much extrapolation from the past performance of stocks even when strong historical growth rates are unlikely to continue. Meanwhile, institutional money managers tend to move in herds towards the perceived safety of glamour investments that have performed well historically. Lakonishok’s team concluded that investment managers didn’t have the time horizons necessary for value strategies to pay off. As a final insult, he suggested that they were generally poor at making decisions, as illustrated by their inferior performance against the market.
On its own, this all makes for very interesting debate and, indeed, substantiates much of this book, but there is more. Lakonishok and his partners were so convinced by the value approach that they set up their own fund management business to execute it. LSV Asset Management has since blossomed into a firm that now manages an astonishing $58 billion of investments across its value equity portfolios!
Value with Momentum
Lakonishok’s approach is to find under-valued, out-of-favour companies at the point when the market is starting to recognise them – a combination of value and momentum. From a fundamentals perspective, he begins by looking at price-to-book, price to-cash flow, price-earnings and price-to-sales ratios in order to identify unloved stocks. However, identifying a group of out-of-favour stocks is just the beginning. The trick is to ascertain which of them are likely to rebound versus being cheap for a reason, such as being near bankruptcy. So, he then looks for those shares that are showing sign of momentum, either in terms of price momentum (relative strength) or in terms of improving analyst sentiment and earnings surprises.
Wait a minute, you might think. Value and momentum? Surely, those strategies are polar opposites – like oil and water – moving in opposite directions. Momentum is the idea that stocks on the way up tend to keep going up, regardless of their value. A Value Investor is likely to shun a momentum stock that is soaring higher, further and further away from its fundamental value, whereas for a momentum investor this trajectory alone makes it a tempting buy.
So how did it do?
It turns out that the approach has been a barn- stormer. According to the American Association of Individual Investors, the Lakonishok screen has made a 15.7% CAGR since inception, compared with 2.3% for the S&P 500, although its more recent performance in our own tracking has been less impressive – much like most momentum strategies in the face of market volatility!
In part, the outperformance is because momentum does well when value doesn’t. Researcher Tobias Moskowitz concluded that “a value-momentum combination mitigates the extreme negative return episodes a Value Investor will face (e.g. the tech boom of the late 1990s and early 2000 or a dismal year like 2008)”.
During the tech bubble, for example, Value Investors had a tough time, since expensive stocks kept getting more expensive, while it was a field day for momentum investors. When the bubble burst, value did well and momentum suffered, but on a blended basis, the two strategies did well consistently.
However, another reason why momentum helps is that it provides an answer one of the biggest issues of value investing, namely the “when will it happen?” question.
Is momentum a signal of a hidden catalyst?
Even if an investment doesn’t go under, a value investment may still end up being a dreary and difficult one, if there is no near-term catalyst for the crystallisation of value. Some examples of possible catalysts include: i) fresh management with new direction, ii) a change in strategy of existing management (e.g. new product strategy, business reorganisation or cost reductions), iii) a disposal or purchase of a meaningful asset, iv) a recapitalisation of the business, v) a takeover bid, or vi) activist shareholders who may put pressure on management to act.
As blogger Wexboy notes, an extended wait for value to be crystallised can have a dramatic effect on your returns. “Imagine you’ve found a neglected jewel which you expect that will ultimately capture an upside of, say, 75%… But when will that happen? In 3 yrs, 5 yrs, 7 yrs..?! Those periods equate to IRRs of 20.5%, 11.8% and 8.3% pa respectively. Now assume a catalyst exists that’s successful in prompting a realization of that full 75% upside within 1 year. That is, of course, a 75% IRR!”
The power of positive momentum in the stock price is it may suggest whether people are finally starting to appreciate the stock. A catalyst for improvement may have finally arrived so that you don’t have to wait forever for the crystallisation of value.
This combination of value and upward momentum is an intriguing approach in a value investing strategy. Previously we looked at how Walter Schloss’ deep value investing strategy would look for stocks that were at or near their long-term lows and this is almost the inverse of that. As we’ve discussed, though, a stock may be cheap, compared to its good fundamentals such as earnings and cash flow, but even the savviest investor cannot be sure when this stock will turn around with the market finally seeing the light about the company’s true worth. Lakonishok’s academic background led him to focus on behavioural finance explanations for the value phenomenon – he therefore recognised the power of momentum as a signal to ascertain which stocks are likely to rebound versus being cheap for a reason and is considerably wealthier than most academics as a result!
Buying good companies cheaply - a “Magic Formula”
“Buying good businesses at bargain prices is the secret to making lots of money.” Joel Greenblatt
Joel Greenblatt made his name running New York hedge fund Gotham Capital and he made a lot of money doing it with annualised returns reported at 50% annually. When he realised that his growing children really ought to understand what a hedge fund manager does for a living he decided to write a book that even they could read. The research and philosophy that he developed turned into The Little Book that Beats the Market[3] and highlighted a ranking system he christened “The Magic Formula”.
The formula essentially translates as buying good companies at a cheap price and its apparent simplicity has won it many followers in the investment community.
At its heart, the Magic Formula involves selecting a basket of between 20 and 30 stocks – some of which may have the potential to make a prospective investor blanch. Unloved, misunderstood, occasionally debt laden or with broken business models, Greenblatt’s selection is not a magic bullet and the large basket reflects the likelihood that some of these companies may well struggle to become investment successes. However, these are profitable businesses and by putting trust in the ‘quant’, the theory is that it won’t take too many success stories for the screen to pay off.
Putting trust in the ‘quant’
Greenblatt’s formula looks to two ratios we have previously discussed : a high return on capital (ROCE) and a high earnings yield (EY) – or, to put that another way, it has to be ‘good’ and ‘cheap’. The return on capital measures how effective the company is at making a profit from its assets – this is used as a proxy for how ‘good’ the company is. The earnings yield takes a company’s operating profit and divides it by its enterprise value – the higher the earnings yield the more ‘cheap’ the stock. By ranking the market from high to low for each indicator and adding the two ranks an investor can come up with a Magic Formula score for all the eligible companies in the market.
Once the ranking has been developed, Greenblatt suggests constructing a portfolio by selecting five to seven stocks every two to three months over a 12-month period. He suggests that each stock should be sold after one year, repeating the steps to reinvest the proceeds of securities sold. This approach should be continued over a long-term (3-5+ year) period. In taxable accounts, he suggests paying attention to after-tax returns and timing the sales accordingly.
The advantage of this screen is that there will always be companies that are trading at a discount for any number of reasons, and the Magic Formula picks them out. However, Greenblatt’s US focus has deprived UK investors from easily applying the screen on this side of the pond (his own website readily produces the results for US stocks). Although its something that we are now addressing at Stockopedia, that’s been frustrating for those UK investors who have been eyeing with interest the impressive returns cited in his book – according to Greenblatt at least, the Magic Formula approach has averaged a 17-year annual return of 30.8% and beats the S&P 500 96% of the time.
Greenblatt’s Magic Formula provides an intriguing insight into the types of stocks and sectors that are currently feeling the cold shoulder of the market. Given that these companies are being valued at a cheap price by the market but also relatively profitable, the screen offers a useful starting point for Value Investors to identify possible mispricing – and applying additional screens such as the Piotroski F-Score can add an extra dimension.
Can Beddard’s blend beat them both?
Interestingly the Interactive Investor blogger Richard Beddard has built up a great following in the UK by doing precisely that. By using a blended approach that aims to highlight the best Magic Formula Scoring stocks that also have a high Piotroski score Beddard believes he can buy cheap, good and financially improving stocks. The theory seems to be working in the UK with our model of Beddard’s thrifty thirty handsomely outperforming both Piotroski’s strategy and Greenblatt’s Magic Formula!
Buying quality at a fair price - Buffett
“You should invest in a business that even a fool can run, because someday a fool will.” Warren Buffett
While the evolution of value investing spans nearly 100 years of twists and turns, one of its greatest influences and its greatest success stories is the world-renowned Warren Buffett. For a man widely regarded as the most successful investor ever, the principles of value investing have remained central to his thinking. However, the way he has evolved his investment philosophy and developed a preference for good quality companies is a twist that all value hunters should take note of.
Buffett is essentially a reformed proponent of the ‘cigar butt’ bargain investing strategy so drilled into him by his tutor Benjamin Graham. His experiences in failing to turn around the fortunes of Berkshire Hathaway, once a textile company that was struggling against competition from cheaper labour in overseas factories, and the counsel of his business partner Charlie Munger, led him in a different direction. In this chapter we will take an in depth look at how he has progressed his philosophy beyond simple bargain stock investing, and why this has worked so well for him.
Whilst never forgetting the intrinsic value and margin of safety teachings, Buffett’s approach is much more focused on the calibre of the business franchise using some of the techniques we outlined in the previous chapter on ‘good’ companies. In essence, he looks for simple, understandable companies that have a durable competitive advantage so as to ensure consistent profits and a strong return on equity. But where he has really excelled is in his ability to buy these stocks when the rest of the market is selling.
Warren Buffett’s background
Buffett originally studied under Ben Graham at the Columbia Graduate Business School. In 1956, at the age of 25, he started an investment partnership which delivered a compound return over the next 13 years of 29.5%. The partnership was closed in 1965 and Buffett used his capital to purchase a controlling interest in Berkshire Cotton Manufacturing, a well established but struggling textile company. This company merged with Hathaway Manufacturing, and also bought interests in two insurance companies in 1967. The combined company was renamed Berkshire Hathaway.
Over the last 44 years, this investment vehicle has averaged an astonishing 20.3% annual growth in book value. Nevertheless, Buffett has argues that the original acquisition of Berkshire Hathaway was his greatest investing mistake, denying him compounded investment returns of about $200 billion over the past 45 years!.
Why is that? Because the textile firm’s assets acted as an anchor on his holding company for 20 years. As he puts it: “for 20 years, I fought the textile business before I gave up… Berkshire Hathaway was earning nothing, year after year after year after year.” By his estimation, if he had just put his Berkshire stake into a good insurance business to begin with, his holding company would be worth twice as much today.
That lesson taught Buffett to focus on companies with ‘durable competitive advantages’ which promise enduring high returns on capital and free cashflow in his pocket. Buffett likens businesses to castles at risk of siege from competitors and the marketplace. Great companies are able to dig deep economic moats around their castles that become increasingly impregnable to competition and market pressures.
These moats bring either pricing power or cost reductions which help sustain very high returns on capital, leading to higher cashflows and returns for investors. Clearly everyone would like to own a business with a wide economic moat but Buffett has been most systematic in tracking them down.
Investment strategy
Over the year, years Buffett has documented his thinking and investment philosophy in annual letters to Berkshire Hathaway shareholders, as well as in numerous speeches and interviews. In his excellent book The Essential Warren Buffett: Timeless Principles for the New Economy, author Robert Hagstrom argues that Buffet’s investment methodology is a hybrid mix of the strategies developed by Graham and Philip Fisher. Indeed, Buffett himself has indicated that: “I’m 15 percent Fisher and 85 percent Benjamin Graham”, although Hagstrom notes that this was in 1990 and that Buffet has probably moved closely towards Fisher since then:
“From Graham, Warren Buffett learned the margin of safety approach - that is, use strict quantitative guidelines to buy shares in companies that are selling for less than their net working capital… From Fisher, Warren Buffett added an appreciation for the effect that management can have on the value of any business, and that diversification increases rather than reduces risk as it becomes impossible to closely watch all the eggs in too many different baskets.”
Hagstrom summarises Buffet’s approach as being based on four key principles:
1. Analyse a stock as a business – Intelligent investing means having the priorities of a business owner who focuses on long- term value rather than as a short term stock trader. In his view, an investor should only buy shares in a company which he would be willing to purchase outright if he had sufficient capital.
Focus on simply understood businesses with a consistent operating history and favourable long term economics
Management must be rational in their allocation of capital and candid with shareholders.
Focus on companies with high return on equity and strong free cash flow that management has been able to reinvest rationally.
2. Demand a margin of safety for each purchase – Following in the footsteps of Graham, Buffett puts great emphasis on establishing a margin of safety but unlike Graham, Buffett has become less interested in cigar butt investing in net-net type companies. Instead, Buffett targets large, successful businesses— those with expanding intrinsic values, which he seeks to buy at a price that makes economic sense based on the kind of business it is in, and based on the quality of the management running the company.
3. Manage a focused portfolio – Buffett’s approach is to concentrate a few stocks that are likely to produce above-average returns over the long haul and have the fortitude to hold steady during any short-term market hiccups. His is very much the ‘hunter’ approach and the antithesis of many of the quants we have discussed, including Ben Graham his tutor. Hagstrom’s book uses the model of legendary baseball player Ted Williams as an example of the value of focus. Williams would wait for a pitch in an area of the plate where he knew he had a high probability of making contact with the ball before swinging. This discipline enabled Williams to have a higher lifetime batting average than the average player. Similarly, Buffett suggests that all investors act as if they owned a lifetime decision card with only 20 investment choice punches in it.
4.Protect yourself from the speculative and emotional excesses of the market – In essence, Buffett feels that the stock market exists simply to facilitate the buying and selling of shares. Anytime an investor tries to turn the market into a predictor of future prices, they run into problems. The only use for a regular glance at the market is to check whether anyone is foolish enough to sell a good business at a great price.
Should you try and invest like Warren Buffett?
The long-term success of Buffett’s approach is undeniable – a $10,000 investment in Berkshire Hathaway in 1965 would have been worth nearly $30 million by 2005 (vs. $500,000 for the S&P 500). However, given the number of qualitative elements in his strategy, it’s not the easiest approach to replicate through, say, a quantitative screen - although our Buffettology based screen has been doing well of late.
Perhaps what is more important is to recognise Buffett’s commitment to the principles of value investing combined with an emphasis on quality – because this gets to the heart of what most investors should think about when it comes to selecting stocks.
But it is worth remembering that just because Warren Buffett has had great success with this approach doesn’t mean you should even try it. It’s been shown time and again that great companies do not necessarily make great stocks especially in this day and age where every market professional has read Buffett and wants their clients to own these kinds of stocks. Thousands if not millions of investors were burnt in the 2000 bubble as the investment community turned Buffett into a guru and his musings into gospel. The over-selling of ‘high quality/great’ companies like Coca-Cola at huge PE multiples on the back of this gospel was a very expensive mistake.
It’s only Buffett’s patience, expertise and prudence that have allowed him to buy these companies at beaten down prices – which are character traits that not many individuals share. Recognising that you are not Warren Buffett could be a very wise strategy indeed.