Value Investing: Understanding the basics
In the following chapters, we discuss the basics of value investing and why value investing has proved to be the most profitable investing strategy of all time. We also look at who its greatest advocates and practitioners are, from Benjamin Graham to Josef Piotroski, and the paradox of why the so-called investment “experts” continue to get it so wrong…
What is value investing?
“Nowadays people seem to know the price of everything and the value of nothing.” Oscar Wilde
Stock market investors can broadly be defined as fitting one of a handful of categories, among them: value, growth, momentum and income. There are a thousand analysts who would beg to differ on that simplification so we will qualify it by saying that there are off-shoots to all of those categories, and in some cases it’s difficult to try and separate them. After all, who wouldn’t want to buy a cheap stock? And who wouldn’t be on the look out for a business, and a stock price, that will grow?
Nevertheless, at its core, the value investing school is a distinct philosophy which involves searching for what is out of favour in order to find a bargain.
Value investing is simple…
For investors that are about to embark on a value investing strategy, there are two pieces of good news. The first is that bargain hunting, or buying dimes for nickels, or however you like to view it, is among the most clear-cut strategies in investing. No-one can argue about the objective or the intended result – it is the search for cheap stocks that have been mispriced and will eventually rise in value and deliver a profit.
The second piece of good news is that there are really only a handful of key principles that a successful Value Investor needs to focus on when considering a purchase. Firstly, what is the stock’s intrinsic value (or how much is it really worth?) and secondly, are you leaving yourself a wide enough margin of safety to protect yourself from the vagaries of unknowns to ensure a good return?
So the basics are… pretty basic. If you compare the price of a stock with your confident valuation of its true worth and find you can buy it comfortably lower than your required margin of safety then you may be on to a winner.
…but it’s not easy…
While that may all sound simple, value investing is much harder than it looks because it runs against almost all human instincts. Investors feel safest when buying the same stocks as everyone else and have a tendency to favour glamour stocks in fast growing industries. Who wants to be the guy holding the bombed out engineering stocks when everyone else is buying Apple?
It is hard to develop a conviction about buying companies experiencing hard times, operating in mature industries, or facing similarly adverse circumstances and even harder to hold onto them in the face of consensus opinion and market volatility.
Which is precisely why it works
But it’s precisely these behavioural tendencies that lead to so many investors over-reacting and driving prices down so low in value stocks. It is this over- reaction that leads to under-valuation which in turn provides the profit- making opportunity for the Value Investor.
As a result, the aspiring Value Investor must become immune to these emotions and learn to be highly contrarian and stoic in nature, buying when the irrational ‘Mr Market’ is selling and selling when he starts to agree with him. It is this contrarian nature that leads to significant payoffs as we shall see.
There are many approaches to harvesting value profits
In the coming chapters, we will explore each of these key principles and ideas in greater detail, identify some shortcuts to finding value stocks and consider five different value investing strategies that have been developed by some of the world’s most successful investors. Value Investors can be broadly defined as fitting one of two distinct categories depending on how they tackle the job at hand – they are either ‘value hunters’ or ‘value farmers’. While hunters such as Warren Buffet focus on making large, highly focused bets on single stocks, the farmers take these value investing ideas and apply them in a broader portfolio fashion in order to ‘harvest’ value-based profits from the market in a systematic fashion.
While contradictory, these approaches have been shown to be equally successful in generating profits for their adherents and as a result will ensure that their authors - including Ben Graham, Joseph Piotroski, Josef Lakonishok, Joel Greenblatt and Warren Buffett - will continue to be hugely influential figures in investing circles.
But before we get into the detail of the techniques, it will pay dividends to dig into the track record of value investing’s most famous sons. The frankly astonishing profits of this group of investors illustrate why value investing is the King of all stock market strategies.
How profitable can value investing be?
“I always knew I was going to be rich. I don’t think I ever doubted it for a minute.” Warren Buffett
To answer this question it pays to go back to the beginning. While value investing has roots that are as old as the Bible, it wasn’t until the 1920s that professionals and academics began documenting their theories and techniques. Many of those approaches have stood the test of time and elevated their practitioners to near legendary status as some of the wealthiest men ever.
Introducing an academic that made a fortune
To start anywhere, you have to start with Benjamin Graham. Graham is widely regarded as the Father of value investing as well as the whole industry of Security Analysis. This influence stems not only from his published works but also from the eventual fame and fortune of the pupils that he taught at Columbia University.
In 1926, Graham started a partnership with Jerome Newman which lasted until his retirement in 1956. Due to his personal experiences with the great crash of 1929, he became pre-occupied with value and safety and while lecturing at Columbia University published ‘Security Analysis’ with a colleague David Dodd. It was a seminal moment. In the aftermath of the Great Depression, the two men deconstructed some early myths about how companies should be valued and urged savvy investors to scrutinise out-of- favour and apparently mispriced stocks for opportunities.
Graham’s philosophy was to invest systematically in extremely undervalued stocks seeking protection from individual bankruptcy by introducing significant diversification and buying stocks at deep discounts to their true worth. It is thanks to Graham that we have a whole catalogue of bargain stock strategies at our disposal with such obscure titles as ‘Net Nets’ and ‘NCAV’ and a whole ream of other concepts that we’ll explore, including Margin of Safety and Mr Market.
In spite of being personally wiped out in the 1929 stock market crash, by the time the Graham-Newman partnership was closed it had delivered an average 17% annualised return to investors, outperforming the market by a considerable margin and making the elderly Graham an exceptionally wealthy man.
A lucky class…
While Graham was clearly an exceptional investor, it was those that studied under him that really shone. His most famous student was a man that needs no introduction – Warren Buffett – who is now one of the richest men in the world. Famously, having taught Buffett classes at school, Graham turned him down for a job, but Buffett persisted and eventually joined the partnership where he worked side by side with a few others by the names of Walter Schloss and Tom Knapp. These individuals who worked with Graham and others who studied under or were influenced by him (such as Bill Ruane who managed the Sequoia fund) are all described as having been schooled in ‘Graham and Dodd’ style value investing.
Is it likely that a group of individuals from the same school of thought could all go on and beat the market for over a generation? For much of the last 25 years, academics have claimed that it would be impossible and that anybody who has managed it must just be lucky. Nobel Prizes have been lauded on these academics who have ‘proven’ that markets are efficient. They claim that the market is a ruthless mechanism that acts to instantly to arbitrage away mispricings so that the current price of a stock is always the most accurate estimate of its value. If this so-called “Efficient Market Theory” is correct, then what hope can there be for stock pickers versus mechanical low cost index funds that track the market?
Talented coin flippers?
Astonishingly, in spite of the incredible assumptions on which this concept is based, the idea and maths of efficient market theory has had a major impact on the professional investment community. The growing denial that markets can indeed offer up gross mispricings led to Warren Buffett weighing into the argument in 1984 with a first class article entitled The Super-Investors of Graham and Doddsville[1]. In it, he demolished the academic theorists with an extended monologue explaining why the performance history of Value Investors like Walter Schloss and Charlie Munger simply could not be explained by luck.
He asked investors to imagine that every American starts with a dollar in a coin flipping competition. After every round they lose or win that dollar. In only 20 rounds the 225 million who started would be reduced to just 215 people holding all the cash and inevitably feeling a bit pumped up and egotistical. Now these academics would have you believe that you’d get the same results by re-running the experiment with orang-utans, but Buffett asked: what if you found that all those orang-utans came from the same zoo and had been trained by the same zoo-keeper? You’d probably want to find out more about his methods. In this case, he noted:
Performance of value investors vs S&P & Dow
“I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville.”
In the paper, Buffett shows the track records of each of nine of these disciples of Graham and Dodd showing that they all generated annual compound returns of between 18% and 29% over track records lasting between 14 to 30 years. Is it likely that these individuals from the same school of thought could all beat the market over a generation if the stock market was a place of luck? Buffett doubted it most eloquently when he said that: “I’d be a bum on the street with a tin cup if the market was always efficient”.
Eventually even the academics start to cave…
Despite being generally deaf to Buffet’s argument, the academic consensus on efficient markets began to crack in 1992 with a paper by Fama and French at the University of Chicago Booth School of Business. They found that small cap stocks with a low price-to-book value (i.e. value stocks) produced a basket of shares that outperformed the rest of the market, effectively admitting that markets aren’t entirely efficient.
Two years later, a paper by Lakonishok, Shleifer, and Vishny split US stocks into ‘value’ and ‘glamour’ segments and concluded that, pretty much whatever your definition of value was, value stocks consistently outperformed glamour stocks by wide margins. Following up on this and other studies, Lakonishok concluded that value investing was likely to remain a “rewarding long term investing strategy”. As we will see later Lakonishok has certainly put his money where his mouth is – he has turned his hand to running his own fund management firm with astonishing results.
Responding to criticism that maybe Lakonishok’s findings were just a US phenomenon, the Brandes Institute in 2008 expanded on his work done to include developed markets in North America, Europe, and Asia. They found that value stocks did well on an individual country basis and in the aggregate, noting that while the degree of outperformance varied, the most significant finding was its consistency. Across valuation metrics, across time, across regions and across market capitalisations value won out! This was confirmed when Robery Kahl, of US fund manager Sabino Asset Management, scrutinised ten academic studies on the subject and found in all ten cases that the value portfolios outperformed the growth portfolios.
So, in conclusion, there has never been any shortage of so-called experts, gurus, charlatans and rogues to advise the unsuspecting investor on failsafe ways to make money on the stock market. You should approach such claims with the scepticism they deserve. In the case of value investing, however, the weight of historical and academic evidence is really overwhelming in support of its effectiveness. In the next chapter, we’ll consider why this is.
Why does value investing work?
“Take all the fools out of this world and there wouldn’t be any fun living in it, or profit.” Josh Billings
So value investing works. It’s been proven in the wild, it’s been tested in the lab, it’s made people rich… but if everyone knows that past performance is no guide to the future how can we be so sure that it’s going to work that we are willing to risk our capital?
The reason value investing will continue to work is because human beings are fundamentally emotional and social creatures that exhibit predictably irrational behavioural tendencies. Until the day (god forbid!) that man and machine become one and these tendencies are ‘debugged’ from our habits, value opportunities and mispricings will continue to be available to in-the- know contrarian investors.
Why do stocks become excessively cheap?
There has been a flow of research in recent years into an arcane field that aims to understand how human beings make decisions and why they make them. So called ‘Behavioural Science’ has over the last 30 years shown that we are not as rational as we would like to think. In fact we suffer from a whole ream of persistent mental biases and judgemental errors that include:
Overconfidence in our abilities: One study has indicated that 93% of drivers believe that they are better than average, a result which is clearly absurd. Stockpickers are no different.
Projecting the immediate past into the distant future: Why is it only when a stock is going up that everyone wants to buy it? More investors want to buy it the more expensive it gets.
An excessive aversion to taking losses: People hang on to their losers and sell their winners!
Herd behaviour driven by a desire to be part of the crowd: This leads in its extreme to bubbles like dot com mania and the shunning of stocks at new lows.
Misunderstanding randomness: Seeing patterns that don’t exist … Tea Leaves, Candlesticks and Ichimoku Clouds anyone?
“Anchoring” on irrelevant information: If you’ve ever seen the cheerleader for a particular stock banging on in a bulletin board you’ll understand this one!
These ‘bugs’ in the human mind lead us into making systematically bad decisions at all points in our lives but especially in our financial lives. It’s even been shown that Market Professionals can be more prone to biases than individuals due to the extra information that flows on their terminals and the general over-confidence that comes with the territory. When such vast sums of money are being poorly allocated by error-prone individuals mispricings are bound to crop up which provide opportunities for the more stoic Value Investor.
These mispricings happen both on an individual stock by stock basis but also to the market as a whole. The tech bubble of the late 1990s and the more recent credit bubble/crunch showed how the market is subject to fads, whims and periods of irrational exuberance and despair. Value Investors need to cultivate and practice the ability to stand apart from the crowd and develop a contrarian instinct to take advantage of these fads, rather than being seduced by them.
For these reasons, Warren Buffet has observed that investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Instead, “once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing”. As a Value Investor, you have to buy whatever other people are selling and when other people are selling it, which is a psychologically difficult thing to do – “value managers have to understand their biases. They know they are scared, but they have to also train their brain to buy at very scary moments, because that’s what really allows people to reap maximum rewards.”
What real world catalysts drive stocks to extreme values?
Investors have a natural tendency to over-react or under-react to news about stocks which can act as the key drivers of pushing stocks to extremes. As Lakonishok explained in his 1993 paper entitled Contrarian Investment, Extrapolation, And Risk[2], we tend to extrapolate the past too far into the future, even when strong historical growth rates are unlikely to continue. Investors tend to wrongly equate a good company with a good investment irrespective of price, to ignore statistical evidence and to develop a ‘mindset’ about a company. If you apply that notion to the idea that value stocks generally have an air of pessimism about them, then it becomes clear why stocks can become undervalued.
Adib Motiwala of Motiwala Capital suggests the following list of reasons as to how a stock may become cheap. These are the kinds of news events that Value Investors should be keeping an eye open for on the newswires:
Missing broker expectations of profit forecasts
Neglect from investors and analysts
A history of losses, fraud or accounting issues
Management issues – poor execution / key executive resignations
A complicated or unloved business operating in an out of favour industry (e.g. Waste Management)
Painted by a common brush (e.g. oil stocks during the BP crisis)
Cyclical stocks at the bottom of the business cycle
Forced selling of securities by funds (i.e. removal from an index or credit crunch)
In some cases, that re-rating will reflect an underlying permanent change to the fundamentals of the business but in many cases, it won’t. This is what creates the opportunity for the patient investor.
How do value stocks get re-priced?
Recognising the fallibility of the market of course raises the question of how this mispricing eventually gets corrected. Interestingly, the process by which value is realised or crystallised is one of the great riddles of the stock-market. As Graham noted in his testimony of the Senate Banking Committee back in 1955, while it may sometimes take the market an inconveniently long time to adjust the price level of a stock back towards its intrinsic value, the beauty of the market is that it usually does get there eventually:
Chairman: When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about – by advertising or what happens?
Ben Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it one way or another.
Part of the explanation is tied up with a concept known as ‘mean- reversion’ or the tendency of values to return to their average level. When investors and analysts put a value on a stock or share, they have a natural tendency to project an expected future growth rates for the company. Because making those predictions is notoriously difficult, they will often extrapolate from past growth rates.
However, this process of estimating profit growth ignores the tendency of growth rates to return to average levels. In other words, companies or sectors that are growing fast will inevitably see earnings growth slow down as competition from other firms catches up. By contrast, slow growth companies and sectors generally see earnings begin to grow faster as management teams take action to operate more efficiently.
The result is that investor expectations play catch-up as the earnings growth rates of both high and low growth companies return to their averages over time. Companies that were temporarily unloved can display extraordinary turnarounds in their share prices in response to these pivotal changes in expectations, handsomely rewarding the shrewd, contrarian players in the market.
Of course there are catalysts other than just stock market investors who notice when stock values get out of whack. Company management themselves can of course start ‘share buyback’ campaigns or competitors can notice their cheaply valued peers and make a takeover bid. Remember everyone wants to make a buck, and when people see a dollar lying on the ground they tend to be incentivised to pick it up.
How long can it take for value to ‘out’?
Ben Graham was always the master of a good analogy, stating that in the short term the stock market behaves like a voting machine, but in the long term it acts like a weighing machine. In other words value always outs eventually. But how long should it take before you throw in the towel?
Joel Greenblatt in his excellent Little Book that Beats the Market[3] has some observations. In backtesting his ‘magic’ value investing formula he found that it could underperform over 1 or 2 year periods but not once in any 3 year period over 17 years did the strategy underperform.
It is the fact that value investing does indeed have periods of underperformance that gives all the rest of the investment world itchy feet. Six months of underperformance is too much for a fund manager to bear in an environment where he’s constantly being graded by quarterly performance milestones. It doesn’t take much for him to throw in the towel on value investing and chase momentum or glamour strategies in the hope of a short term gain.
Value Investing rewards patient investors who have the tenacity and contrarianism to wait out these periods of underperformance for the value to out. Bargains are not hard to find, the difficulty is in sticking to them when all around you are telling you to throw in the towel. As Warren Buffett has said “I don’t try to jump over 7-foot hurdles: I look for 1-foot hurdles that I can step over”… the difficulty is that those 1-foot hurdles lie far off the beaten track.
So what have we learnt?
As a strategy, value investing scores highly on the basis of its fundamental and psychological components. Academic research has shown that value portfolios frequently outperform stocks selected on the basis of growth or momentum. Meanwhile, the natural tendency of investors to, a) be generally negative about value stocks and, b) over-react or under-react to news about stocks, means that market psychology is a major boon for value investing. For those prepared to let their natural instincts take over and extrapolate too much from the past to predict the future, this is a problem. But for the contrarian Value Investor that is aware that others are contributing to the mispricing of stocks, knowledge is power.
So, if you don’t overtrade, have the discipline to hunt where others don’t look, invest time and money in good tools, and have a self-critical learning process that allows you to overcome your natural behavioural biases, then the potential to profit is enormous!
Why can’t someone value invest for me?
“The secret of being a top-notch con man is being able to know what the mark wants, and how to make him think he’s getting it.” Ken Kesey (One flew over the Cuckoo’s Nest)
So with all this compelling evidence of the power of value investing, can your fund manager be trusted to deliver the goods? Unfortunately, despite the growing evidence that value strategies work, it is unlikely that a well thought-through value-based investing approach is being put to work for you and your family or anyone else that saves money in a pension or unit trust or investment fund.
Indeed in an age of high-tech, high-speed trading, herd behaviour and information overload, the evidence overwhelmingly suggests that value investing simply doesn’t fit the mould for many institutional money managers and that Graham & Doddsville Value Investing managers are becoming increasingly hard to find.
Who hires these guys?
The extraordinary truth is that 75% of actively managed funds underperform their benchmark over the long term primarily due to high fees. Often the real cost of owning a fund is not published - once all these hidden fees are added to the published expenses the total annual cost of owning a fund can be over 4%.
As most fund managers typically make their money on fees rather than from making good investments their incentives are skewed towards gathering more money to manage rather than focusing on good investment performance.
The result? As their funds grow they have a tendency to chase glamour and momentum in large cap stocks rather than aiming at small cap value that both the Value Investors AND the academics have now shown provide the best returns in the market. Herd mentality takes over and your savings pay the price of mediocrity.
The pressure on fund managers to report consistent quarterly returns if they want to keep their jobs has a terrible impact on their holding periods. They regularly indulge in ‘window dressing’ to make it appear that they were smart in holding the glamour stocks and are typically holding stocks for shorter and shorter time horizons than are necessary for value strategies to pay off.
More generally, a mountain of research suggests that fund management is riddled with bad decision making, herd behaviour and excessive compensation leading to significant underperformance in the long term.
The only sane approach is to do it yourself
All this adds up to the fact that you can be fairly sure that no-one is applying the techniques of the world’s greatest investors on your behalf. So, if you want to reap the rewards you may have to do it yourself.
If you really don’t have the time to spend on your own financial welfare the simple way to ensure you beat the majority of fund managers is by investing in a tracker fund. Better than that you can invest in a growing number of Exchange Traded Funds that aim to follow the value investing creed.
But individuals who do have the time and discipline to do their own research are generally going to be better off taking investing matters into their own hands. Forget all the media noise about ruthless high-speed markets and fearsome traders working to arbitrage away mispricing. There are cheap, neglected, misjudged stocks out there and with the right techniques up your sleeve it isn’t so hard to find them and profit from them.