Value investing

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Value investing is an investment paradigm that derives from the ideas on investment that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis. Although value investing has taken many forms since its inception, it generally involves buying securities that appear under priced by some form of fundamental analysis.[1] As examples, such securities may be stock in public companies that trade at discounts to book value or tangible book value, have high dividend yields, have low price-to-earning multiples or have low price-to-book ratios.

High-profile proponents of value investing, including Berkshire Hathaway chairman Warren Buffett, have argued that the essence of value investing is buying stocks at less than their intrinsic value.[2] The discount of the market price to the intrinsic value is what Benjamin Graham called the "margin of safety". The intrinsic value is the discounted value of all future distributions.[citation needed] However, the future distributions and the appropriate discount rate can only be assumptions. ([citation needed] Graham never recommended using future numbers, only past ones). For the last 25 years, Warren Buffett has taken the value investing concept even further with a focus on "finding an outstanding company at a sensible price" rather than generic companies at a bargain price.[citation needed]

Graham never used the phrase, "value investing" — the term was coined later to help describe his ideas and has resulted in significant misinterpretation of his principles, the foremost being that Graham simply recommended cheap stocks.

History[edit]

Benjamin Graham[edit]

Value investing was established by Benjamin Graham and David Dodd, both professors at Columbia Business School and teachers of many famous investors. In Graham's book The Intelligent Investor, he advocated the important concept of margin of safety — first introduced in Security Analysis, a 1934 book he co-authored with David Dodd — which calls for a cautious approach to investing. In terms of picking stocks, he recommended defensive investment in stocks trading below their tangible book value as a safeguard to adverse future developments often encountered in the stock market.[citation needed]

Further evolution[edit]

However, the concept of value (as well as "book value") has evolved significantly since the 1970s. Book value is most useful in industries where most assets are tangible. Intangible assets such as patents, brands, or goodwill are difficult to quantify, and may not survive the break-up of a company. When an industry is going through fast technological advancements, the value of its assets is not easily estimated. Sometimes, the production power of an asset can be significantly reduced due to competitive disruptive innovation and therefore its value can suffer permanent impairment. One good example of decreasing asset value is a personal computer. An example of where book value does not mean much is the service and retail sectors. One modern model of calculating value is the discounted cash flow model (DCF), where the value of an asset is the sum of its future cash flows, discounted back to the present.[citation needed]

Value investing performance[edit]

Performance of value strategies[edit]

Value investing has proven to be a successful investment strategy. There are several ways to evaluate its success. One way is to examine the performance of simple value strategies, such as buying low PE ratio stocks, low price-to-cash-flow ratio stocks, or low price-to-book ratio stocks. Numerous academics have published studies investigating the effects of buying value stocks. These studies have consistently found that value stocks outperform growth stocks and the market as a whole.[3][4][5]

Performance of value investors[edit]

Simply examining the performance of the best known value investors would not be instructive, because investors do not become well known unless they are successful. This introduces a selection bias. A better way to investigate the performance of a group of value investors was suggested by Warren Buffett, in his May 17, 1984 speech that was published as The Superinvestors of Graham-and-Doddsville. In this speech, Buffett examined the performance of those investors who worked at Graham-Newman Corporation and were thus most influenced by Benjamin Graham. Buffett's conclusion is identical to that of the academic research on simple value investing strategies—value investing is, on average, successful in the long run.

During about a 25-year period (1965–90), published research and articles in leading journals of the value ilk were few. Warren Buffett once commented, "You couldn't advance in a finance department in this country unless you thought that the world was flat."[6]

Well-known value investors[edit]

Benjamin Graham is regarded by many to be the father of value investing. Along with David Dodd, he wrote Security Analysis, first published in 1934. The most lasting contribution of this book to the field of security analysis was to emphasize the quantifiable aspects of security analysis (such as the evaluations of earnings and book value) while minimizing the importance of more qualitative factors such as the quality of a company's management. Graham later wrote The Intelligent Investor, a book that brought value investing to individual investors. Aside from Buffett, many of Graham's other students, such as William J. Ruane, Irving Kahn and Charles Brandes have gone on to become successful investors in their own right.

Graham's most famous student, however, is Warren Buffett, who ran successful investing partnerships before closing them in 1969 to focus on running Berkshire Hathaway. Charlie Munger joined Buffett at Berkshire Hathaway in the 1970s and has since worked as Vice Chairman of the company. Buffett has credited Munger with encouraging him to focus on long-term sustainable growth rather than on simply the valuation of current cash flows or assets.[7] Columbia Business School has played a significant role in shaping the principles of the Value Investor, with professors and students making their mark on history and on each other. Ben Graham’s book, The Intelligent Investor, was Warren Buffett’s bible and he referred to it as "the greatest book on investing ever written.” A young Warren Buffett studied under Ben Graham, took his course and worked for his small investment firm, Graham Newman, from 1954 to 1956. Twenty years after Ben Graham, Roger Murray arrived and taught value investing to a young student named Mario Gabelli. About a decade or so later, Bruce Greenwald arrived and produced his own protégés, including Paul Sonkin—just as Ben Graham had Buffett as a protégé, and Roger Murray had Gabelli.

Laurence Tisch, who led Loews Corporation with his brother, Robert Tisch, for more than half a century, also embraced value investing. Shortly after his death in 2003 at age 80, Fortune wrote, “Larry Tisch was the ultimate value investor. He was a brilliant contrarian: He saw value where other investors didn't -- and he was usually right.” By 2012, Loews Corporation, which continues to follow the principles of value investing, had revenues of $14.6 billion and assets of more than $75 billion.[8]

Mutual Series has a well-known reputation of producing top value managers and analysts in this modern era. This tradition stems from two individuals: Max Heine, founder of the well regarded value investment firm Mutual Shares fund in 1949 and his protégé legendary value investor Michael F. Price. Mutual Series was sold to Franklin Templeton Investments in 1996. The disciples of Heine and Price quietly practice value investing at some of the most successful investment firms in the country.

Seth Klarman is a Mutual Series alum and the founder and president of The Baupost Group, a Boston-based private investment partnership, authored Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor, which since has become a value investing classic. Now out of print, Margin of Safety has sold on Amazon for $1,200 and eBay for $2,000.[9] Another famous value investor is John Templeton.

Irving Kahn, a notable value investor and the oldest active investment professional in the world, was one of Graham's teaching assistants at Columbia University in the 1930s. He was a close friend and confidant of Graham's for decades and made research contributions to Graham's texts Security Analysis, Storage and Stability, World Commodities and World Currencies and The Intelligent Investor. Kahn was a partner at various finance firms until 1978 when he and his sons, Thomas Graham Kahn and Alan Kahn, started the value investing firm, Kahn Brothers & Company. Irving Kahn remains chairman of the firm at the age of 108.

Michael Larson is the Chief Investment Officer of Cascade Investment, which is the investment vehicle for the Bill & Melinda Gates Foundation and the Gates personal fortune. Cascade is a diversified investment shop established in 1994 by Gates and Larson. Larson graduated from Claremont McKenna College in 1980 and the Booth School of Business at the University of Chicago in 1981. Larson is a well known value investor but his specific investment and diversification strategies are not known. Larson has consistently outperformed the market since the establishment of Cascade and has rivaled or outperformed Berkshire Hathaway's returns as well as other funds based on the value investing strategy.

Martin J. Whitman is another well-regarded value investor. His approach is called safe-and-cheap, which was hitherto referred to as financial-integrity approach. Martin Whitman focuses on acquiring common shares of companies with extremely strong financial position at a price reflecting meaningful discount to the estimated NAV of the company concerned. Martin Whitman believes it is ill-advised for investors to pay much attention to the trend of macro-factors (like employment, movement of interest rate, GDP, etc.) because they are not as important and attempts to predict their movement are almost always futile. Martin Whitman's letters to shareholders of his Third Avenue Value Fund (TAVF) are considered valuable resources "for investors to pirate good ideas" by another famous investor Joel Greenblatt in his book on special-situation investment You Can Be a Stock Market Genius (ISBN 0-684-84007-3, pp 247).

Joel Greenblatt achieved annual returns at the hedge fund Gotham Capital of over 50% per year for 10 years from 1985 to 1995 before closing the fund and returning his investors' money. He is known for investing in special situations such as spin-offs, mergers, and divestitures.

Charles de Vaulx and Jean-Marie Eveillard are well known global value managers. For a time, these two were paired up at the First Eagle Funds, compiling an enviable track record of risk-adjusted outperformance. For example, Morningstar designated them the 2001 "International Stock Manager of the Year" and de Vaulx earned second place from Morningstar for 2006. Eveillard is known for his Bloomberg appearances where he insists that securities investors never use margin or leverage. The point made is that margin should be considered the anathema of value investing, since a negative price move could prematurely force a sale. In contrast, a value investor must be able and willing to be patient for the rest of the market to recognize and correct whatever pricing issue created the momentary value. Eveillard correctly labels the use of margin or leverage as speculation, the opposite of value investing.

Christopher H. Browne of Tweedy, Browne was well known for value investing. According to the Wall Street Journal, Tweedy, Browne was the favorite brokerage firm of Benjamin Graham during his lifetime; also, the Tweedy, Browne Value Fund and Global Value Fund have both beat market averages since their inception in 1993.[4] In 2006, Christopher H. Browne wrote The Little Book of Value Investing in order to teach ordinary investors how to value invest.[5]

Peter Cundill was a well-known Canadian value investor who followed the Graham teachings. His flagship Cundill Value Fund allowed Canadian investors access to fund management according to the strict principles of Graham and Dodd.[10] Warren Buffett had indicated that Cundill had the credentials he's looking for in a chief investment officer.[11]

Amit Ayare, a Graham-Buffett-styled Value Investor, manages an Indian Equities Portfolio for Indian and Global High Net Worth Individual(HNI) Clients.

Josh Galt is an active swing trader who is also the founder and CEO of MAM Group and The Josh Galt Group. He is known for his ability to use trends in data to forecast market direction.[12] Galt uses the social media site YouTube to connect with investors and clients.[13]

Other notable value investors include: Mason Hawkins, Whitney Tilson, Mohnish Pabrai, Li Lu, Guy Spier and Tom Gayner who manages the investment portfolio of Markel Insurance.

Criticism[edit]

Value stocks do not always beat growth stocks, as demonstrated in the late 1990s.[14] Moreover, when value stocks perform well, it may not mean that the market is inefficient, though it may imply that value stocks are simply riskier and thus require greater returns.[14]

An issue with buying shares in a bear market is that despite appearing undervalued at one time, prices can still drop along with the market.[15] Conversely, an issue with not buying shares in a bull market is that despite appearing overvalued at one time, prices can still rise along with the market.

Also, one of the biggest criticisms of Value Investing is that it could potentially mislead retail value investors; this is because a low priced stock, or a stock that saw a drop in its price significantly, could be due to a fundamental change in the company's financial health. To that end, a Stanford accounting professor by the name of Joseph Piotroski developed a collection of metrics which he termed the "F-Score" that is designed to help weed out the under performers and winners in advance.

To determine which companies are in the best financial health, Professor Piotroski screens each stock based on an accounting-based checklist, awarding one point if the company met the pre-determined criteria. The results of this 'F-Score' proved interesting: in his paper, Professor Piotroski showed that over a 20-year test period, the returns earned by a value investor could be increased by 7.5% each year.[16] These results were also validated by an external source: according to the American Association of Individual Investors,[17] Piotroski's F-Score was the only one among its 56 screening methodologies that had positive results during the financial crisis of 2008.

Another issue is the method of calculating the "intrinsic value". Some analysts believe that two investors can analyze the same information and reach different conclusions regarding the intrinsic value of the company, and that there is no systematic or standard way to value a stock.[18] But there is no ambiguity in the calculated value in value investing as taught by Benjamin Graham. The stock selection procedures given by Benjamin Graham himself are very specific and are intended to avoid exactly this kind of subjectivity by focusing on documented and objective past numbers, instead of subjective and predicted future ones. The ambiguity arises only when investors use formulas not given by Graham or use subjective predicted numbers against Graham's recommendations.[19]

Value investing books and resources[edit]

See also[edit]

Value Investors at Wikiquote[edit]

References[edit]

  1. ^ Graham, Benjamin (1934). Security Analysis New York: McGraw Hill Book Co., 4. ISBN 0-07-144820-9.
  2. ^ Graham (1949). The Intelligent Investor New York: Collins, Ch.20. ISBN 0-06-055566-1.
  3. ^ The Cross-Section of Expected Stock Returns, by Fama & French, 1992, Journal of Finance
  4. ^ Firm Size, Book-to-Market Ratio, and Security Returns: A Holdout Sample of Financial Firms, by Lyon & Barber, 1997, Journal of Finance
  5. ^ Overreaction, Underreaction, and the Low-P/E Effect, by Dreman & Berry, 1995, Financial Analysts Journal
  6. ^ Joseph Nocera, The Heresy That Made Them Rich, The New York Times, October 29, 2005
  7. ^ Warren Buffett's 1989 letter to Berkshire Hathaway shareholders
  8. ^ Brooker, Katrina. Like father, like son: A Tisch family story. Fortune, 2004-06-17
  9. ^ The $700 Used Book. (2006, Aug. 7). BusinessWeek, Personal Finance section. Accessed 11-11-2008.
  10. ^ R.I.P. Peter Cundill « The Wealth Steward
  11. ^ Buffett likes the cut of Cundill's jib
  12. ^ [1]
  13. ^ [2]
  14. ^ a b Robert Huebscher. Burton Malkiel Talks the Random Walk. July 7, 2009.
  15. ^ Conversely, an issue with not buying shares in a bull market is that despite appearing overvalued at one time, prices can still rise along with the market.When Value Investing Doesn't Work
  16. ^ http://www.ruf.rice.edu/~rountree/FSA/Piotroski%20value%20investing%202000.pdf
  17. ^ http://www.aaii.com/journal/article/2008-aaii-stock-screen-roundup-piotroski-strategy-defeats-the-bear
  18. ^ [3]
  19. ^ Aren't quality and value of a stock subjective?
  20. ^ Graham and Dodd. 1934. Security Analysis: Principles and Technique, 1E. New York and London: McGraw-Hill Book Company, Inc.
  21. ^ Graham and Dodd. 1940. Security Analysis: Principles and Technique, 2E. New York and London: McGraw-Hill Book Company, Inc.
  22. ^ Graham et al. 1951. Security Analysis: Principles and Technique, 3E. New York: McGraw Hill Book Company, Inc.
  23. ^ Graham et al. 1962. Security Analysis: Principles and Technique, 4E. New York: McGraw-Hill Book Company, Inc.
  24. ^ Graham and Dodd. 1988. Security Analysis: Principles and Technique, 5E. McGraw-Hill Professional
  25. ^ Graham and Dodd. 2008. Security Analysis: Principles and Technique, 6E. McGraw-Hill Professional