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Chapter 1
Value Investing
Definitions, Distinctions, Results, Risks, and Principles
What Value Investing Is
Value investing in the manner initially defined by Benjamin Graham and David Dodd rests on three key characteristics of financial markets:
- The prices of financial securities are subject to significant and capricious movements. Mr. Market, Graham's famous personification of the impersonal forces that determine the price of securities at any moment, shows up every day to buy or sell any financial asset. He is a strange fellow, subject to all sorts of unpredictable mood swings that affect the price at which he is willing to do business.
- Despite these gyrations in the market prices of financial assets, many of them do have underlying or fundamental economic values that are relatively stable and that can be measured with reasonable accuracy by a diligent and disciplined investor. In other words, the intrinsic value of the security is one thing; the current price at which it is trading is something else. Though value and price may, on any given day, be identical, they often diverge.
- A strategy of buying securities only when their market prices are significantly below the calculated intrinsic value will produce superior returns in the long run. Graham referred to this gap between value and price as 'the margin of safety'; ideally, the gap should amount to about one-half, and not be less than one-third, of the fundamental value. He wanted to buy a dollar for 50 cents; the eventual gain would be large and, more important, secure.
Starting with these three assumptions, the central process of value investing is disarmingly simple. A value investor estimates the fundamental value of a financial security and compares that value to the current price Mr. Market is offering for it. If price is lower than value by a sufficient margin of safety, the value investor buys the security. We can think of this formula as the master recipe of Graham and Dodd value investing. Where their legitimate descendants differ from one another--where each may add his or her unique flavor--is in the precise way they handle some of the steps involved in the process:
- Selecting securities for valuation
- Estimating their fundamental values
- Calculating the appropriate margin of safety required for each security
- Deciding how much of each security to buy, which encompasses the construction of a portfolio and a choice about the amount of diversification the investor desires
- Deciding when to sell securities
These are not trivial decisions. To search for securities selling below their intrinsic value is one thing; to find them is quite another. It is because the descendants have devised alternative methods that value investing has remained a vital discipline through all market conditions in the more than six decades since Graham and Dodd first published Security Analysis. Profiles of some of the more prominent descendants constitute the second half of this book.
What Value Investing Isn't
No rational investor admits to searching for securities selling for more than their underlying value. Everyone is looking to buy low and sell high. 1 What is it that differentiates real value investors, who are actually quite rare, from all the others who trade in the securities markets?
One large class of investors who obviously do not qualify are "technical" analysts, or technicians (see Figure 1.1). Technicians avoid fundamental analysis of any kind. They pay no attention to a company's balance sheet or income statement, its line of business, the nature of its product markets, or anything else that might concern a fundamental investor of any stripe. They care nothing for its economic value. Instead, they focus on trading data, that is, the price movements and volume figures for any security. They believe that the history of these movements, reflecting the supply and demand for that security over time, traces patterns that they can analyze to infer future price movement. They construct charts to represent this information, and they scrutinize them for signs that will predict how prices will move next and thus allow them to make a profitable trade. For example, momentum investors extrapolate the current price trend and buy securities whose prices are rising in the expectation that they will continue to go up. Sometimes they compare the day's price for the security to a trend line made up of the average prices of the last 30, 90, 150, or some other number of days. Crossing that trend line, up or down, can indicate a change in direction. Surely they intend to buy low and sell high, but low and high here refer to the previous and future prices of the security, unconnected to its fundamental value. For technical investors, Mr. Market is the only game in town. It is also a game that lends itself to trading--buying and selling over a very short term. Very few traders ignore technical information.
Even when we turn back to people who legitimately see themselves as fundamental investors, concerned with the real economics of the companies whose securities they buy, Graham and Dodd value investors are a distinct minority.
We can divide the class of fundamental investors into those who focus on macroeconomic issues and those who concentrate on the microeconomics of specific securities. Macrofundamentalists are concerned with broad economic factors that affect the universe of securities as a whole, or at least in large groups: inflation rates, interest rates, exchange rates, unemployment rates, and the rates of economic growth at the national or even international level. They closely monitor the actions of policy makers, like the Federal Reserve Board, and aggregate investor and consumer sentiment. They use their information to forecast broad economic trends, and they then use the forecasts to decide which groups of securities (or even individual issues) are likely to be most affected by the changes they predict. Their approach is often referred to as top down, starting with the overall economy and working down to specific companies and securities. Like every other investor, they intend to buy low and sell high, using what they hope are their superior predictions to move before the market as a whole recognizes what is happening. They do not, as a rule, do direct calculations of the value of individual securities or particular classes of securities, though such calculations could be consistent with a macrofundamentalist approach. Although there are some famous and successful macrovalue investors, most value investors in the Graham and Dodd tradition are microfundamentalists.
Even within the society of microfundamentalists--those who analyze the economic fundamentals of companies and look at securities one by one--value investors in the Graham and Dodd tradition are still a minority. A more common approach to microfundamentalist investing takes the current price of a stock or other security as the point of departure. These investors study the history of this security, noting how the price has moved in response to changes in those economic factors that are thought to influence it: earnings, industry conditions, new product introductions, improvements in production technology, management shakeups, growth in demand, shifts in financial leverage, new plant and equipment investments, acquisitions of other companies and divestitures of lines of business, and so on. There is more than enough to examine. They then try to anticipate how the critical variables on this list are likely to change, relying in large measure on company and industry sources as well as on their more general knowledge.
Most forecasts focus on company earnings. Security prices incorporate the market's collective prediction about future earnings. If these investors find that their estimates of future earnings and other important variables exceed the market's expectations, then they purchase the securities. They assume that when new information about earnings and the other matters is released, their predictions will be validated, and the market will drive up the price of the securities. They have bought low, based on superior knowledge of the future, and they intend to sell high.
Though this approach shares with value investing a concentration on economic fundamentals and specific securities, there are major differences. First, it focuses on prior and anticipated changes in prices, not on the level of prices relative to underlying values. One could apply this analysis equally well to a stock trading at 10, 20, or 50 times the forecast earnings. A value investor would not regard these situations as equivalent. Second, this approach does not incorporate an identifiable margin of safety to safeguard the investment from the capricious behavior of Mr. Market, who, after all, has been known to sink the price of shares in response to good news. So while Graham and Dodd value investing is most frequently a microfundamentalist approach, not all, or even most, microfundamentalists are value investors.
Each of these alternatives to value investing can lead to a successful investment record, provided it is carefully and diligently pursued. Statistical studies increasingly suggest that security prices and volumes do trace consistent and recognizable patterns (there are positive serial correlations in the short run and reversion to the mean over the longer term). There are successful technical investors. Macroeconomic variables can be forecast with some accuracy and will affect securities markets in systematic and identifiable ways. There are successful macrofundamentalist investors. Analysts who energetically pursue information from company and industry sources, ferreting out trends ahead of the pack, should in theory--and sometimes do in practice--obtain above-average investment returns.
Nevertheless, it is important to remember that security trading is a zero-sum game. For every buyer there is a seller, and the future will prove one of them to have made a mistake. Indeed, when we take effort and expense into account, approximately 70 percent of active professional investors have done worse than they would have by adhering to a passive and low-cost strategy of simply buying a share of the market as a whole--a representative sample of all available securities. We can acknowledge the effectiveness of passive management without having to subscribe to the idea that the price Mr. Market offers for a security is the best estimate of its fundamental value.
Does Value Investing Work?
The case for value investing as a superior approach is both theoretical and factual. We develop the theory in our detailed discussion of the procedures of modern value investing. We contend that these methods embody a surer practical use of economics and statistics than do the most popular alternatives. But investing is like other contact sports: The best proof of the theory is in the results. The historical record confirms that value investing strategies have worked; over extended periods, they have produced better returns than have both the leading alternatives and the market as a whole.
Three distinct sources provide evidence of this superiority. The first comes from a battery of mechanical selection tests. They work like this:
- Take all the stocks in some large universe, say the New York Stock Exchange or all the stocks in the Compustat database.
- Sort them into groups (deciles, quintiles, quartiles) using some measure of value, like market price to book price or market price to earnings; the value portfolios are those with low price-to-book or low price-to-earnings ratios.
- Record the prices at the start date, usually the first trading day of the year.
- Hold these portfolios for a fixed period of time, generally one year.
- Record the prices at the end of the year.
- Add the dividends paid to the change in prices to get the total return on holding each portfolio for that one year period.
- Compare the total returns of each portfolio.
Many studies have been conducted employing different versions of this approach. The results demonstrate almost invariably that the value portfolios produce better than average returns (average here meaning returns on the entire market) in almost all periods and all kinds of markets. Low market-to-book portfolios have outperformed the market by 3 to 5 percent a year or more, since the 1920s, and low price-to-earnings portfolios have had similar success. By contrast, portfolios constructed of highly priced stocks, measured by high market-to-book and high price-to-earnings ratios, have done poorly. Some studies refer to these as glamour portfolios. They are highly priced mainly because the companies have experienced rapid sales and earnings growth in the recent past. Unfortunately, all that success and expectations of more have already been incorporated into the stock price by the time the portfolios are constructed.
These mechanical selections of stocks do produce portfolios that look very much like those that a diligent value investor, analyzing stocks one by one, would construct, especially as value investing was practiced in its early period. But value investing is not the same thing as a mechanical approach--a computer program--that selects stocks on the basis of a statistical measure indicating which ones are cheap. Calculations of intrinsic value are usually more intricate and require more detailed knowledge of company and industry economics than can be disclosed by simple financial ratios. Nevertheless, the striking historical success of these value portfolios produced by mechanical selection should remind us of the high standards that an active value investing strategy must meet. Seventy percent of active professional money managers underperform the market; imagine how few exceed market performance by 3 to 5 percent annually over many decades.
It is reassuring, therefore, that some large investment management institutions that have adopted systematic value strategies in the Graham and Dodd spirit, such as Oppenheimer and Company and Tweedy, Browne, have records comparable to the mechanical value portfolios and superior to the market as a whole. 2 The performance of these institutions is the second source of support for the argument that value investing produces superior returns. Unlike the mechanical studies, which are backtests of selection rules applied to historical data, these institutions have generated real returns for real clients. Value investing works in the world as well as in the lab.
The final piece of evidence is those money managers whom Warren Buffett called the 'superinvestors of Graham and Doddsville.' To a remarkable extent, value investors in the Graham and Dodd tradition have dominated the select ranks of those money managers who have markedly outperformed the market over an extended period of time.
Is Extra Return the Reward for Extra Risk?
It is certainly possible that the higher returns achieved by value investing from each of these three sources--mechanically selected portfolios, value-oriented institutions, and individual Graham and Dodd investors--occur only because these portfolios are riskier than the market as a whole. If that were so, then their superior returns would be nothing more than an appropriate reward for bearing this increased risk. Academic financial experts have been emphatic in arguing not only that higher return is the reward for higher risk, but also that there is no way to beat the market's average return other than by assuming additional risk.
The problem with this argument is that when standard academic measures of risk--either annual return variability or beta as defined by modern finance theory--have been calculated for our value portfolios, they have generally been lower than the same risk measures applied to the market as a whole. In addition, value portfolios have proven to be less risky than the market as a whole when tested by other measures of risk, such as how much a stock drops in reaction to bad news about the company, the extent of price declines during bear markets, or simply the level of maximum loss experienced. These measures are closer to our common-sense understanding of risk and are more appropriate for value investors, who regard price fluctuations as opportunities to buy or sell, not as accurate estimates of the intrinsic worth of the security.
For our mechanically selected value portfolios, which have been subjected to the most thorough statistical scrutiny, their average one-year returns have been higher; their average three-year holding period returns have been higher; their average five-year holding period returns have been higher; they have provided superior returns during recessions; and they have outperformed glamour portfolios during the worst months for the stock market as a whole. The value approach, even in its mechanical application, is no fair-weather friend.
As another alternative approach to risk, we can refer to Warren Buffett's account of how he came to buy a large chunk of the shares of the Washington Post Company. The date was late 1973. It was a miserable time for the economy, the stock market, and the national temperament, and, naturally, a great moment for value investors. The market capitalization of the Washington Post Company had dropped to $80 million. At that moment, the whole company could have been sold to any of 10 buyers for at least $400 million. Clearly, Mr. Market was in a dreadful mood. Now, Buffett asked, had the market value of the stock declined again, from $80 million down to $40 million, would that have made a purchase of the shares more risky? According to modern investment theory, the answer is yes, because it would have increased the volatility of the prices. According to Buffett, the answer is not at all, because it would have increased an already ample margin of safety and lowered whatever risk--he thinks there was none to begin with--existed in the purchase. As a calculation of risk, the margin of safety has nothing in common with the volatility of a security's price. In order to use it, you have to acknowledge the existence of an intrinsic value and feel confident about your ability to estimate it.
Finding Value
The physical universe is probably expanding, but perhaps not any faster than the universe of securities and other investment vehicles, such as derivatives and mutual funds. To keep from losing their way in the vastness of investment space, value investors have relied on a three-phase process to direct their work:
- A search strategy to locate potentially rich areas in which value investments may be located;
- An approach to valuation that is powerful and flexible enough to recognize value in different guises, while still protecting the investor from succumbing to euphoria and other delusions;
- A strategy for constructing an investment portfolio that reduces risk and serves as a check on individual security selection.
We will discuss each of these steps in the chapters that follow.
Value investing is an intellectual discipline, but it may be that the qualities essential for success are less mental than temperamental. First, a value investor has to be aware of the limits of his or her competence. You have to know what you know and be able to distinguish genuine understanding from mere general competence. Most value investors are specialists in either particular industries or certain special circumstances, such as bankruptcy workouts. Not every stock that looks like a bargain is worth more than its price. You must be able to tell the difference between the underpriced and the merely cheap. Even the most broad-gauged investor does better operating within his or her circle of competence.
Second, value investing demands patience. You have to wait for Mr. Market to offer you a bargain. Fortunately, you are not compelled to act until that bargain is available. In Warren Buffett's useful analogy, investing is like batting without called strikes. You can take as many pitches as you want until you spot the one you like. Then you swing, and if you have done the analysis intelligently, your chances of success are high. What big league hitter wouldn't love to play under these rules? Patience is also necessary after the securities are bought. Even if you are correct about the intrinsic value, it generally takes time for the rest of the market to come around. After all, you bought it because it was out of favor. The market's estimate of its worth does not change overnight. A value investor needs to be able to sit still.
Sitting still need not mean doing nothing. What does a value investor do when he or she cannot find securities to buy that meet the dual criteria of falling within his or her circle of competence and being priced low enough to permit an adequate margin of safety? At one point in his career, Warren Buffett sent the money he had been managing back to the limited partners on the grounds that the market was so highly priced that he could find no place to invest it. (He did convince William Ruane to establish a mutual fund to accommodate those who wanted to stay invested.) But most money managers are reluctant to part with funds under their control. Value investors have traditionally parked the funds temporarily in money market instruments or other secure investments. That has been the default strategy. There are other default alternatives. An institutional equity manager, for example, whose performance is judged by comparing it to that of a benchmark portfolio like the Standard & Poor's 500, ought to select that benchmark as his or her default and only purchase stocks individually when they meet all the value criteria he or she has established. We will talk more about this issue when we discuss portfolio construction and diversification.
The Rest of the Book
Chapter 2 describes appropriate search strategies for value investors. Just as geologists hunting for oil, gold, or some other precious resource have created models that indicate what type of terrain is most likely to reward their drilling, value investors have methods for identifying areas of potentially rich investment opportunities. We explain why certain types of securities are more likely to be undervalued than the market as a whole, and how these securities can be identified.
Chapter 3 discusses valuation proper. We examine the standard approach to valuation--discounted cash flow analysis--and identify the serious flaws inherent in the application of this method. We then offer some alternatives originally presented by Graham and Dodd. The first is to put a value on the assets of a company by starting with its financial statements and then adjusting certain assets to reflect their true economic value, which is the cost of reproducing them at current prices. The most obvious candidate for a desirable security is a stock that is selling below the reproduction cost of its current assets--cash, receivables, inventory--after all liabilities have been paid. These are Benjamin Graham's famous net-net stocks, and although it was easier to find them during the Depression than it is today, such opportunities can occasionally be located.
A second way to calculate the company's intrinsic value is to examine its stream of earnings over a period of years and to estimate how much the company should earn on average over the course of a business cycle. This figure should correspond to a market-level return on the intrinsic (reproduction) value of the assets. When the earnings repeatedly exceed this norm, the company may have earnings power that supports an intrinsic value higher than its adjusted net worth. These situations are not common, but they are much less rare than Graham's net-nets. Finally, but only for those rare companies that possess a sustainable competitive advantage, the profitable growth of the firm needs to be incorporated into the valuation.
Chapter 4 provides a more detailed discussion and a real-world example of how a company should be valued on the basis of the reproduction costs of its assets. Chapter 5 presents a method for analyzing the earnings power value. For a company to generate earnings in excess of an average return on its adjusted net worth on a sustainable basis, it must have a franchise, which is a special and defensible competitive advantage. We explain the economics behind these competitive advantages, show how to recognize a franchise, and demonstrate how to value the securities in cases where a franchise exists. Chapter 6 applies this analysis to the recent history of a company with a franchise.
Chapter 7 deals with the least reliable ingredient of valuation: the value of growth. Wall Street loves growth, and companies love to grow; this is a match made in heaven. Managers gain recognition and power; they have more positions to fill and can promote generously; budgets expand; corporate jets abound. Growth means a move up in class. The problem is that most growth is not profitable in the crucial sense that there must be money left over after the additional capital required for growth has been compensated. The only profitable growth is growth within the franchise. This is hard to accomplish, and value investing as a discipline tries to inoculate the investor against paying for growth outside the franchise or for franchise growth that may never materialize. For value investors who are determined to buy growth--and who are willing to pay for it--this chapter describes approaches that put growth investing within a value framework and thus help guard against the siren call of profits increasing without end. The framework is the history of Intel as a company and as a potential investment.
Chapter 8 demonstrates how value investors construct portfolios to reduce risk over and above what is provided by the margin of safety for individual securities. There are times when Mr. Market is so euphoric that he puts a high price on everything he owns. Value investors have to be able to just say no and wait until Mr. Market comes to his senses--or better, until he turns so sour and negative that he will part with anything at a bargain price. At the same time, each value investor needs a default position for funds that have not found a value home. The default stance depends on the standards against which the investor is measured and on other circumstances that vary with the situation. We present some alternative default strategies.
In Part III we explore the distinctive approaches of eight value investors. Some of them are household names; others are known only to value investing aficionados. For most of them, we offer one or two live cases to show specifically how they put their methods to work. We believe that value investing is a genuine academic discipline, and that it is closely tied to economic and financial theory. But it is also a way to invest real money, and as such, the arguments are tested by results in the market.
