Value investing is synonymous with investing in undervalued businesses. The central idea is to invest in companies selling at a discount to their intrinsic value, and with an appropriate margin of safety. While the main ideas of value investing are well codified, how individual investors apply the concepts vastly differ.
Benjamin Graham: From Security Analysis to the Intelligent Investor
Graham needs little introduction for his contributions in making investing a profitable enterprise for those who apply his principles. My own view is that Security Analysis has less relevance (beyond its principles) to the modern investor than the Intelligent Investor. What is interesting is that towards the end of his days, Graham regarded his work in Security Analysis to be almost useless, and adopted a “basket approach” towards investing as opposed to researching and investing in individual companies with the rigour espoused in his earlier days.
Through interviews recorded with him in the late 70’s, his reasoning is clear. The advent of the financial analyst as a profession had made it much more difficult to find “undervalued businesses” per se. In this aspect, he was very much in the camp of the “efficient market theorist”. The proliferation of analysts with an understanding of his work made it easy for them to identify and buy “undervalued” businesses, effectively correcting the market inefficiency that existed in the first place.
This did not mean that dollar bills selling for 50 cents did not exist. Rather, they did not exist in a sufficient enough quantity to make it a worthwhile investment considering the time and effort spent. As such, he espoused a view that selecting companies based on the criteria given for both the Defensive Investor & the Enterprising Investor, combined with the sound principles of investing laid out in The Intelligent Investor would enable the intelligent investor to obtain a satisfactory return.
Towards the end of his life, he further refined his work into set criteria of 10 rules to follow.
List of 10 Stock Selection Criteria by Benjamin Graham:
1. An earnings-to-price yield at least twice the AAA bond rate
2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
3. Dividend yield of at least 2/3 the AAA bond yield
4. Stock price below 2/3 of tangible book value per share
5. Stock price below 2/3 of Net Current Asset Value (NCAV)
6. Total debt less than book value
7. Current ratio great than 2
8. Total debt less than 2 times Net Current Asset Value (NCAV)
9. Earnings growth of prior 10 years at least at a 7% annual compound rate
10. Stability of growth of earnings in that no more than 2 declines of 5% or more in yearend earnings in the prior 10 years are permissible.
The first 5 set of rules are primarily valuation based criteria that aim to ensure that any investments made fulfil the criteria of possessing a sufficient margin of safety. The second set of rules are a “safety criteria” that prevents investors from investing in over-leveraged institutions, or ensuring that there is some equity remaining in the event of a bankruptcy.
There have been numerous studies to show that as a whole, buying the lowest quintile of companies based on a simple criteria (i.e. P/E, P/B) results in superior results as opposed to the benchmark index and so called “glamour stocks” wherein lies businesses with the highest quintile in regards to valuation. However, this is much harder to implement in reality when it comes to forming ones portfolio.
What Graham’s later work (which was based on his research, using a back test of data of about 30 years) does is codify a simple and elegant way of investing based on sound principles that investors can implement easily. His set of criteria has been extensively back tested by (Henry R. Oppenheimer study) and more recently by James Montier, and the results have been most satisfactory.
His “basket approach” towards investing stands in stark contrast to his earlier work laid out in Security Analysis. However, there is no reason why someone familiar with fundamental analysis cannot apply his knowledge to filter out companies that he believe will or will not perform well in the future years, may it be for quantitative or qualitative factors.
Therein lays a danger however, of overestimating our abilities to outperform a system as it introduces many other performance variables into the system. The average investor will have to combat the influence of behavioural finance, such as anchoring, or growing attached to his purchased company. At other times, he may simply not have sufficient information, or may lack the ability (not for lack of trying) to properly analyze the situation.
In many ways, Graham’s basket approach is a simple quant strategy.
There is a need, in my opinion to address the idea of uncertainty. Contrary to what one may assume, earning a satisfactory return on one’s investment does not require prodigious memory or knowledge of the financial markets. What many esteemed individuals have established is that we need to know what we do not know.
With that in mind, there is a need for the investor to take an unbiased and honest account of his own capability and time that he can devote to his work to see if there exists a reason for him to modify an existing system which already works. Joel Greenblatt, the creator of the Magic Formula has provided for us a real time experiment of what happens with investors try to “interfere” with a system and the results are most revealing. Investors had an option of managing their own accounts, or having it professionally managed whereby stocks were systematically chosen, and sold and bought according to the magic formula. Investors with self managed accounts than proceeded to buy companies that they thought were “better” (because the prices were appreciating), and sold off companies that they thought wouldn’t do well (because prices were falling). Other investors simply gave up half way with the system when it failed to outperform the index.
The key take away in my opinion is that investors who choose to follow a system should establish – (1) its soundness (2) adhere to the set principles once you embark on it. In this case, I feel that Graham’s system, which was refined from his extensive years of experience should allow most investors to earn a satisfactory return as long as they take the long term view, and adhere to it.
Warren Buffett – Combining Quantitative with Qualitative
I am of the opinion that a reading of both biographies of Warren Buffett are required if an investor wishes to adopt his approach of investing, along with the numerous other interviews that can be found online to gain an understanding of how he operates. The essence of what he does is the same as Graham – expect that he applies it to a myriad of investment opportunities.
Moving away from equities, he may identify investments in debt instruments such as bonds which are mispriced, making them “undervalued”. Berkshire Hathaway operates very differently from most insurance companies, and may choose to make underwriting losses for years if it feels that the company is not being adequately compensated for the risk subsumed, only choosing to underwrite when prices become attractive again. Buffett takes a long term view towards his investments, but at the same time, he has no qualms about selling if the price is right (something that is often overlooked in the world of bite size information). He has taken Graham’s basic principle of investing in investments with appropriate margins of safety, and applied it different situations.
In a way, Buffett’s evolution was prompted by both experience and necessity. As his funds grew, the sphere of companies and opportunities that he could invest in shrunk. Graham’s style was much easily implemented by individual investors that it was for those with significant assets under management. Furthermore, buying whole “cigar butt” businesses proved much harder to dispose than their respective common stock as he came to realise later on. Finally, there is a psychological element to it that is rarely touched upon – that the liquidation of businesses often meant that real jobs was lost, livelihoods were affected. This often created resentment – not something that Buffett was particularly comfortable with.
Buffett was greatly influenced by his partner Charlie Munger, and Philip Fisher’s book – Common Stocks & Uncommon Profits. The focus here was on qualitative factors – whether management was good, whether a business had a sustainable competitive advantage and other such factors. Success often leaves clues – such as businesses earning a Return on Equity above the average rate of other companies in the same industry, or it being the lowest cost provider, or if the company has a sustainable competitive advantage. Such companies sell at a large discount to intrinsic value, and the goal is to pay a reasonable price in return.
Thus comes the difference in both Graham’s and Buffett’s approach. While Graham preferred to pay 50 cents for a dollar, Buffett was content to pay 70 – 90 cents for a dollar bill with a goal that that dollar bill would appreciate with time! Because Graham dealt with companies that were often cheap for a reason, there was great importance in not overpaying for it. Buffett on the other hand spent a great deal of time analyzing the company on other qualitative factors as his focus was to find a company that would steadily grow its business with time, allowing the share price to appreciate with it.
While Buffett’s approach has worked for Buffett, there are practical concerns that I have with books that detail the “Warren Buffett Way”, trying to encapsulate it in a hundred or so pages. The greatest problem is that while investors may have access to some of Buffett’s thinking, they do not have access to his knowledge. He has spent the past decades accumulating a vast array of knowledge in the industries. He has the time to pour over thousands of annual reports and books, to discuss matters with people in the industry. This is something that the average investor cannot achieve easily.
Regardless of which approach is taken, the central ideas of intelligent investing remain the same. Much as I would like to provide a “definitive” answer as to which approach is better, the truth is that there is none. Investors must evaluate honestly their abilities, and then decide for themselves which is better suited to them.
On a personal note, Graham’s quantitative approach appeals more to me, and his work forms the basis of how most of my investments are selected. That being said, I have also adopted Buffett’s approach for certain businesses that I feel sufficiently comfortable with.