Benjamin Graham

In the academic literature a value stock is defined as a company with a low price-book, price-sales, price-earnings and/or price-cash flow ratio. A company with both of the following characteristics is considered to be a value stock, regardless of the company’s financial strength:
*price-book: 0.5,
*price-earnings: 8.

In our article The determinants of financial strength we provided the following advice for investors:

Hence we recommend always guaranteeing – either on a stock level or on a portfolio level – minimal safety margins regarding financial strength prior to taking a look at the two other risks, valuation risk and business risk. Based on the above discussed quantitative measures of financial strength value investors can work out investment strategies with an extremely low financial risk profile, guaranteeing not only an almost non-existent “permanent loss of capital” – as coined by Benjamin Graham – but also strong performance during downturns and significant long-term outperformance.

Consequently from a Grahamite point of view the aforementioned two characteristics are insufficient to consider a company to be a value stock. In order to define – within a Grahamite framework – a company as a value stock, this also depends on the financial strength of the company concerned. The following table illustrates this issue. The company in the first column can only be defined as a value stock from an academic point of view. The company in the last column can – considering the combination of low valuation and sufficient financial strength – be defined as a value stock from a Grahamite point of view.

Academic value Grahamite value
 

*price-book: 0.5

*price-earnings: 8

*debt to equity: 300%

*equity to total assets: 20%

 

*price-book: 0.5

*price-earnings: 8

*debt to equity: 50%

*equity to total assets: 55%

The relevance of the aforementioned insights is emphasized by the actual returns of LSV Asset Management.* The Conservative Equity Value Fund started with a Net Asset Value of $10 in 2007. On April 30, 2012, this document shows a Net Asset Value of $7.30, significantly below the starting value. A closer look at the document shows that financials comprise 27.3% of the total stock portfolio. Financials suffered a major blow during the financial crisis, as shown by theKBW Bank index, and were only saved by the monetary largesse of the Federal Reserve. The fact that financials are part of the portfolio is illustrative of the fact that at LSV they implement academic value. Consequently, avoiding a “permanent loss of capital” cannot be guaranteed.

In a recent quarterly letter Jeremy Grantham accentuated the problem of career risk faced by asset managers:

For us agents, he [Keynes] might better have said “The market can stay irrational longer than the client can stay patient.”

Some investors will definitely always quit value investing after a couple of years of under- or negative performance. “Human nature is not much affected by the passing years.” By guaranteeing objective, quantifiable minimal safety margins regarding financial strength agents can nevertheless hope to increase the clients’ confidence in the solidness of the stock portfolio in which they are invested.** This confidence can contribute to emotionally learning to tide over distressing periods (e.g. 2007-2009) and/or the inevitable periods of underperformance.

* LSV Asset Management was established by Lakonishok, Shleifer and Vishny. The three professors are well known for their seminal 1994 research paper.

** Quantifying the financial strength of a company does not require rocket science. Some simple ratios derived from the financial statements will do the job.

By Steven De Klerck