Editor’s note: Ben Graham Formula some great data. The presentation comes from an occasional contributor to the website. It explains the methodology used for his value fund. Whether you are interested in the fund or not, the data and article is EXTREMELY interesting.
Ben Graham Formula – By Steven De Klerck
Slide 1: This presentation will explain the investment principles of the CAPITA Global Quant Value Fund. In a first step we will develop the necessary knowledge. Knowledge is the perfect counterbalance for the return-destroying emotions that often creep into our investment decisions. Next we will apply this knowledge with the development of the value strategy within the CAPITA Global Quant Value Fund. Finally we pay attention to the psychological pitfalls.
Slide 2: The presentation consists of six parts. In a first part we refer to the founding father of fundamental quantitative analysis and value investing: Benjamin Graham. In a second and third part we discuss the historical results of quantitative value investing with a focus on financial safety. Subsequently the acquired knowledge is transformed step by step in the investment strategy used within the CAPITA Global Quant Value Fund. We will observe that successful value investing technically is simple. “Investing is simple, but not easy”, Warren Buffett appropriately quoted. With regard to the “not easy” part, as investors, we often are confronted with emotions (doubt, fear, panic, greed,…), notably in periods of inferior and/or negative returns. In the last part but one we pay attention to the way in which Benjamin Graham advised investors to deal with these emotions. In a final part we discuss the conclusions.
Slide 3: Ben Graham’s investment philosophy
Slide 4: We start with a concise retrospective of Benjamin Graham’s investment philosophy. With Security Analysis(1934) and The Intelligent Investor (1949) Graham laid the foundations of quantitative value investing. Security Analysiswas written at the time of The Great Depression. In this book Graham looks back over this for investors extremely difficult period; in nominal terms the Dow Jones dropped no less than 90%. Graham, amongst other things, comments upon the mistakes which investors over the period 1925-1929 fell victim to. Graham was also Warren Buffett’s professor at Columbia University. Warren Buffett described The Intelligent Investor as “By far the best book on investing ever written.”
Slide 5: Successful investing, as Graham concludes in The Intelligent Investor, requires the combination of both an adequate safety margin for each stock on the one hand and a wide diversification of risk on the other.
Slide 6: An adequate safety margin for a stock is looked after by focusing on the so-called “intrinsic value factors”. This implies the focus on fundamental quantitative elements such as “earnings, dividends, assets and capital structure”. Based on these accounting numbers valuations (e.g. a price-to-earnings ratio) and other financial ratios (e.g. solvency) can be calculated. All too often investors use speculative, subjective elements as input to investment decisions.
Slide 7: With speculative elements Graham means the “intangible value factors” such as the assessment of management and forecasts of future pay-offs. Such “intangible value factors” are not objectively quantifiable; the valuation of these factors is extremely subjective and fluctuates widely with the optimism and pessimism on the stock market. In Security Analysis (1934) Graham refers for example to The Roaring Twenties or The New Era; from 1925 through 1929 the valuation of the US stock market substantially surpassed the historical average. More and more investors paid attention to future earnings expectations, expectations that invariably were raised in order to account for the absurd valuations.
In 1949 Benjamin Graham concluded that the fundamental quantitative approach has realized attractive returns in the past. In the next part of this presentation we will see that this quantitative approach also has evidently realized strong returns in the decades after 1949.
Slide 8: Empirical evidence – Part 1
Slide 9: We begin with the academic – and at the same time very simple – definition of a value stock and a growth stock. A value stock is defined as a stock with a (relatively) low price-to-book, price-to-sales, price-to-earnings and/or price-to-cash flow ratio (or possibly other indicators such as for example the enterprise value-ebit ratio). Companies with a price-to-book ratio smaller than 1, a price-to-sales ratio smaller than 0.75 and/or a price-to-earnings ratio smaller than 10 usually are considered to be value stocks. A growth stock is defined as a stock with a (relatively) high price-to-book, price-to-sales, price-to-earnings and/or price-to-cash flow ratio. Companies with a price-to-book ratio larger than 3, a price-to-sales ratio larger than 2 and/or a price-to-earnings ratio larger than 25 usually are considered to be growth stocks.
Slide 10: Numerous studies have documented the historical returns of value stocks versus those of growth stocks, both in developed markets, emerging markets and in frontier markets. One of these studies was published in 2004 by Chan & Lakonishok. In this study the largest US companies, in terms of market capitalization, are divided in ten stock portfolios. The first portfolio, the value portfolio, contains the stocks with the lowest valuation in terms of price-to-book, price-to-sales, price-to-earnings and price-to-cash flow. The tenth stock portfolio, the growth portfolio, includes the stocks with the highest valuation in terms of price-to-book, price-to-sales, price-to-earnings and price-to-cash flow. Each year stock portfolios are established based on these valuation measures. Subsequently Chan & Lakonishok (2004) document the returns of these ten stock portfolios over the 1969-2000 period. What is to be concluded? The value portfolio realizes a compound annual return of 15.6%; the growth portfolio realizes a return of only 6.2%.
Slide 11: The study by Chan & Lakonishok (2004) runs out in 2000. We have implemented this study over the 1969-2013 period. Again we note a return of 15.2% for value stocks. For growth stocks we document a compound annual return of only 8.4%. We would like to highlight the simplicity of this investment strategy. Four simple valuation measures. A pure focus on objective, quantifiable criteria. No subjective, qualitative inputs. No forecasts.
Slide 12: What explains the higher historical returns of value stocks? The veil was already raised when discussing Ben Graham’s investment philosophy, in the beginning of this presentation. Graham warns investors to introduce as less as possible subjective elements, such as future earnings expectations, when taking investment decisions. The subjective elements, as Graham literally posed, “are not susceptible to mathematical calculation”. The introduction of “intangible value factors” results in overoptimistic growth expectations, in particular for growth stocks and promising companies. This viewpoint was confirmed by Skinner & Sloan (2002). Skinner & Sloan (2002) in a nutshell show that growth stocks, following the publication of disappointing results, are punished much worse than value stocks. In case of results which are in accordance with or exceed expectations there is no significant difference between the returns of value stocks and growth stocks. The findings of Skinner & Sloan (2002) perfectly match the vision of Graham in The Intelligent Investor (1949):
What seems to happen, rather, is that the price remains high until the earnings actually show a definite falling off – which invariably seems to take the followers of the issue by surprise. Then we have the market decline usually associated with a disappointing development – a decline