Value Investment: The Approach And Its Applicability by Anton F. Balint
This article is designed to give the reader an overview on what value investment is, its establishment and application throughout the years and the reason why it has worked so well. Also, at the end, there will be a reading list with books, articles and other resources for those who want to take it a step further.
The bedrock of value investment
As Oaktree Capital’s Chairman, Marks Howard, put it in an interview with Joel Greenblatt, value means different things to different people. However, generally speaking, value investment is not a strict formula of identifying good investment opportunities but a philosophy – it is a way of viewing investment as a profession and the factors that influence it.
In the library of every value investor there are two books that form the basis of our investment philosophy and strategy: The Intelligent Investor and Security Analysis. The ideas in these holy books of value investment, written by the man who built his fortunes by following the principles presented in them – Benjamin Graham, have been applied rigorously by legendary investors such as Warren Buffett, Joel Greenblatt, Mohnish Pabrai, Peter Lynch and Guy Spier, to name just a few.
Benjamin Graham’s strategy focused on buying bargain stocks, i.e. stocks that traded to a discount to their liquidation value or ‘net nets’ (stocks that traded to a discount to their net value calculated as current assets minus total liabilities). Value investing is by definition a conservative philosophy of investment: it is built on two strong concepts that stood the test of time: ‘intrinsic value’ and ‘margin of safety’. They were created at a time when disclosure of company operations and accounting practices was not as transparent as it is today. It was a time when the American economy has been hit by the 1930s Great Depression and the wealth of many stock market investors was wiped out: a time of panic when reason was no longer king and impulsive decisions took over the investors’ minds and actions. Ben Graham understood these flaws of financial markets and developed a strategy based on mathematical decisions (financial statements’ analysis) and philosophical principles designed to protect his wealth from being wiped out.
However, over time the mathematical strategy put together by Benjamin Graham in Security Analysis, the book that helped Warren Buffett to start his career as an investor, became outdated. Nowadays, it is almost impossible to find stocks that trade at a deep discount to their liquidation value or even book value. Nonetheless, the principles expressed so clearly in his books stood the test of time and proved to work both in times of prosperity and after economic bubbles burst.
Times change but principles are eternal
It is at this point that value investors must be eager to learn and expand the application of these two concepts. One of the greatest additions to the value investment approach, is the work of Philip A. Fisher, the author of Common Stocks and Uncommon Profits and the man that influenced Charles Munger in his investment strategy and portfolio management. Philip Fisher focused on buying good businesses at good prices. He analysed a wide range of qualitative factors such as: the management’s ability to run the organization in a shareholder orientated manner, the company’s dedication to stay ahead of the competition by investing in R&D, the loyalty of its customers and the possibility of new market entrants. It is the idea of buying a quality business at cheap prices that turned Berkshire Hathaway into one of the world’s most valuable companies and that made the partnership between Mr. Buffett and Mr. Munger one of the most successful in financial history. It is also the man that crystalized Warren Buffett’s idea of long term competitive advantage-the moat: buying companies that enjoy large ‘moats’. Of course, identifying the competitive advantages of a company is no easy task and requires a combination of both quantitative and qualitative analysis but the effort pays off.
However, one investor took the ideas of margin of safety and intrinsic value a step further by twitching their application to match today’s market conditions. Before we discuss his contribution to value investment it is important to understand two things. Firstly, the success that Benjamin Graham and his scholars enjoyed by applying his investment strategy mathematically, in other words by analysing company reports and buying cheap businesses, was also due to the fact that the formula resonated with the market’s behaviour and psychology. This does not mean that it aligned itself with the market but on the contraire it worked perfectly to contradict the market in the right way. Secondly, the market’s behaviour is the result of its participants’ actions, more often than not, are impulsive and lack a rational justification: human feelings of panic, fear or hope and excitement take control over the ‘buy and sell’ decisions. As a result, each day the market presents us with a new list of prices that may or may not reflect the real value of the listed companies.
Tobias Carlisle, in his book Deep Value, suggested that buying stocks at a low acquiring multiple (defined as Enterprise Value divided by the Operating Earnings), on the long-term, the investors can cash on extremely good results. Remember, that value investment progressed from simply meaning buying cheap businesses to buying good businesses cheap. Therefore, by using Enterprise Value, the investor takes into account the debt the company has, and the operating earnings will allow the investor to compare the company with other opportunities in a more objective manner: the ‘bottom line’ or net earnings are usually subjected to extraordinary situations – one time losses or gains. Mr. Carlisle’s approach to apply the principles of value investment reflects the current market behaviour and economic conditions and that is why it works: low interest rates, fast access to information and an army of market participants focused on quarterly performance rather than business fundamentals tend to cause mispricing of companies. Of course, having a list of companies that sell at a low acquiring multiple will not guarantee above average returns: as value investors we are sceptical and we like to find the intrinsic value of our stocks. Therefore, a thorough analysis of the business, from its reports to its management’s attitude and consumer confidence, is necessary in order to make an investment decision.
These are just two of the many possible ways one can apply the principles of intrinsic value and margin of safety. Moreover, value investment, as a philosophy, shaped the meaning of various financial terms – like goodwill. Warren Buffett in a letter to shareholders in 1983, made the difference between accounting goodwill (the premium paid for the identifiable assets of a business when it is acquired that is then added in the balance sheet as an asset whose value decreases with time) and economic goodwill (the capitalized value of the excess return a company is believed to produce in the future). The arcane nature of these concepts can put many investors off. However, from a value investor’s perspective, you want to purchase businesses with a lot of economic good will and be warry of those that have their accounting goodwill as a vast proportion of their assets on the balance sheet.
We have seen how the philosophy was developed and its applicability changed in order to reflect the markets. However, we still need to assess why has it worked that well?
The market as a machine
John Bogle in his book, The Clash of Cultures, put forward many ideas for why a long-term approach to investment works. One of them was the reversion to the mean – prices tend to reverse to historical means. In other words, in long-term it is not the impulsive behaviour of the market that decides the value of the company but the company’s earnings power. Value investors will see a familiar idea between these lines: Ben Graham stated that in the short-term, the market is a voting machine but in the long run, the market is a weighing machine: the intrinsic value (the earnings power, the very qualitative fabric of the business) will be reflected only over time. It makes sense: we must allow the business to grow; we must give it a chance to prove its competitive advantage. This is what value investment, indirectly, does: it ignores the short term market vicissitude and allows us to focus on a long time horizon.
As promised above the conclusion will be a reading list for those that want to take it a step further and research more about value investment.
The Intelligent Investor – Benjamin Graham
Common Stocks and Uncommon Profits – Philip A. Fisher
The Warren Buffett Way – Robert Hagstrom
One up on Wall Street – Peter Lynch
Beating the Market – Peter Lynch
Poor Charlie’s Almanac – Charles Munger
The Manual of Ideas – John Mihaljevic
The Education of a Value Investor – Guy Spier
The Essays of Warren Buffett: Lessons for Investors and Managers – Warren Buffett
Outsiders: Eight Unconventional CEOs and Their Radical Blueprint for Success – William Thorndike
The Clash of Cultures: Investment vs. Speculation – John Bogle
Bull: A History of the Boom and Bust – Maggie Mahar
Oaktree Capital Chairman’s Memeos – found on Oaktree’s website
Accounting goodwill vs. Economic goodwill – http://www.berkshirehathaway.com/letters/1983.html
Greenbackd – Tobias Carlisle’s blog, http://greenbackd.com