Considering the popularity of value investing, it is somewhat surprising that a paper recently published by Joseph Calandro in the Journal of Investing was the first formal attempt to categorize the development of this highly-effective and influential school of thought over time. The following article summarizes this categorization of value investing's past and present and offers suggestions on what its future may hold.
Founding Era: 1934 to 1973
The “official” founding of value investing can be dated to 1934 with the publication of Benjamin Graham and David Dodd’s seminal book, Security Analysis. The strategic concept upon which value investing was founded is as insightful as it is simple; namely, that assets purchased at prices for less than their liquidation value (estimated as current assets less total liabilities or “net-net value”) provide an opportunistic and relatively low risk form of investment (where risk is defined as the possibility of loss) due to the “margin of safety” afforded by the discount from liquidation value.
Over time, some investors would come to base margins of safety off of earnings power and even growth value in addition to the balance sheet. Exhibit 1, taken from Professor Bruce Greenwald’s popular book Value Investing: From Graham to Buffett and Beyond, profiles the different approaches of modern value investing, as well as some of the professionals associated with each approach as of the book’s publication.
The cornerstone of value investing has always been, and will always remain, firmly grounded in the margin of safety principle, regardless of how any specific margin may be estimated. The Founding Era effectively ends with the publication of the 1973 edition of Graham’s immensely popular book, The Intelligent Investor, which distills lessons from Security Analysis to a non-professional audience. Shortly after the book’s publication, in 1976, Graham passed away at the age of 82.
Post-Graham Era: 1973 to 1991
The start of the Post-Graham Era coincides with the great 1973–74 bear market which, amongst other things, presented numerous investment opportunities akin to those seen at the beginning of the Founding Era. Therefore, it was not coincidental that such a market environment saw the ascendancy of a number of highly-successful value investors such as Gary Brinson, Jeremy Grantham, John Neff and others.
Nevertheless, it was during this period that modern financial economic theories were beginning to take hold. In his bestselling book, Capital Ideas, Peter Bernstein summarized these theories, all of which tend to find disfavor with professional value investors. For example:
- Economists believe that markets are “efficient,” while value investors know that, at times, markets can behave extremely inefficiently;
- Economists believe that capital structure is “irrelevant,” while value investors know that capital structure is always relevant (for example, a company financed with 100% debt is quite different from one financed with 100% equity);
- Economists believe that investments should be guided by modern portfolio theory and asset pricing models, while value investors understand, and carefully exploit, the fact that volatility and statistical measures of it are not risk; and
- The option pricing models of financial economics do not consider underlying value; conversely, to a value investor, value is a component of option pricing just like it is a pricing component for every other economic good.
Despite the success of professional value investors during this era, the challenge for the school’s theorists and practitioners was to determine how the basic insights of value investing could be reinterpreted for modern investors, and to demonstrate the significance of that reinterpretation given the market conditions investors were wrestling with.
Modern Era: 1991 to Present
To address the above challenge, value investor Seth A. Klarman, co-founder and president of The Baupost Group, picked up where Graham left off. The 20th and final chapter of The Intelligent Investor is titled, “‘Margin of Safety’ as the Central Concept of Investment,” while the title of Klarman’s 1991 book is Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. The lucidity of Klarman’s book, coupled with his investing track record, set the tone for the Modern Era of value investing.
Support for this position can be found in the influence that Margin of Safety has had on all of the prominent value investing books that were published after it, from Bruce Greenwald’s aforementioned book (chapter 13 of which profiles Klarman), to the sixth edition of Security Analysis (for which Klarman served as lead editor) to Howard Marks’s recently-published value investing book, The Most Important Thing Illuminated (which was endorsed by, and contains annotations from, Klarman).
One of the strengths of modern value investing theory is that it can be applied to all forms of investments, not just stocks and bonds. For example, consider derivatives. Bestselling books, like Michael Lewis’s The Big Short, demonstrate that a number of investors really did “catch” the recent financial crisis by purchasing credit default swaps (CDS) at margin of safety-consistent prices prior to the crisis. Significantly, one of those investors was Klarman. How did the investors do it?
While the specifics of their investments are not publicly available, there is a real-time record of similar investments in the influential and long-running value investing newsletter, Grant’s Interest Rate Observer, published by investor/historian/financial analyst/journalist James Grant. A compendium of Grant’s newsletters leading up to “the big short” was published in a bestselling book titled Mr. Market Miscalculates (Mr. Market being Graham’s euphemism for the short-term-oriented trading environment that dominates the financial markets). On page 171 of the book, which was taken from the September 8, 2006 edition of Grant’s Interest Rate Observer, it was noted that a hedge fund was “expressing a bearish view on housing in the CDS market by buying protection on the weaker tranches of at risk mortgage structures. At the cost of $14.25 million a year, the fund has exposure to $750 million face amount of mortgage debt.”
To see how margin of safety-rich this investment was at the time, consider the following: one way that commercial insurance companies evaluate risk pricing is to divide the premium of risk transfer (in this case, $14.25 million) by the amount of risk being transferred (in this case, $750 million), which here gives a “rate on line” of $0.014. By comparison, it is not uncommon for many businesses to pay $40,000 or more per year for $1 million of general liability insurance, which equates to a “rate on line” of $0.04.
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