Value investing

Last updated

Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. [1] The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham and David Dodd at Columbia Business School in 1928, and subsequently developed in their 1934 text Security Analysis .

Contents

The early value opportunities identified by Graham and Dodd included stock in public companies trading at discounts to book value or tangible book value, those with high dividend yields, and those having low price-to-earning multiples, or low price-to-book ratios.

High-profile proponents of value investing, including Berkshire Hathaway chairman Warren Buffett, have argued that the essence of value investing is buying stocks at less than their intrinsic value. [2] The discount of the market price to the intrinsic value is what Benjamin Graham called the "margin of safety". For the last 25 years, under the influence of Charlie Munger, Buffett expanded the value investing concept with a focus on "finding an outstanding company at a sensible price" rather than generic companies at a bargain price. [3] Hedge fund manager Seth Klarman has described value investing as rooted in a rejection of the efficient market hypothesis (EMH). While the EMH proposes that securities are accurately priced based on all available data, value investing proposes that some equities are not accurately priced. [4]

Graham never used the phrase "value investing" the term was coined later to help describe his ideas and has resulted in significant misinterpretation of his principles, the foremost being that Graham simply recommended cheap stocks. And now The Heilbrunn Center [5] is the home of the Value Investing Program [6] at Columbia Business School.

History

Benjamin Graham

Benjamin Graham (pictured) established value investing along with fellow professor David Dodd. Benjamin-Graham-fundamental.jpg
Benjamin Graham (pictured) established value investing along with fellow professor David Dodd.

Value investing was established by Benjamin Graham and David Dodd, both professors at Columbia Business School and teachers of many famous investors. In Graham's book The Intelligent Investor , he advocated the important concept of margin of safety  — first introduced in Security Analysis , a 1934 book he co-authored with David Dodd — which calls for an approach to investing that is focused on purchasing equities at prices less than their intrinsic values. In terms of picking or screening stocks, he recommended purchasing firms which have steady profits, are trading at low prices to book value, have low price-to-earnings (P/E) ratios, and which have relatively low debt. [7]

Further evolution

However, the concept of value (as well as "book value") has evolved significantly since the 1970s. Book value is most useful in industries where most assets are tangible. Intangible assets such as patents, brands, or goodwill are difficult to quantify, and may not survive the break-up of a company. [8] When an industry is going through fast technological advancements, the value of its assets is not easily estimated. Sometimes, the production power of an asset can be significantly reduced due to competitive disruptive innovation and therefore its value can suffer permanent impairment. One good example of decreasing asset value is a personal computer. An example of where book value does not mean much is the service and retail sectors. One modern model of calculating value is the discounted cash flow model (DCF), where the value of an asset is the sum of its future cash flows, discounted back to the present. [9]

Value investing performance

Performance of value strategies

Value investing has proven to be a successful investment strategy. There are several ways to evaluate the success. One way is to examine the performance of simple value strategies, such as buying low PE ratio stocks, low price-to-cash-flow ratio stocks, or low price-to-book ratio stocks. Numerous academics have published studies investigating the effects of buying value stocks. These studies have consistently found that value stocks outperform growth stocks and the market as a whole. [10] [11] [12] [13] A review of 26 years of data (1990 to 2015) from US markets found that the over-performance of value investing was more pronounced in stocks for smaller and mid-size companies than for larger companies and recommended a "value tilt" with greater emphasis on value than growth investing in personal portfolios. [14]

Performance of value investors

Simply examining the performance of the best known value investors would not be instructive, because investors do not become well known unless they are successful. This introduces a selection bias. A better way to investigate the performance of a group of value investors was suggested by Warren Buffett, in his May 17, 1984 speech that was published as The Superinvestors of Graham-and-Doddsville. In this speech, Buffett examined the performance of those investors who worked at Graham-Newman Corporation and were thus most influenced by Benjamin Graham. Buffett's conclusion is identical to that of the academic research on simple value investing strategies—value investing is, on average, successful in the long run.

During about a 25-year period (1965–90), published research and articles in leading journals of the value ilk were few. Warren Buffett once commented, "You couldn't advance in a finance department in this country unless you thought that the world was flat." [15]

Well-known value investors

The Graham-and-Dodd Disciples

Ben Graham's Students

Benjamin Graham is regarded by many to be the father of value investing. Along with David Dodd, he wrote Security Analysis, first published in 1934. The most lasting contribution of this book to the field of security analysis was to emphasize the quantifiable aspects of security analysis (such as the evaluations of earnings and book value) while minimizing the importance of more qualitative factors such as the quality of a company's management. Graham later wrote The Intelligent Investor , a book that brought value investing to individual investors. Aside from Buffett, many of Graham's other students, such as William J. Ruane, Irving Kahn, Walter Schloss, and Charles Brandes went on to become successful investors in their own right.

Irving Kahn was one of Graham's teaching assistants at Columbia University in the 1930s. He was a close friend and confidant of Graham's for decades and made research contributions to Graham's texts Security Analysis , Storage and Stability , World Commodities and World Currencies and The Intelligent Investor . Kahn was a partner at various finance firms until 1978 when he and his sons, Thomas Graham Kahn and Alan Kahn, started the value investing firm, Kahn Brothers & Company. Irving Kahn remained chairman of the firm until his death at age 109. [16]

Walter Schloss was another Graham-and-Dodd disciple. Schloss never had a formal education. When he was 18, he started working as a runner on Wall Street. He then attended investment courses taught by Ben Graham at the New York Stock Exchange Institute, and eventually worked for Graham in the Graham-Newman Partnership. In 1955, he left Graham’s company and set up his own investment firm, which he ran for nearly 50 years. [17] Walter Schloss was one of the investors Warren Buffett profiled in his famous Superinvestors of Graham-and-Doddsville article.

Christopher H. Browne of Tweedy, Browne was well known for value investing. According to the Wall Street Journal , Tweedy, Browne was the favorite brokerage firm of Benjamin Graham during his lifetime; also, the Tweedy, Browne Value Fund and Global Value Fund have both beat market averages since their inception in 1993. [18] In 2006, Christopher H. Browne wrote The Little Book of Value Investing in order to teach ordinary investors how to value invest. [19]

Peter Cundill was a well-known Canadian value investor who followed the Graham teachings. His flagship Cundill Value Fund allowed Canadian investors access to fund management according to the strict principles of Graham and Dodd. [20] Warren Buffett had indicated that Cundill had the credentials he's looking for in a chief investment officer. [21]

Warren Buffett & Charlie Munger

Graham's most famous student, however, is Warren Buffett, who ran successful investing partnerships before closing them in 1969 to focus on running Berkshire Hathaway. Buffett was a strong advocate of Graham's approach and strongly credits his success back to his teachings. Another disciple, Charlie Munger, who joined Buffett at Berkshire Hathaway in the 1970s and has since worked as Vice Chairman of the company, followed Graham's basic approach of buying assets below intrinsic value, but focused on companies with robust qualitative qualities, even if they weren't statistically cheap. This approach by Munger gradually influenced Buffett by reducing his emphasis on quantitatively cheap assets, and instead encouraged him to look for long-term sustainable competitive advantages in companies, even if they weren't quantitatively cheap relative to intrinsic value. Buffett is often quoted saying, "It's better to buy a great company at a fair price, than a fair company at a great price." [22]

Other Columbia Business School Value Investors

Columbia Business School has played a significant role in shaping the principles of the Value Investor, with professors and students making their mark on history and on each other. Ben Graham’s book, The Intelligent Investor, was Warren Buffett’s bible and he referred to it as "the greatest book on investing ever written.” A young Warren Buffett studied under Ben Graham, took his course and worked for his small investment firm, Graham Newman, from 1954 to 1956. Twenty years after Ben Graham, Roger Murray arrived and taught value investing to a young student named Mario Gabelli. About a decade or so later, Bruce Greenwald arrived and produced his own protégés, including Paul Sonkin—just as Ben Graham had Buffett as a protégé, and Roger Murray had Gabelli.

Mutual Series and Franklin Templeton Disciples

Mutual Series has a well-known reputation of producing top value managers and analysts in this modern era. This tradition stems from two individuals: Max Heine, founder of the well regarded value investment firm Mutual Shares fund in 1949 and his protégé legendary value investor Michael F. Price. Mutual Series was sold to Franklin Templeton Investments in 1996. The disciples of Heine and Price quietly practice value investing at some of the most successful investment firms in the country. Franklin Templeton Investments takes its name from Sir John Templeton, another contrarian value oriented investor.

Seth Klarman, a Mutual Series alum, is the founder and president of The Baupost Group, a Boston-based private investment partnership, and author of Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor, which since has become a value investing classic. Now out of print, Margin of Safety has sold on Amazon for $1,200 and eBay for $2,000. [23]

Other Value Investors

Laurence Tisch, who led Loews Corporation with his brother, Robert Tisch, for more than half a century, also embraced value investing. Shortly after his death in 2003 at age 80, Fortune wrote, "Larry Tisch was the ultimate value investor. He was a brilliant contrarian: He saw value where other investors didn't -- and he was usually right." By 2012, Loews Corporation, which continues to follow the principles of value investing, had revenues of $14.6 billion and assets of more than $75 billion. [24]

Michael Larson is the Chief Investment Officer of Cascade Investment, which is the investment vehicle for the Bill & Melinda Gates Foundation and the Gates personal fortune. Cascade is a diversified investment shop established in 1994 by Gates and Larson. Larson graduated from Claremont McKenna College in 1980 and the Booth School of Business at the University of Chicago in 1981. Larson is a well known value investor but his specific investment and diversification strategies are not known. Larson has consistently outperformed the market since the establishment of Cascade and has rivaled or outperformed Berkshire Hathaway's returns as well as other funds based on the value investing strategy.

Martin J. Whitman is another well-regarded value investor. His approach is called safe-and-cheap, which was hitherto referred to as financial-integrity approach. Martin Whitman focuses on acquiring common shares of companies with extremely strong financial position at a price reflecting meaningful discount to the estimated NAV of the company concerned. Whitman believes it is ill-advised for investors to pay much attention to the trend of macro-factors (like employment, movement of interest rate, GDP, etc.) because they are not as important and attempts to predict their movement are almost always futile. Whitman's letters to shareholders of his Third Avenue Value Fund (TAVF) are considered valuable resources "for investors to pirate good ideas" by Joel Greenblatt in his book on special-situation investment You Can Be a Stock Market Genius. [25]

Joel Greenblatt achieved annual returns at the hedge fund Gotham Capital of over 50% per year for 10 years from 1985 to 1995 before closing the fund and returning his investors' money. He is known for investing in special situations such as spin-offs, mergers, and divestitures.

Charles de Vaulx and Jean-Marie Eveillard are well known global value managers. For a time, these two were paired up at the First Eagle Funds, compiling an enviable track record of risk-adjusted outperformance. For example, Morningstar designated them the 2001 "International Stock Manager of the Year" and de Vaulx earned second place from Morningstar for 2006. Eveillard is known for his Bloomberg appearances where he insists that securities investors never use margin or leverage. The point made is that margin should be considered the anathema of value investing, since a negative price move could prematurely force a sale. In contrast, a value investor must be able and willing to be patient for the rest of the market to recognize and correct whatever pricing issue created the momentary value. Eveillard correctly labels the use of margin or leverage as speculation, the opposite of value investing.

Other notable value investors include: Mason Hawkins, Thomas Forester, Whitney Tilson, [26] Mohnish Pabrai, Li Lu, Guy Spier [27] and Tom Gayner who manages the investment portfolio of Markel Insurance. San Francisco investing firm Dodge & Cox, founded in 1931 and with one of the oldest US mutual funds still in existence as of 2019, [28] emphasizes value investing. [29] [30]

Criticism

Value stocks do not always beat growth stocks, as demonstrated in the late 1990s. [31] Moreover, when value stocks perform well, it may not mean that the market is inefficient, though it may imply that value stocks are simply riskier and thus require greater returns. [31] . Furthermore, Foye and Mramor (2016) find that country-specific factors have a strong influence on measures of value (such as the book-to-market ratio) this leads them to conclude that the reasons why value stocks outperform are country-specific. [32]

An issue with buying shares in a bear market is that despite appearing undervalued at one time, prices can still drop along with the market. [33] Conversely, an issue with not buying shares in a bull market is that despite appearing overvalued at one time, prices can still rise along with the market.

Also, one of the biggest criticisms of price centric value investing is that an emphasis on low prices (and recently depressed prices) regularly misleads retail investors; because fundamentally low (and recently depressed) prices often represent a fundamentally sound difference (or change) in a company's relative financial health. To that end, Warren Buffett has regularly emphasized that "it's far better to buy a wonderful company at a fair price, than to buy a fair company at a wonderful price."

In 2000, Stanford accounting professor Joseph Piotroski developed the F-score, which discriminates higher potential members within a class of value candidates. [34] The F-score aims to discover additional value from signals in a firm's series of annual financial statements, after initial screening of static measures like book-to-market value. The F-score formula inputs financial statements and awards points for meeting predetermined criteria. Piotroski retrospectively analyzed a class of high book-to-market stocks in the period 1976-1996, and demonstrated that high F-score selections increased returns by 7.5% annually versus the class as a whole. The American Association of Individual Investors examined 56 screening methods in a retrospective analysis of the financial crisis of 2008, and found that only F-score produced positive results. [35]

Another issue is the method of calculating the "intrinsic value". Some analysts believe that two investors can analyze the same information and reach different conclusions regarding the intrinsic value of the company, and that there is no systematic or standard way to value a stock. [36] In other words, a value investing strategy can only be considered successful if it delivers excess returns after allowing for the risk involved, where risk may be defined in many different ways, including market risk, multi-factor models or idiosyncratic risk. [37]

See also

Related Research Articles

Fundamental analysis analysis of a businesss financial statements

Fundamental analysis, in accounting and finance, is the analysis of a business's financial statements ; health; and competitors and markets. It also considers the overall state of the economy and factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management. There are two basic approaches that can be used: bottom up analysis and top down analysis. These terms are used to distinguish such analysis from other types of investment analysis, such as quantitative and technical.

To invest is to allocate money in the expectation of some benefit in the future.

Benjamin Graham American investor

Benjamin Graham was a British-born American economist, professor and investor. He is widely known as the "father of value investing", and wrote two of the founding texts in neoclassical investing: Security Analysis (1934) with David Dodd, and The Intelligent Investor (1949). His investment philosophy stressed investor psychology, minimal debt, buy-and-hold investing, fundamental analysis, concentrated diversification, buying within the margin of safety, activist investing, and contrarian mindsets.

Contrarian Investing is an investment strategy that is characterized by purchasing and selling in contrast to the prevailing sentiment of the time.

David Dodd American educator and economist

David LeFevre Dodd was an American educator, financial analyst, author, economist, professional investor, and in his student years, a protégé of, and as a postgraduate, close colleague of Benjamin Graham at Columbia Business School.

In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio. Individuals have different profit objectives, and their individual skills make different tactics and strategies appropriate. Some choices involve a tradeoff between risk and return. Most investors fall somewhere in between, accepting some risk for the expectation of higher returns.

<i>The Intelligent Investor</i> 1949 book by Benjamin Graham

The Intelligent Investor by Benjamin Graham, first published in 1949, is a widely acclaimed book on value investing.

Stock trader a person or company involved in trading equity securities (share stock in companies)

A stock trader or equity trader or share trader is a person or company involved in trading equity securities. Stock traders may be an agent, hedger, arbitrageur, speculator, stockbroker. Such equity trading in large publicly traded companies may be through a stock exchange. Stock shares in smaller public companies may be bought and sold in over-the-counter (OTC) markets.

Margin of safety is the difference between the intrinsic value of a stock and its market price.

<i>Security Analysis</i> (book) 1934 book by Benjamin Graham

Security Analysis is a book written by professors Benjamin Graham and David Dodd of Columbia Business School, which laid the intellectual foundation for what would later be called value investing. The first edition was published in 1934, shortly after the Wall Street crash and start of the Great Depression. Among other terms, Graham and Dodd coined the term margin of safety in Security Analysis.

Growth investing is a style of investment strategy focused on capital appreciation. Those who follow this style, known as growth investors, invest in companies that exhibit signs of above-average growth, even if the share price appears expensive in terms of metrics such as price-to-earnings or price-to-book ratios. In typical usage, the term "growth investing" contrasts with the strategy known as value investing.

Financial statement analysis

Financial statement analysis is the process of reviewing and analyzing a company's financial statements to make better economic decisions to earn income in future. These statements include the income statement, balance sheet, statement of cash flows, notes to accounts and a statement of changes in equity. Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, financial health, and future prospects of an organization.

"The Superinvestors of Graham-and-Doddsville" is an article by Warren Buffett promoting value investing, published in the Fall, 1984 issue of Hermes, Columbia Business School magazine. It was based on a speech given on May 17, 1984, at the Columbia University School of Business in honor of the 50th anniversary of the publication of Benjamin Graham and David Dodd's book Security Analysis. The speech and article challenged the idea that equity markets are efficient through a study of nine successful investment funds generating long-term returns above the market index. All these funds were managed by Benjamin Graham's alumni, following the same "Graham-and-Doddsville" value investing strategy but each investing in different assets and stocks.

John P. Reese is an American author, financial columnist, and money manager. He has written two books about investing, and is a columnist for several international financial publications, including Forbes magazine and Forbes.com; Canada's The Globe and Mail; RealMoney.com ; and the Israeli newspaper Globes.

Seth Andrew Klarman is an American billionaire investor, hedge fund manager, and author. He is a proponent of value investing. He is the chief executive and portfolio manager of the Baupost Group, a Boston-based private investment partnership he founded in 1982.

Walter Schloss American investor

Walter J. Schloss was an American investor, fund manager, and philanthropist. He was a well-regarded value investor, as well as a notable disciple of the Benjamin Graham school of investing. He died of leukemia at the age of 95.

A period of financial distress occurs when the price of a company or an asset or an index of a set of assets in a market is declining with the danger of a sudden crash of value occurring, either because the company is experiencing increasing problems of cash flow or a deteriorating credit balance or because the price had become too high as a result of a speculative bubble that has now peaked.

Mr. Market

Mr. Market is an allegory created by investor Benjamin Graham to describe what he believed were the irrational or contradictory traits of the stock market and the risks of following groupthink. Mr. Market was first introduced in his 1949 book, The Intelligent Investor.

The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's current market price to its book value. The calculation can be performed in two ways, but the result should be the same each way. In the first way, the company's market capitalization can be divided by the company's total book value from its balance sheet. The second way, using per-share values, is to divide the company's current share price by the book value per share.

Factor investing is an investment approach that involves targeting quantifiable firm characteristics or “factors” that can explain differences in stock returns. Over the last fifty years, academic research has identified hundreds of factors that impact stock returns. Security characteristics that may be included in a factor-based approach includes size, value, momentum, asset growth, profitability, leverage, term and carry.

References

  1. Graham, Benjamin, Dodd, David (1934). Security Analysis New York: McGraw Hill Book Co., 4. ISBN   0-07-144820-9.
  2. Graham (1949). The Intelligent Investor New York: Collins, Ch.20. ISBN   0-06-055566-1.
  3. "Value Investing Strategy | By Stock Markets Channel". www.stockmarkets.com. Retrieved 2018-09-06.
  4. Seth Klarman (1991). Margin of Safety: Risk-averse Value Investing Strategies for the Thoughtful Investor. HarperCollins, ISBN   978-0887305108, pp. 97-102
  5. "The Heilbrunn Center for Graham and Dodd Investing".
  6. "Value Investing Program".
  7. "The Benjamin Graham Stock Screen - Investing Like the Godfather of Value Investing". Pennies and Pounds.
  8. Investing Into Digital Assets
  9. "Discounted Cash Flow". Investopedia.com. Retrieved August 28, 2019.
  10. Basu, Sanjoy (1977). "Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis" (PDF). Journal of Finance. 32, no. 3 (June) (3): 663–682. doi:10.1111/j.1540-6261.1977.tb01979.x.
  11. The Cross-Section of Expected Stock Returns, by Fama & French, 1992, Journal of Finance
  12. Firm Size, Book-to-Market Ratio, and Security Returns: A Holdout Sample of Financial Firms, by Lyon & Barber, 1997, Journal of Finance
  13. Overreaction, Underreaction, and the Low-P/E Effect, by Dreman & Berry, 1995, Financial Analysts Journal
  14. Craig L. Israelsen (2011, updated 2016) Comparing the results of value and growth stock market indexes excerpted from Israelsen's 7Twelve: A Diversified Investment Portfolio with a Plan (John Wiley & Sons Inc.), ISBN   0470605278; Fidelity.com, accessed 07 Feb 2020
  15. Joseph Nocera, The Heresy That Made Them Rich, The New York Times, October 29, 2005
  16. "IRVING KAHN's Obituary on New York Times". New York Times. www.legacy.com. Retrieved 18 November 2016.
  17. The Walter Schloss Approach to Value Investing
  18. R.I.P. Peter Cundill « The Wealth Steward
  19. "Buffett likes the cut of Cundill's jib". Archived from the original on 2011-08-24. Retrieved 2012-02-02.
  20. Warren Buffett's 1989 letter to Berkshire Hathaway shareholders
  21. The $700 Used Book. (2006, Aug. 7). BusinessWeek, Personal Finance section. Accessed 11-11-2008.
  22. Brooker, Katrina. Like father, like son: A Tisch family story. Fortune, 2004-06-17
  23. Greenblatt, Joel (1999-02-25). You Can Be a Stock Market Genius. p.  247. ISBN   978-0-684-84007-9.
  24. "Tilson Funds". www.tilsonfunds.com. Retrieved 18 November 2016.
  25. "Guy Spier - Aquamarine Capital". Aquamarine Capital. Retrieved 18 November 2016.
  26. Barclay Palmer (2019) What Are the Oldest Mutual Funds? Investopedia.com, accessed 17 October 2019
  27. David B. Zenoff. The Soul of the Organization: How to Ignite Employee Engagement and Productivity at Every Level. Apress, Mar 1, 2014, p. 89
  28. Andrew Daniels (2017) Dodge & Cox: Built to Last, Morningstar.com, accessed 18 Jan 2020
  29. 1 2 Robert Huebscher. Burton Malkiel Talks the Random Walk. July 7, 2009.
  30. "A New Perspective on the International Evidence Concerning the Book-Price Effect".
  31. Conversely, an issue with not buying shares in a bull market is that despite appearing overvalued at one time, prices can still rise along with the market.When value investing Doesn't Work [ permanent dead link ]
  32. Piotroski, Joseph D. (2000). "Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers" (PDF). The University of Chicago Graduate School of Business. Retrieved 15 March 2020.
  33. "AAII: The American Association of Individual Investors". www.aaii.com. Retrieved 18 November 2016.
  34. "It's All About Style: Growth and Value Investing in Institutional Portfolios". www.jpmorgan.com. Archived from the original on 13 October 2013.
  35. Li, Xiaofei; Brooks, Chris; Miffre, Joelle (2009). "The value premium and time-varying volatility". Journal of Business Finance and Accounting. 36 (9–10): 1252–1272. CiteSeerX   10.1.1.187.3128 . doi:10.1111/j.1468-5957.2009.02163.x. ISSN   1468-5957.

Further reading