Although modern investment theory says the market is efficient, that isn’t quite true.
It’s possible to beat the market by value investing.
Value investors stress the current value of assets and earnings.
Securities prices move almost randomly.
The value of a company is the discounted sum of its future cash flows.
No one knows the future, but value investors use indicators of fundamental value as guidelines.
Yet there is such a thing as fundamental value.
Buy when the price falls below the fundamental value.
Yesterday’s under-performers are tomorrow’s stars. Yesterday’s stars are tomorrow’s dogs.
Real value exists only where there are barriers to entry. Only a few things (government regulation, costs, brand) create barriers to entry.
Why Value Investing Works
“The case for value investing as a superior approach is both theoretical and practical.”
Modern investment theory holds that the market is efficient. If that is true, then a stock price already reflects all the available information about a company. And, thus, you can’t beat the market except by chance. Modern investment theory also defines risk as volatility of returns, instead of loss of capital. And, theory dictates, the best approach is to buy a broad cross section, an "index," adjusted for your risk preference. Value investors think the stock market is not quite efficient for many reasons. Although value investing fell out of favor during the recent "New Economy" craze, the popping of that bubble confirmed the value investor’s suspicion of the market’s efficiency.
Many investors make decisions based more on emotion than on a rational analysis of data, as confirmed by new insights on behavioral finance. Moreover, some studies have found that portfolios assembled using variants of value-investing principles - such as low price to earnings ratios - beat the market indices. The market often overvalues or undervalues stocks. Sometimes a firm’s total stock market capitalization (share price multiplied by the number of outstanding shares) is less than its book value (assets minus liabilities). Thus, an investor could buy the whole firm on the market, sell its assets and make a profit.
What Is Value Investing?
“Investing may not be neurosurgery, but it isn’t child’s play either.”
In its simples terms, value investing is the process of calculating the fundamental value of a security, comparing this value to the market price and buying if the value is sufficiently higher than the price to provide a cushion against risk. Value investors are not, repeat not:
Technicians, who look only at price movement patterns, ignoring fundamental value.
Macro-fundamental, or top-down investors, who try to read and predict the market’s response to broad economic events but do not usually scrutinize individual stocks.
Price and earnings forecasters, who estimate future earnings based on various factors and buy when their estimate beats the market’s estimate, implied in the market price.
Value investing demands two virtues: humility and patience. Value investors have to know what they know and know what they don’t know. The best tend to specialize in one area and develop a real understanding of its economics, since a big, meaningful gap exists between "undervalued" and "cheap." Value investors have to wait until a real bargain comes along. When they find and buy it, they have to wait until the market recognizes the fundamental value and the market price adjusts. Both waits may be long.
“To recall a piece of wisdom Warren Buffett frequently cites, if you have been in the poker game for thirty minutes and still don’t know who the patsy is, you can be pretty certain the patsy is you.”
How do investors find value? Most securities are irrelevant to most value investors. The focus, at least in these pages, is on corporate bonds and, primarily, stocks.
“Graham loved his ’net-nets,’ the stocks he could buy for substantially less than the current assets of the company minus all its liabilities.”
Value investing could not work if the market were truly rational and efficient, but it is not. Major funds have policies that forbid them to own certain kinds of stocks. Some policies, for example, forbid investing in tobacco stocks. If enough funds share the same prohibition, then the price of such stock will be depressed because few investors will want it at any value. This depression may be permanent - unless the prohibitions are suddenly reversed, these stocks will not benefit even if the market recognizestheir value.
The second prohibition, one that matters greatly to value investors, concerns size. Many funds are forbidden to own small stocks, that is, stocks in firms with low market capitalization. As a result, the price of small stocks does not always reflect their full value. When small companies grow large enough for big investment funds to own them, the demand for them increases. Thus the stock of a company once too small to own now qualifies for purchase by the funds. For example, take spin-offs. Big firms often dispose of divisions by spinning them off as independent companies. The parent company sends each investor a proportionate number of shares in the spin-off. If - as often happens - the spin-off is too small to qualify for ownership by the fund that owns the parent company’s stock, the fund managers dump the spin-off on the market. Value investors often find bargains in spin-offs.
“But in the contemporary investment world, net-nets are, with only the rarest exception, a distant memory.”
Three categories where value investors may reasonably expect to find bargains are:
The obscure - This includes small stocks, spin-offs and boring stocks. Since funds can’t own small stocks, analysts don’t cover them and the stocks stay obscure. Spin-offs may be small, unheralded and dumped, despite their merits. And, the market tends to ignore boring firms that chug along in monotonous mediocrity. When they do something new, no one may be looking (except the astute value investor).
The pariahs - Bankrupts, companies in troubled industries and companies subject to lawsuits can all offer bargains because investors tend to over-react to bad news.
Special situations - The Resolution Trust Company took over busted Savings and Loans and pumped their assets into the market at bargain prices - bargains for investors with the expertise and time to find the real values. Some stocks may be good performers, except for one division that drags down the numbers. To boost the stock price, all management has to do is shoot the dog. However, finding and recognizing these special situations takes time and knowledge.
“Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral, nor - in our view - financially fattening).” [ Warren Buffett]
One way to calculate value is to estimate future cash flows but, since the future is unknown, this is basically a guess. Value investors consider three factors to compute fundamental value:
Assets - Look at the balance sheet. Work from the top down. Some values have to be adjusted because accounting numbers are more accurate for some assets and liabilities than for others. What matters is the assets’ value if they were sold today. If an industry is on the path to extinction, its equipment and inventory may not have more than scrap value. If the industry will continue to exist, the proper value is the "reproduction value," the cost of replacing the asset. In general, items at the top of the balance sheet - cash, receivables, inventory - have values close to the book value. The book value is more questionable farther down the balance sheet. Usually it’s possible to come up with an estimate more reliable than an estimate of future earnings. The assets and liabilities are real, exist now and do have some value.
Cash flow - Benjamin Graham and David Dodd used the Earnings Power Value (EPV) formula to calculate the level of distributable cash flow that a company could reasonably sustain. The formula is: "EPV = Adjusted Earnings x 1/R, where R is the current cost of capital." Because companies often artificially inflate earnings by booking some costs as allegedly non-recurring, the savvy value investor researches the history, calculates the usual ratio of such charges to reported earnings and reduces current reported earnings appropriately. The investor may need to make a similar adjustment for depreciation and amortization, which can also misrepresent the real need to reinvest. Finally, the investor considers the business cycle, adjusting earnings based on whether the company is at its top or bottom. The EPV must be sustainable. For assurance that it is, look for sustaining strategic advantages like franchise value.
Growth - Investors often overemphasize growth, but sales and earnings expansion may not add much value. Growth isn’t free. It requires equipment, inventory and capital. If a firm has a strong franchise, high entry barriers and an EPV much higher than asset value, growth may have value. Otherwise, it’s not worth much.
“Use knowledge to reduce uncertainty.”
Franchise value is the difference between EPV and asset value. Assess these categories:
EPV lower than asset value - Use the EPV as a guide to intrinsic value. Either management is doing a bad job (and could only be dislodged in a takeover) or the industry suffers from overcapacity (so increased value requires reduced capacity).
EPV approximately equal to asset value - Management is probably mediocre and the firm lacks a competitive edge. To check, examine management’s returns and judge whether they are about average. Is the industry stable, or do competitors come and go? This kind of firm may be a good value investment if market price falls far enough below fundamental value for a margin of safety, but growth estimates are worthless.
EPV is higher than asset value - If the difference is big, management may be outstanding, the company may have substantial competitive advantages or both. Great management can only worsen, so reduce EPV to reflect that risk. If the firm has a competitive edge, value investors test the sustainability of that advantage.
“We should be struck here by a glaring inconsistency between the precision of the algebra and the gross uncertainties infecting the variables that drive the model.”
A company making healthy profits will attract competitors while profit opportunities exist. Competitors stop coming when potential returns no longer exceed the cost of the capital needed to generate the returns, that is, when there is no profit. Thus a profitable firm with an EPV significantly bigger than its asset value, may not be a great investment. For example, Daimler-Benz made enormous profits in the ’60s, so other car makers launched competitive models. By the 1980s, the Mercedes Benz had competition from BMW, Jaguar, Rover, Citroen, Peugeot, Honda (Acura), Toyota (Lexus) and Nissan (Infiniti). Despite their car’s prestige, Daimler-Benz generated pretax returns of only 7.2% from 1995 to 1997 (calculated on identifiable assets in its automobile business). This is at or below the cost of capital.
“People remember the recent past better than the distant past, and they informally generalize from a few cases that are memorable rather than incorporate the full body of data into their analysis.”
A franchise only has value when competitors can’t easily enter the market and take chunks of it away. Only a few things create real barriers to entry:
Government - Licenses and other legally protected privileges, e.g. cable franchises.
Costs - Expense creates a barrier if the incumbent has cost advantages no one can duplicate, especially patents or proprietary knowledge a competitor can’t match or buy. Economies of scale matter; if unit costs fall as more units are produced, a new entrant can’t match a high-volume leader (absent new technology or processes).
Revenues - In rare cases, customers are so attached to a particular brand (think Coca-Cola) that it is very difficult for a new entrant to seduce them. Also, costly switching virtually traps customers, i.e., buyers of corporate software suites must also train staff and debug. Here, the cost of switching helps protect Microsoft’s franchise.
“We dislike risk and hate losing money.”
Identifying undervalued securities is not enough. An investor needs to assemble a portfolio of securities with prudent attention to risk, including a diversification strategy. Modern investment theory says investors will not be compensated for risk if they invest in only one or a few, closely related securities. For adherents of this theory, risk means up and down volatile returns. Value investors reject much of modern investment theory and its approach to diversification. But they don’t put all their eggs in one basket, either.
“Sitting still need not mean doing nothing.”
The diversifier reduces the correlation among investments in the portfolio so that the same wave doesn’t swamp all the ships. Value investors control risk by specializing in situations that don’t correlate with the market, such as take-overs, spin-offs, arbitrage, bankruptcy and workouts. They double-check their conclusions by watching insiders or knowledgeable investors and by closely scrutinizing their calculations for errors. They use position limits to restrict how much they invest in any one stock or security. Or, like Warren Buffett, they buy whole companies.