Value Investing (posted 27 Feb 99)

Most investors would claim to buy 'value' assets regardless of what they do in practice. After all, it would not be smart to say that your investment choices represent anything else. But value investing is more usually thought of as a particular investment style, in some ways contrarian, but generally as the counterpoint to growth investing (see CONTRARIAN INVESTING and GROWTH INVESTING).

A caricature of the investment world divides it into value investors - those who buy stocks that have fallen in price in the belief that the rest of the market has missed a bargain - and growth or momentum investors - who buy stocks that have gone up in the hope that they turn out to have been 'cheap at any price'. Value investors are typically thought of as painstaking, cautious and focused on safe and solid businesses (though value opportunities are often found among smaller cap stocks); while growth investors are portrayed as fun, trend-setting and focused on the prospects for tomorrow's winning companies (often those just recently launched on the market - see INITIAL PUBLIC OFFERINGS and INTERNET INVESTING).

Value investors believe that stock prices are often wrong as indicators of underlying corporate net worth. They dispute the efficient market hypothesis, which suggests that prices reflect all available information (see MARKET EFFICIENCY), and see investment opportunities created by discrepancies between stock prices and the underlying value of the asset. To uncover these opportunities, they use a variety of classic valuation tools, such as price-to-earnings (p/e) ratios, dividend yields and gearing. Typical characteristics of a value stock are a low p/e, a high yield and low gearing.

The man usually described as the world's first investment analyst, Benjamin Graham, who taught the first business school course on fundamental analysis at Columbia University in 1929, was also the father of value investing. Graham recommended that investors either buy and hold a portfolio of undervalued blue chips - what he called 'defensive investment' - or, if they are prepared to put a lot of time and energy into careful security analysis, pursue 'aggressive' or 'enterprising investment', hunting out bargains where there is a solid 'margin of safety' between the price paid for a stock and its 'true' value.

In his book The Intelligent Investor, Graham describes the benefits of low p/e investing: 'If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue - relatively, at least - companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should be both conservative and promising.'

Value investing guru: Warren Buffett

The modern day guru of value investing is Warren Buffett, though he dislikes the value/growth dichotomy and seems to have no single straightforward valuation formula. Buffett is one of the most celebrated and successful investors in the world and the returns on his investments over the past three decades have outperformed indexes of the US stock market. How has he done it?

Benjamin Graham wrote that 'investing is most intelligent when it is most businesslike', words that encapsulate Buffett's philosophy that the successful investor should buy a business rather than a stock. This means being able to answer three basic questions: is the business simple and understandable? Does it have a consistent operating history? And does it have favorable long-term prospects? Buffett has made most of his money out of sectors he knows intimately, such as media and financial services, and he rarely invests outside this 'circle of competence'. Knowing the industries, he can then look closely and critically at a company's market standing, earnings potential and management skills to evaluate whether he should invest in its stock.

Buffett buys companies that he likes and understands, 'good businesses' in which he can get to know the management and judge their actions in the context of his own experience. 'I am a better investor because I am a businessman, and a better businessman because I am an investor', he says.

Is management rational in its financial, operational and capital expenditure policies? Is it candid with the shareholders about performance and does it actively aim to maximize returns to shareholders? And does it resist the institutional imperative to act in its own interests rather than those of the shareholders? Buffett contends that these are all essential questions to ask before investing in a company. And even when proven talented new management comes into a weak company looking to turn it around, you still need to be careful. As Buffett quips, 'when a company with a reputation for incompetence meets a new management with a reputation for competence, it is the reputation of the company that is likely to remain intact.'

It is clear that Buffett's investments have often been more a judgment of the people running a company than the numbers. Nevertheless, there are some powerful and fundamental financial tenets underlying his evaluation of businesses. They include a focus on the measure of return on equity rather than earnings per share, a search for companies with high profit margins, and a check that, for every dollar retained, a company has created at least one dollar of market value. In addition, Buffett calculates 'owner earnings', a company's net income plus depreciation, depletion and amortization, less capital expenditure and any additional working capital.

Using these measures and the company's price quoted on the stock market, Buffett can answer two final questions about a potential purchase: what is the value of the business? And can it be purchased at a significant discount to its value? The critical factor in a successful investment, he contends, is determining the 'intrinsic value' of a business and paying a fair or bargain price for it. Opportunities arise when the market forces down the price of a good business or when investor indifference allows a superior business to be priced at half of its intrinsic value.

One principle that is central to Buffett's business analysis is that it does not matter what the overall stock market is doing. You should certainly be psychologically and financially ready for the market's inevitable volatility, and well prepared to see your holdings decline perhaps 50% in value without becoming panic-stricken. But you must also remember that the market is unpredictable and manic depressive, at times wildly excited or unreasonably depressed. Good businesses will not suffer from those moods over the long-term.

Similarly, Buffett would argue, there is no point in worrying about the economy and the impact that boom, recession, depression and recovery might have on your portfolio. Again you need to be prepared for the worst: 'Noah did not start building the Ark when it was raining.' But at the same time, you should be investing only in businesses that can be profitable in all economic environments, concentrating your analysis on the current and potential occupants of your portfolio rather than trying to make macroeconomic forecasts (see ECONOMIC FORECASTING).

Buffett is equally belligerent about how many different stocks the ideal portfolio should hold, the degree to which it should follow the principle of diversification. He is of the opinion that a portfolio should generally be concentrated on a limited number of businesses which the investor can get to know really well. Otherwise, returning to the Old Testament theme, 'one buys two of everything and in the end owns a zoo'. Berkshire's short list of equity assets reflects this view.

Buffett also believes that the best way to outperform the herd over the long-term is to avoid excessive trading of stocks and to reinvest dividends in order to compound gains. Indeed, Berkshire itself has not paid its shareholders a dividend since 1967. In times when many fund managers are constantly changing their portfolio, shifting in and out of a wide variety of stocks and incurring heavy dealing costs, a buy and hold strategy can be highly successful.

The important characteristic of such a strategy is that you do not need a lot of good ideas to do well. Brokers are always looking to encourage trading activity in your account. But just a few good decisions made and adhered to are as likely to give you the returns you are seeking, if not better. Buffett thinks the key is patience: 'lethargy bordering on sloth remains the cornerstone of our investment style'.

And you do not have to be an expert at corporate valuation to benefit from this style of investing. The main thing is to understand the businesses you own or plan to buy. That information can easily be gleaned through their annual reports, the relevant business and financial press and a host of other corporate data, much of which is easily available via the internet.

Counterpoint

Like beauty, value is in the eyes of the beholder. Critics would say that Warren Buffett does not practice value investing as defined by financial value. What he really does is buy intangible assets, often depressed big names. And his relationship investing, based as it is on extensive personal contacts across US business, hardly makes him a useful role model for the individual investor.

Dominant investors like Buffett have an opportunity to drive a hard bargain. When they are the buyer of last - or nearly last - resort, as should be the case with value investors, they can command special privileges from the companies they are investing in. Buffett has often bought a special class of stock directly from a company, which accords him dividend preference. In return, he has assured management of his continuing voting support (see CORPORATE GOVERNANCE). This guaranteed proxy voting may have unrecognized monetary value he is able to capture for his shareholders, potentially at a risk to other shareholders in the enterprise. He certainly cannot be seen as a shareholder advocate.

Keynes said if you want to forecast the outcome of a beauty contest, look at the judges, not the beauties. Value depends on stationarity of market factors with the same preferences persisting through time. Since price is generally more volatile than the underlying factors - conventional earnings, dividends, book value, sales or whatever - an attractive statistical relationship of price to these factors is often corrected by nothing more complex than regression to the mean.

Although value proponents ascribe their success to disciplined adherence to enduring truths like p/e, much of their success can be replicated by 'negative auto-correlation' or trend reversal. Not only is price more volatile than the underlying financial characteristics, but price may lead changes in those characteristics. Thus, if financial fortunes of earnings are changing, price changes may correctly anticipate those changes and may not be a good indicator of unrecognized investment merit.

A statistician would say that according to standard distribution, there must be someone occupying Buffett's performance slot and it would be someone who had done the right things. But is it a consequence of skill or luck? While Buffett mocks theorists of market efficiency, his superior performance still does not demonstrate that the market is not efficient or that active management will naturally outperform passive strategies like indexing (see ACTIVE PORTFOLIO MANAGEMENT and INDEXING).

Value investment tends to work best when the market as a whole is low. There are few guaranteed bargains when the market is highly priced, and with a strongly rising market, growth stocks often rise faster then value stocks. So the late 1990s, with a rampant bull market in the United States and elsewhere, have been grim times for most kinds of value investors. Years of poor performance are eroding the long-term case for value stocks.

In the United States, for example, the S&P 500 beat the Dow Jones Average by eight percentage points in both 1997 and 1998. The Dow has been hit by downgrades from fading industrial and consumer stocks, such as Boeing and Coke, while technology stocks, notably Microsoft, have supported the S&P. Economic conditions seem to be powerfully against value investing with falling long-term interest rates increasing the present value of growing revenue streams compared with static ones.

Furthermore, because value stocks tend to be weaker companies in cyclical industries, they are especially vulnerable to an economic slowdown. The assumption that the great companies will always survive and demonstrate their true value, which underlies the classic Graham view of investing, may no longer be true. These days, many leaders of the world's dominant corporations fear that in just a few years time, their 'lunch will be eaten' by competitors they have not yet heard of.

Jeremy Grantham of Grantham, Mayo, Van Otterloo & Co. LLC comments: 'Value stocks have been bid up to a level where they may not even have an appropriate risk premium far less an excess return. For value investing has always had a hidden but serious risk: the sixty year flood. The so-called price/book effect (and the small stock effect) sound like a free lunch, but in 1929-33, 20% of all companies went bankrupt. They were not the large high quality blue chips but small 'cheap stocks' with low price/book ratios. To add insult to injury, the data indicates that the best growth managers add more to growth than the best value managers can add to value, probably because the fundamentals and the prices are more dynamic for growth stocks.'

Where next?

Value investing is founded on a variety of security valuation tools. But if you had just a single question to ask of a company or industry - even a country - to determine the market value of a security, what would it be? It should probably be about borrowing capacity: can you borrow, how much and at what price? If you have this information, you need to have very little else. If the issuer of the security concerned can borrow more money at a lower cost than its competitors, then buy it.

The same holds true for a country. Currency of course is a method of borrowing - a representation on paper of the fulfillment of a promise to provide goods and services in the future, very much like borrowing. In the old days, borrowing was fulfilled by completion of a project and then the borrowing was paid off. But that is no longer true; now debt is rolled over and the ability to re-borrow in order to pay off old debt is essential for individuals, companies and countries.

For the tide to turn in favor of the value approach to investing, it is likely that small companies need to come out of their slump of the late 1990s. While value investing is not synonymous with small caps, highly valued markets suggest that value is more likely to be found among smaller companies. But with the contraction of liquidity, diminishing borrowing capacity and quality preference spreads widening, small caps are hurt lots and seem doomed to continue their bear market.

This also relates to emerging markets - small cap countries - except that the small caps in most emerging markets are local companies with local (rather than internationally trained) management and must borrow at local costs (usually much higher than the international borrowing costs of the large firms in those markets). Following the Asian crisis and its aftermath, the borrowing capacity of the large companies is severely limited and the small ones can get nothing except limited trade finance. Local players tend to speculate in the local companies and international investors in the well-known names. The indexes, mostly made up of large emerging market companies will go up and down now almost entirely on funds flowing from global (US and European) investors, not on fundamentals alone. And the locals will use small stocks for the speculation and trading on inside information (see EMERGING MARKETS and INTERNATIONAL MONEY).

Read on

In print

Benjamin Graham, The Intelligent Investor: A Book of Practical Counsel
Benjamin Graham and David Dodd, Security Analysis - the standard work on fundamental analysis, first published in 1934
Robert Hagstrom, The Warren Buffett Way
Janet Lowe, Warren Buffett Speaks
Roger Lowenstein, Buffett: The Making of an American Capitalist

Online

www.berkshirehathaway.com - website with Warren Buffett's annual letters to shareholders in Berkshire Hathaway