Value investing

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.

Stock market board

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. The Heilbrunn Center[5] at Columbia Business School is the current home of the Value Investing Program[6]

History

While managing the endowment of King's College, Cambridge starting in the 1920s, economist John Maynard Keynes first attempted a strategy based on market timing, or predicting the movement of the finance market generally. When this method was unsuccessful, he turned to a strategy very similar to what would later be described as value investing. In 2017, Joel Tillinghast of Fidelity Investments wrote:

Instead of using big-picture economics, Keynes increasingly focused on a small number of companies that he knew very well. Rather than chasing momentum, he bought undervalued stocks with generous dividends. [...] Most were small and midsize companies in dull or out of favor industries, such as mining and autos in the midst of the Great Depression. Despite his rough start [by timing markets], Keynes beat the market averages by 6 percent a year over more than two decades.[7]

Keynes used many similar terms and concepts as Graham and Dodd (e.g. an emphasis on the intrinsic value of equities). But a review of his archives at King's College found no evidence of contact between Keynes and his American counterparts so he is believed to have developed his investing theories independently, and did not teach his concepts in classes or seminars as did Graham and Dodd. While Keynes was long recognized as a superior investor, the full details of his investing theories were not widely known until decades after his 1946 death.[8] Furthermore, while there was "considerable overlap" of Keynes's ideas with those of Graham and Dodd, their respective ideas were not entirely congruent.[9]

Benjamin Graham
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.[10]

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. 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.[11]

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.[12][13][14][15] 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.[16]

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."[17]

Well-known value investors

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.[18]

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.[19] 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.[20] In 2006, Christopher H. Browne wrote The Little Book of Value Investing in order to teach ordinary investors how to value invest.[21]

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.[22] Warren Buffett had indicated that Cundill had the credentials he's looking for in a chief investment officer.[23]

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."[24]

Buffett is a particularly skilled investor because of his temperament. He has a famous quote stating "be greedy when others are fearful, and fearful when others are greedy." In essence, he updated the teachings of Graham to fit a style of investing that prioritizes fundamentally good businesses over those that are deemed cheap by statistical measures. He is further known for a talk he gave titled the Super Investors of Graham and Doddsville. The talk was an outward appreciation for the fundamentals that Benjamin Graham instilled in him.

Michael Burry

Dr. Michael Burry, the founder of Scion Capital, is another strong proponent of value investing. Burry is famous for being the first investor to recognize and profit from the impending subprime mortgage crisis, as profiled by Christian Bale in The Big Short. Burry has said on multiple occasions that his investment style is built upon Benjamin Graham and David Dodd’s 1934 book Security Analysis: "All my stock picking is 100% based on the concept of a margin of safety." [25]

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.[26]

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.[27]

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.[28]

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"[29] 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,[30] Mohnish Pabrai, Li Lu, Guy Spier[31] 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,[32] emphasizes value investing.[33][34]

Criticism

Value stocks do not always beat growth stocks, as demonstrated in the late 1990s.[35] 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.[35] 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.[36]

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.[37] 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.[38] 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.[39]

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.[40] 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.[41]

See also

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. Joel Tillinghast (2017). Big Money Thinks Small: Biases, Blind Spots and Smarter Investing. Columbia University Press, ISBN 9780231544696
  8. Chambers, David and Dimson, Elroy, John Maynard Keynes, Investment Innovator (June 30, 2013). Journal of Economic Perspectives, 2013, Vol 27, No 3, pages 1–18, Available at SSRN: https://ssrn.com/abstract=2287262 or http://dx.doi.org/10.2139/ssrn.2287262
  9. J. E. Woods, On Keynes as an investor, Cambridge Journal of Economics, Volume 37, Issue 2, March 2013, Pages 423–442, https://doi.org/10.1093/cje/bes061
  10. "The Benjamin Graham Stock Screen - Investing Like the Godfather of Value Investing". Pennies and Pounds.
  11. "Discounted Cash Flow". Investopedia.com. Retrieved August 28, 2019.
  12. 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.
  13. The Cross-Section of Expected Stock Returns, by Fama & French, 1992, Journal of Finance
  14. Firm Size, Book-to-Market Ratio, and Security Returns: A Holdout Sample of Financial Firms, by Lyon & Barber, 1997, Journal of Finance
  15. Overreaction, Underreaction, and the Low-P/E Effect, by Dreman & Berry, 1995, Financial Analysts Journal
  16. 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
  17. Joseph Nocera, The Heresy That Made Them Rich, The New York Times, October 29, 2005
  18. "IRVING KAHN's Obituary on New York Times". New York Times. www.legacy.com. Retrieved 18 November 2016.
  19. The Walter Schloss Approach to Value Investing
  22. R.I.P. Peter Cundill « The Wealth Steward
  23. "Buffett likes the cut of Cundill's jib". Archived from the original on 2011-08-24. Retrieved 2012-02-02.
  24. Warren Buffett's 1989 letter to Berkshire Hathaway shareholders
  25. Raza, Sheeraz (2016-12-20). "Learning From Dr. Michael Burry's Investment Philosophy". ValueWalk. Retrieved 2020-11-18.
  26. The $700 Used Book. (2006, Aug. 7). BusinessWeek, Personal Finance section. Accessed 11-11-2008.
  27. Brooker, Katrina. Like father, like son: A Tisch family story. Fortune, 2004-06-17
  28. Greenblatt, Joel (1999-02-25). You Can Be a Stock Market Genius. p. 247. ISBN 978-0-684-84007-9.
  29. "Morningstar Hall of Fame: Fund Manager of the Year Winners". newsroom.morningstar.com. Retrieved 2020-11-02.
  30. "Tilson Funds". www.tilsonfunds.com. Retrieved 18 November 2016.
  31. "Guy Spier - Aquamarine Capital". Aquamarine Capital. Retrieved 18 November 2016.
  32. Barclay Palmer (2019) What Are the Oldest Mutual Funds? Investopedia.com, accessed 17 October 2019
  33. David B. Zenoff. The Soul of the Organization: How to Ignite Employee Engagement and Productivity at Every Level. Apress, Mar 1, 2014, p. 89
  34. Andrew Daniels (2017) Dodge & Cox: Built to Last, Morningstar.com, accessed 18 Jan 2020
  35. Robert Huebscher. Burton Malkiel Talks the Random Walk. July 7, 2009.
  36. "A New Perspective on the International Evidence Concerning the Book-Price Effect".
  37. 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
  38. Piotroski, Joseph D. (2000). "Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers" (PDF). Journal of Accounting Research. The University of Chicago Graduate School of Business. 38: 1–41. doi:10.2307/2672906. JSTOR 2672906. S2CID 18308749. Retrieved 15 March 2020.
  39. "AAII: The American Association of Individual Investors". www.aaii.com. Retrieved 18 November 2016.
  40. "It's All About Style: Growth and Value Investing in Institutional Portfolios". www.jpmorgan.com. Archived from the original on 13 October 2013.
  41. 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. S2CID 15777428.

Further reading
  • Graham, Benjamin; Dodd, David L. (2009) [1934]. Security Analysis. New York: McGraw-Hill. ISBN 978-0-07-159253-6.
  • Lowe, Janet (1996). Value Investing Made Easy: Benjamin Graham's Classic Investment Strategy Explained for Everyone. New York: McGraw-Hill. ISBN 978-0-07-038859-8.
  • The Theory of Investment Value (1938), by John Burr Williams. ISBN 0-87034-126-X
  • The Intelligent Investor (1949), by Benjamin Graham. ISBN 0-06-055566-1
  • You Can Be a Stock Market Genius (1997), by Joel Greenblatt. ISBN 0-684-84007-3.
  • Contrarian Investment Strategies: The Next Generation (1998), by David Dreman. ISBN 0-684-81350-5.
  • The Essays of Warren Buffett (2001), edited by Lawrence A. Cunningham. ISBN 0-9664461-1-9.
  • The Little Book That Beats the Market (2006), by Joel Greenblatt. ISBN 0-471-73306-7.
  • The Little Book of Value Investing (2006), by Chris Browne. ISBN 0-470-05589-8.
  • "The Rediscovered Benjamin Graham - selected writings of the wall street legend," by Janet Lowe. John Wiley & Sons
  • "Benjamin Graham on Value Investing," Janet Lowe, Dearborn
  • "Value Investing: From Graham to Buffett and Beyond" (2004), by Bruce C. N. Greenwald, Judd Kahn, Paul D. Sonkin, Michael van Biema
  • "Stocks and Exchange - the only Book you need" (2013), by Ladis Konecny, ISBN 9783848220656, value investing = chapter 2-5, 7, 8, 11-14
  • "Modern Security Analysis: Understand Wall Street Fundamentals" (2013), by Fernando Diz and Martin J. Whitman, ISBN 978-1118390047
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