I’ve started dabbling in stocks like many who bought and sold shares based on a recommendation, tips, and gut feel. At the beginning, knowing a little was a dangerous thing, for instance, I learned a bit about technical analysis and tried to speculate with money I do not have. I clearly got burnt and I found myself very distracted in my course of work. I was frustrated I could not perform better which I know I could at work. This is when I decided to change my approach and I studied value investing and decided to be a good value investor. I never looked back. Let me share with you what I know that triggered my interest.
Value investors are bargain hunters and many investors describe themselves as such. But who is a value investor? In this article, we begin by addressing this question and argue that value investors come in many forms. Some value investors use specific criteria to screen for what they categorize as undervalued stocks and invest in these stocks for the long term. Other value investors believe that bargains are best found in the aftermath of a sell-off and that the best time to buy a stock is when it is down. Still, others adopt a more activist approach, where they buy large stakes in companies that they believe are undervalued and push for changes that they believe will unleash this value.
Value investing is backed by empirical evidence from financial theorists and by anecdotal evidence– the success of value investors like Ben Graham and Warren Buffett are part of investment mythology– but it is not for all investors. We will consider what investors need to bring to the table to succeed at value investing.
Who is a Value Investor?
Morningstar is a widely used source of mutual fund information, and it categorized 38% of mutual funds as value funds in 2001. But how did it make this categorization? While it did look at the way these funds described themselves in their prospectus, the ultimate categorization was based on a far simpler measure. Any fund that invested in stocks with low price-to-book ratios or low price-earnings ratios, relative to the market, was categorized as a value fund. This categorization is fairly conventional, but we believe that it is too narrow a definition and misses the essence of value investing.
Another widely used definition of value investors suggests that they are investors interested in buying stocks for less than what they are worth. But that is too broad a definition because you could potentially categorize most active investors as value investors on this basis. After all, growth investors (who are often viewed as competing with value investors) also want to buy stocks for less than what they are worth. So, what is the essence of value investing? To understand value investing, we have to begin with the proposition that the value of a firm is derived from two sources– investments that the firm has already made (assets in place) and expected future investments (growth opportunities). What sets value investors apart is their desire to buy firms for less than what their assets-in-place are worth. Consequently, value investors tend to be leery of large premiums paid by markets for growth opportunities and try to find their best bargains in more mature companies that are out of favor.
Even with this definition of value investing, there are three distinct strands that we see in value investing. The first and perhaps simplest form of value investing is passive screening, where companies are put through a number of investment screens– for example, low PE ratios, marketability, and low risk– and those that pass the screens are categorized as good investments. In its second form, you have contrarian value investing, where you buy assets that are viewed as untouchable by other investors because of poor past performance or bad news about them. In its third form, you become an activist value investor who buys equity in undervalued or poorly managed companies but then use the power of your position (which has to be a significant one) to push for change that will unlock this value.
Benjamin Graham: The Passive Screener
There are many investors who believe that stocks with specific characteristics– good management, low risk, and high-quality earnings, for example– outperform other stocks and that the key to investment success is to identify what these characteristics are. While investors have always searched for these characteristics, it was Ben Graham in his classic books on security analysis who converted these qualitative factors into quantitative screens that could be used to find promising investments.
Many value investors claim to trace their antecedents to Ben Graham and to the book on security analysis he co-authored with David Dodd in 1934 as their investment bible. But who was Ben Graham, and what were his views on investing? Did he invent screening, and do his screens still work?
Ben Graham started life as a financial analyst and later was part of an investment partnership on Wall Street. While he was successful on both counts, his reputation was made in the classroom. He taught at Columbia and the New York Institute of Finance for more than three decades and during that period developed a loyal following among his students. In fact, much of Mr. Graham’s fame comes from the success enjoyed by his students in the market.
It was the first edition of Security Analysis that Ben Graham put his mind to converting his views on markets to specific screens that could be used to find undervalued stocks. While the numbers in the screens did change slightly from edition to edition, they preserved their original form and are as follows:
- Earnings to price ratio that is double the AAA bond yield
- PE of the stock has to be less than 40% of the average PE for all stocks over the past 5 years
- Dividend Yield > 2/3 AAA Corporate Bond Yield
- Price < 2/3 of Tangible Book Value
- Price < 2/3 of Net Current Asset Value, where net current asset value is defined as liquid current assets including cash minus current liabilities
- Debt-Equity Ratio (Book Value) has to be less than 1
- Current Assets > Twice Current Liabilities
- Debt < Twice Net Current Assets
- Historical Growth in EPS (over last 10 years) > 7%
- No more than 2 years of declining earnings over the previous 10 years
Any stock that passed all 10 screens, Graham argued, would make a worthwhile investment. It is worth noting that while there have been a number of screens that have been developed by practitioners since these first appeared, many of them are derived from or are subsets of these original screens. The best support for Graham’s views on value investing come from the success of many of his students at Columbia. While they chose diverse paths, many of them ended up managing money and posting records of extraordinary success. In the section that follows, we will look at the most famous of his students– Warren Buffett.
Warren Buffett: Sage from Omaha
No investor is more lionized or more relentlessly followed than Warren Buffett. The reason for the fascination is not difficult to fathom. He has risen to become one of the wealthiest men in the world with his investment acumen, and the pithy comments on the markets that he makes at stockholder meetings and in annual reports for his companies are widely read.
How does one become an investment legend? Warren Buffett started a partnership with 7 limited partners in 1956, when he was 25, with $105,000 in funds. He generated a 29% return over the next 13 years, developing his own brand of value investing during the period. One of his most successful investments during the period was an investment in American Express after the company’s stock price tumbled in the early 1960s. Buffett justified the investment by pointing out that the stock was trading at far less than what the American Express card generated in cash flows for the company for a couple of years. By 1965, the partnership was at $26 million and was widely viewed as successful.
The moment that made Buffett’s reputation was his disbanding of the partnership in 1969 because he could not find any stocks to buy with his value investing approach. At the time of the disbanding, he said, ’On one point, I am clear. I will not abandon a previous approach whose logic I understand, although I might find it difficult to apply, even though it may mean foregoing large and apparently easy profits to embrace an approach which I don’t fully understand, have not practiced successfully and which possibly could lead to substantial permanent loss of capital.’ The fact that a money manager would actually put his investment philosophy above short-term profits, and the drop in stock prices in years following this action, played a large role in creating the Buffett legend.
Buffett then put his share of the partnership (about $25 million) into Berkshire Hathaway, a textile company whose best days seemed to be in the past. He used Berkshire Hathaway as a vehicle to acquire companies (GEICO in the insurance business and non-insurance companies such as See’s Candy, Blue Chip Stamps, and Buffalo News) and to make investments in other companies (Am Ex, The Washington Post, Coca-Cola, and Disney). His golden touch seemed to carry over, and Berkshire Hathaway’s stock price reflected his success. An investment of $100 in Berkshire Hathaway in December 1988 would have outstripped the S&P 500 four-fold over the next 13 years.
As CEO of the company, Buffett broke with the established practices of other firms in many ways. He refused to fund the purchase of expensive corporate jets and chose to keep the company in spartan offices in Omaha, Nebraska. He also refused to split the stock as the price went ever higher to the point that relatively few individual investors could afford to buy a round lot in the company. On December 31, 2001, a share of Berkshire Hathaway stock was trading at US$75,600, making it by far the highest-priced stock in the United States. He insisted on releasing annual reports that were transparent and included his views on investing and the market, stated in terms that could be understood by all investors.
Assessing Buffett
It might be presumptuous of us to assess an investor who has acquired mythic status, but is Warren Buffett worthy of his reputation? If so, what accounts for his success, and can it be replicated? We believe that his reputation is well deserved and that his extended run of success cannot be attributed to luck. While he has had his bad years, he has always bounced back in subsequent years. The secret to his success seems to rest on the long view he brings to companies and his discipline– the unwillingness to change investment philosophies even in the midst of short-term failure.
Much has been made of the fact that Buffett was a student of Graham at Columbia University and their adherence to value investing. Warren Buffett’s investment strategy is more complex than Graham’s original passive screening approach. Unlike Graham, whose investment strategy was inherently conservative, Buffett’s strategy seems to extend across a far more diverse range of companies, from high-growth firms like Coca-Cola to slower-growth firms such as Blue Chip Stamps. While Graham and Buffett both might use screens to find stocks, the key difference as we see it between the two men is that Graham strictly adhered to quantitative screens whereas Buffett has been more willing to consider qualitative screens. For instance, Buffett has always put a significant weight on both the credibility and the competence of top managers when investing in a company.
In more recent years, he has had to struggle with two byproducts of his success. Buffett’s record of picking winners has attracted a crowd of imitators who follow his every move and buy everything he buys, making it difficult for him to accumulate large positions at attractive prices. At the same time, the larger funds at his disposal imply that he is investing far more than he did two or three decades ago in each of the companies that he takes a position in, which makes it more difficult for him to be a passive investor. It should come as no surprise, therefore, that he is a much more an activist investor than what he used to be, serving on boards of The Washington Post and other companies and even operating as interim Chairman of Salomon Brothers during the early 1990s.
Be Like Buffett?
Warren Buffett’s approach to investing has been examined in detail, and it is not a complicated one. Given his track record, you would expect a large number of imitators. Why, then, do we not see other investors using his approach to replicate his success? There are three reasons (according to Aswath Damodaran):
- Markets have changed since Buffett started his first partnership. His greatest successes occurred in the 1960s and the 1970s, when relatively few investors had access to information about the market and institutional money management was not dominant. Even Warren Buffett would have difficulty replicating his success in today’s market, where information on companies is widely available and dozens of money managers claim to be looking for bargains in value stocks.
- In recent years, Buffett has adopted a more activist investment style and has succeeded with it. To succeed with this style as an investor, though, you would need substantial resources and have the credibility that comes with investment success. There are few investors, even among successful money managers, who can claim this combination.
- The third ingredient of Buffett’s success has been his patience. As he has pointed out, he does not buy stocks for the short term but businesses for the long term. He has often been willing to hold stocks that he believes to be undervalued through disappointing years. In those same years, he has faced no pressure from impatient investors because stockholders in Berkshire Hathaway have such high regard for him. Many money managers who claim to have the same long-time horizons that Buffett has come under pressure from investors wanting quick results.
According to Damodaran, it is easy to see what Warren Buffett did right over the last half-century, but it will be very difficult for an investor to replicate that success.
So while I once harbored the dream of being the next Warren Buffett, it is clear to me as I journey on, I am not him and will not be able nor is it practical to emulate him. It does not mean that you cannot apply some of the thoughts and disciplines used by many schooled under Ben Graham to become a value investor. That is the path I have walked since.
Credits: Portions of this were extracted from Aswath Damodaran’s “Value Investing for Grown Ups? Value Investing”