The idea of value investing is perhaps most simply expressed in an old Wall Street axiom: “Buy straw hats in winter and overcoats in summer.” But is the concept as eminently straightforward as it first appears? And how did it make Warren Buffett the richest man in the world?
“What is a cynic? A man who knows the price of everything and the value of nothing.” Oscar Wilde, Lady Windermere’s Fan (1892)
Whether you are a value investor or someone who knows nothing whatsoever about investing, it is likely you will agree that the only sensible time to buy something is when it is being offered for sale at a price which represents good value. Most of us, given the opportunity to acquire something for less than we perceive it to be worth, can hardly contain ourselves, which is why hordes of people flood to the sales.
Of course, the discount shopper’s fallacy is that when buying something reduced by 70%, one is actually making money, when in reality most of what we buy perishes or becomes obsolete, superseded by superior technology or changes in fashion. Charity shops are littered with the ‘must have’ dresses of yesteryear. The swanky new car never looks quite so shiny away from the bright lights of the showroom. Value tends to diminish over time.
There are exceptions, however. Think Ferrari 250 Gran Turismo Omologato purchased in the early 1960s. The list price in America when the car first left Maranello was $18,000. One pound was worth 2.81 dollars in 1962, so inflating by the average rate of inflation over the past 52 years, we derive a current value for the brand new GTO of a little under £100,000. At Bonham’s auction in California in August this year, one of the 39 GTOs made by Ferrari sold for $38.1m. Today sterling trades at 1.60 to the dollar (43% lower than in 1962), which means a sports car that cost £100,000 52 years ago is now valued at £23.8m. That is equivalent to tax-free annual appreciation of approximately 11%. Acquiring an asset for less than its inherent value and holding on to it until other people appreciate that value – that is value investing.
To quote the greatest living value investor, Warren Buffett: “Whether stocks or socks, I like buying quality merchandise when it is marked down.” Buffett learned how to invest from his mentor Benjamin Graham, the father of value investing. Graham co-authored the seminal work on how to analyse a company with David Dodd, his colleague at New York’s Columbia Business School. Their ground-breaking 1934 work, Security Analysis, published in the aftermath of the worst period in stock market history, laid the intellectual foundation for value investing.
Written around the same time, Harvard graduate John Burr Williams’s doctoral dissertation, The Theory of Investment Value (1938), presented the theory that the value of a business is determined by discounting the cash the business will receive over its life at an appropriate interest rate. Today we call this the dividend discount model and it remains widely used. However, it was Graham’s later work of 1949, The Intelligent Investor, which captured young Buffett’s imagination. Rejected by Harvard, the business school on which he had fixed his ambitions, Buffett was delighted to discover in 1950 that Graham and Dodd were not dead, but still teaching. He wrote a pleading letter to Dodd, head of admissions at Columbia as well as its head of finance, requesting a place. Dodd broke with convention and accepted Buffett one month before the start of term and without an interview.
Buffett attended Graham’s classes and, after graduating with a master’s degree in economics, was invited by his former lecturer to join his company, the Graham-Newman Corporation. Graham and Buffett worked together for two years before Graham retired and Buffett, then aged 25, set up his own investment partnership. Six years later, as the first 250 GTO left Maranello, Buffett began buying shares in an ailing textile company, Berkshire Hathaway. By 1965 he owned enough shares to take control of the enterprise. What happened next is legendary, for over the ensuing 40 years Buffett grew the net worth of Berkshire Hathaway from $22 million to $69 billion (representing annual growth of 22.3%), incidentally becoming the richest man in the world. So what did Graham teach him?
At first glance, value investing is simple – there are just two rules. The first is ‘do not lose money’. The second is ‘never forget rule one’. To avoid breaking rule one, a value investor only buys shares when they are being offered for sale with a margin of safety. A margin of safety exists only when the share price is at least two-thirds less than the company’s intrinsic value, which bears no relation to its market value.
As Oscar Wilde’s famous quip pointed out, monetary worth (price) and intrinsic worth (value) may not be the same. Some things are intrinsically priceless – the love of your life, a beautiful sunset, an evening with friends – and cannot be objectively measured: however, the intrinsic value of a company can be. Graham’s margin of safety rule requires that when adding up all the shares issued by a company and multiplying by the current share price, the figure derived must be at least 60% less than the value of the assets the company owns. When assessing the value of the company’s assets, plant, property and equipment count for nothing; neither do short- and long-term liabilities. Strict value investors of the Graham school are concerned only with net current assets, believing shares are frequently mispriced due to the human emotions of fear and greed. The tendency for prices to correct over time, a statistical phenomenon termed ‘mean reversion’, provides the opportunity to profit from these mispricings.
Where Buffett enhanced Graham’s approach is in the appreciation of the qualitative aspects of a company. While Graham would not consider the specifics of the business nor ponder the capabilities of its management, caring only for the margin of safety, Buffett, influenced by Phil Fisher’s 1954 work Common Stocks and Uncommon Profits, would want to see consistency of profit derived from an inimitable business accompanied by exceptionally talented management. And so value investing evolved from valuing only the current cashflows and assets to consider long-term sustainable growth.
The academic evidence in support of value investing is substantial, even overwhelming. As a buyer of cheap stocks, one is automatically positioned away from the herd. As Sir John Templeton, arguably the greatest stock picker of the 20th century, said: “If you want to have a better performance than the crowd, you must do things differently from the crowd.” He advocated buying company shares “at the point of maximum pessimism”, a view supported by Richard Thaler and Werner De Bondt’s paper Does the Stock Market Overreact? (published in the Journal of Finance in July 1985), which analysed 56 years of New York Stock Exchange data to show that the worst-performing stocks over a five-year period subsequently outperformed the stock market by 19.6% on average over the ensuing three years. They did even better against the stocks that had performed best over the previous five years, which on average underperformed the market by 5.0% over the subsequent three years. The ‘bad’ stocks therefore outperformed the former darlings by 24.6% on average.
So, if value investing is so obviously a good way to invest, why don’t more people use it? Firstly, it only works because everyone isn’t doing it and there are other ways to invest, otherwise the inefficiencies would be ironed out immediately. Secondly, it is complicated by our emotions and false rationalisations. When shares are cheap, they are cheap for a reason and it is that reason one has to look beyond. Control of self is possibly the greatest investment challenge.
A key tenet of value investing is not to try to ‘time’ the market, but to remain fully invested at all times as 80-90% of the investment return on stocks occurs around 2-7% of the time. As shown by a study undertaken at research firm Sanford Bernstein covering the period 1926-1993, missing the 60 best months in the stock market would have brought down one’s return from 11% to almost zero. Given this, it is necessary to be fully invested at all times: missing out on the big moves makes investing more or less pointless.
The principles of value investing have stood the test of time and remain as relevant today as they were when Graham and Dodd taught at Columbia. In spite of the growth in the fund management industry and the alternative investment approaches employed over the years, the discipline of value investing continues to generate substantial returns to those with the patience and self-control to remain true to its philosophy.
James Maltin, investment director