“Value Investing is figuring out what something is worth and paying a lot less for it” – Joel Greenblatt
Value investing is one of the world’s most well-known investment philosophies and has been used to describe the investment strategy of some of history’s most successful investors, such as Warren Buffet and Peter Lynch. On paper the strategy itself seems fairly intuitive, the key tenet of value investing is to buy companies at a discount to their intrinsic value, leaving yourself with enough room below the valuation to generate a substantial ‘margin of safety’, aimed at minimising downside risk.
Recently however, it has become common to hear the term 'value' used to describe the stocks themselves, with investors often splitting companies into two distinct categories: growth companies and value companies. Whereas previously value investing was thought of as a philosophical framework used in the investment decision-making process, now it is being used to describe the purchase of cheap unloved stocks. The approach seems to have morphed into a part contrarian, part bargain hunter approach, where the focus is on companies with low price to book or price to earnings ratios.
This approach does have some basis in reality, as we will discuss later, as there are several examples in academic literature describing the so-called ‘value effect’, where low price to book companies have outperformed the market. However, focusing solely on cheap companies ignores many of the principles of value investing which have proven so successful, and runs the risk of buying so called ‘value traps’, those companies which appear cheap, but will likely remain cheap for some time due to a raft of potential reasons, such as structural industry headwinds. Ultimately 'value' is determined by what you get for what you give. While it is more difficult to ascertain the sustainability of high growth, it doesn't mean a high growth, high PE and high price to book value stock is not a 'value' investment.
Origins of Value Investing
The origins of value investing can be traced back to one man; Benjamin Graham, a former professor of finance at Columbia Business School. Widely known as the author of the popular book ‘The Intelligent Investor’ published in 1949, Graham also co-authored the book ‘Security Analysis’ with David Dodd, which preceded The Intelligent Investor. Although The Intelligent Investor is arguably more widely known, and often recommended to new investors, Security Analysis is the seminal piece on Value Investing, and represents the first major work published on the strategy. In these two books, Graham introduces the concepts of ‘intrinsic value’ and ‘margin of safety’, arguably the two ideas most important to value investing.
Intrinsic value is the underlying value of a company, derived through some form of fundamental analysis, such as a discounted cash flow analysis. It can be thought of as the value of future cash flows the company will produce, and represents the value received by the investor when they purchase shares on the market. Importantly, this is different from the market price of a stock, with Warren Buffet stating that “Price is what you pay, value is what you get”. It makes sense then to invest only in companies which represent good value, by trading at a price lower than their intrinsic value, which leads us to the concept of margin of safety.
Margin of Safety
The margin of safety is quite simply, the difference between the price paid for a stock on the market, and the value received by the investor (i.e. the stock’s intrinsic value). Graham advocated purchasing securities with a substantial margin of safety, which provides the investor with two key advantages. Firstly, stocks trading at large discounts to their intrinsic values intuitively offer the potential for large returns. If we assume stocks trend towards their fair value over the long term, then those stocks trading at large discounts should offer larger returns than those trading at narrow discounts, or even those stocks trading at a premium to intrinsic value. Secondly, the margin of safety provides investors with an element of downside risk, and helps account for the uncertainty present in valuation. Valuation is difficult, it provides an educated estimation at best, and makes no guarantees as to the future stock price. Investing with a margin of safety allows room for both errors of judgement and those present within the valuation model.
The two principles above combine to form the essence of value investing: essentially value investing is about buying companies on sale, receiving more value from the stock than you pay for it. To highlight his point, Graham used the metaphor of Mr. Market, to reinforce the distance between price and value. Imagine having a 50% ownership stake in a business, and everyday your business partner, Mr Market, offers to either buy your ownership stake in the business from you, or sell you his ownership stake. The prices Mr Market offers can fluctuate wildly (as the stock market does), some days he will offer a price well above the fair value for his half of the business, and others he may offer far below it. As the business owner you are free to accept Mr Market’s offers or ignore them, intuitively it makes sense to accept his offer to buy his half of the business when it is below fair value, and the same holds true in the stock market. Just as it makes no sense to accept Mr Market’s offer when it is wildly overpriced, it makes no sense to buy shares trading above their intrinsic value, rather the individual investor should focus on buying shares which represent good value, which trade at a discount to their fair value.
What is Value Investing?
The Value Effect
When aiming to buy stocks which trade at a discount to fair value, it is important to distinguish between those that are cheap, and those which represent good value. In recent years the term value has moved away from the philosophy of value investing, and come to describe a subset of stocks, typically with low price-to-earnings and/or low price-to-book ratios, which are said to outperform the market in the long term. This idea of ‘value stocks’ was first discussed in the early 1990’s by Eugene Fama (interestingly, the father of the efficient markets hypothesis) and Kenneth French in their academic paper titled “The Cross-Section of Expected Stock Returns”, which introduced their three factor model. The Fama-French three factor model suggests that returns of individual stocks are driven by three factors: the market return, the size of the company (i.e. small-cap vs large-cap) and the book-to-market ratio (inverse of the price-to-book ratio), finding that low price-to-book and small-cap companies tend to outperform the market in the long term.
While these findings did demonstrate the existence of a ‘value effect’ and were the subject of thorough back testing and analysis, the problem is that once a particular strategy or pattern which generates outperformance in the market is identified, it is quickly eliminated through sheer weight of competition. As transaction costs and thus barriers to entry for participation in the share market are low, once profitable strategies are identified the number of participants implementing these strategies/ideas increases, with the increased competition reducing the available abnormal profits as economic theory would suggest. To highlight this, we’ve looked at the performances of three MSCI factor indexes for both Australia and the US: Momentum, Growth and Value indexes, which separate stocks into categories based on their underlying characteristics. While not perfect, this does illustrate that while value stocks have gone through periods of outperformance, they have not been the consistent outperformers that the Fama-French model suggests.
Relative Performance of Quant Factors - Australia
Relative Performance of Quant Factors - United States
As the charts show, value stocks have struggled to consistently outperform both growth and momentum strategies in both Australia and the US. In the US, since the beginning of 2009 value has consistently underperformed growth and momentum strategies, explaining the surge in articles coming out of the US suggesting that ‘value investing may be dead’, or asking if ‘value investing is gone for good.’ It’s here that we need to make the important distinction between value stocks, and value investing. Value investing refers to the strategy of buying a stock at a discount to its intrinsic value, whereas value stocks are stocks trading at low price-to-book ratios. It is important to keep in mind that low price-to-book companies, or ‘cheap’ companies, don’t necessarily represent value for money, it is all too easy to get suckered in to value traps when focusing on companies which appear cheap. While the value effect has outperformed previously, there is no guarantee that this strong performance will continue, and it is entirely likely that increased attention to its performance will reduce the chance of future outperformance. Value investing on the other hand will never truly go out of style, because at its core value investing is simply about receiving more value than the price paid for the stock, which is intuitively what every investor aims for, i.e. for their investment to be worth more in the future than what they paid for it.
Determining the Intrinsic Value
“Any attempt to value businesses with precision will yield values that are precisely inaccurate”
– Seth Klarman
Where value investing gets tricky then is in determining the intrinsic value of a stock; without estimating a stock’s fair value it is impossible to decide if it is over or under valued. Intrinsic value though is of course no guarantee; it is at best an educated guess. As Seth Klarman, author of Margin of Safety (essential reading on value investing) and hedge fund manager states, attempting to precisely calculate a figure for fair value is imprecise by nature, and attempting to be excessively precise only makes the valuation subject to more errors. This doesn’t mean that attempting to determine intrinsic value is futile, as through careful and thorough analysis it is possible to determine under-priced securities and achieve strong returns, but rather it is important not to be detailed for detailed’s sake. Warren Buffet and Charlie Munger of Berkshire Hathaway, arguably the most famous and successful value investors of all time, are big proponents of a simplified approach when it comes to valuation. On complex valuation formulas, Charlie Munger stated in the most recent Berkshire annual meeting “If you want a formula, you should go back to graduate school. They’ll give you lots of formulas that won’t work.” While this comment was made tongue-in-cheek, it does reinforce the idea that valuation estimates are exactly that, estimates, and should not be seen as exact future values of a stock price.
The most common way to determine intrinsic value is through what is known as Discounted Cash Flow analysis, or a DCF model. These models attempt to value companies based on the future cash flows they will generate for their investors, or the free cash flow. This seems a fairly logical way to value a business, as a shareholder of a company you are a part-owner of the business, and are entitled to a proportionate share of the cash flows it generates, therefore the business is worth the value of the cash it generates for you. While a DCF model can be a good indicator of value however, it is important to remember its drawbacks, namely that it relies heavily on inputs and estimations from the modeller, leaving room for inaccuracies and errors. As such, and given that it is impossible to accurately predict the future, there is always an element of uncertainty within these models. This does not mean these models are worthless however, there is still a lot of value in this form of analysis and likely always will be, it is just important for the individual investor to keep in mind that valuations are not set in stone, and should be used as a guide only.
Benjamin Graham states it best:
“The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It need only establish that the value is adequate”.
The valuation reached from a DCF is not to be taken as an exact figure, but rather is used to determine whether sufficient value is present within the stock to justify an investment. For example, if a stock currently trades at $5, and a valuation of $10 is reached using a DCF, there is no guarantee the stock will ever trade at $10, but the valuation provides a significant enough margin of safety that it presents a compelling investment case in terms of valuation (although in reality there are several other factors to consider). There are other methods used to value businesses, such as comparable analysis which compares price multiples of the desired company to those of its peers and constructs a valuation from there, and qualitative factors to consider as well which won’t show up in the numbers of a model (such as competitive strength, positioning within the market and quality of management), but which are still entirely relevant. While there are many methods of valuing a business it is important to remember that the valuation is a guide only, and that a reasonable margin of safety should be established between current market price and intrinsic value, to provide downside protection.
Value Investing in Quality Companies
The intrinsic value of most companies can be difficult to predict while most company’s performance often revert to the mean i.e. bad things happen to good businesses, and good things happen to bad businesses. However, for some exceptional companies, there is a persistence of high quality for long periods of time, which gives greater confidence in the intrinsic value, and so investors in these companies should rationally pay a relative premium for these stocks in relation to their current earnings and book values.
Ultimately, the margin of safety comes from the ability of a business to deliver high returns on invested capital over time, and that comes from a sustainable competitive advantage, usually created by exceptional people. A value investor does not hesitate in paying up for quality, but this does not mean that he or she is overpaying. The way to figure out whether this type of investor has overpaid or underpaid is not by focusing on P/E multiples based on historical earnings, but in comparing the price paid by the investor with the earnings delivered by the business many years later. To be sure, paying high multiples of near-term earnings will make sense only if future earnings will be significantly higher than at present. So, the focus should be on long-term earning power and not current or past earnings.
The kinds of quality businesses value investors look to invest in are those that have fundamental momentum: that is, a probabilistic tendency to continue to deliver exceptional performance. In other words, these businesses do not conform to the principle of mean reversion, at least not for a very long time, but sometimes long enough for them to become great investment candidates at the right price. For many of today’s value investors, their investment process starts not with looking for cheap stocks, but with looking for companies that benefit from entrenched competitive advantages and business models that produce significant and growing volumes of distributable cash flow.
The Super-Investors of Graham and Doddsville
Having now mentioned how difficult and imprecise valuation can be, it begs the question as to whether value investing even remains relevant in the modern age. Security Analysis was first published in 1934 and many question its relevance given the changes in technology, increase in amount of information available to investors, and sheer weight of participants currently active in the financial markets. Value investing also seems to be at odds with the efficient markets hypothesis, widely accepted in academic literature. If we hold the hypothesis to be true, then finding stocks trading at discounts to intrinsic value (and therefore representing good value) should be impossible, as the theory posits that stock prices represent all available public information, and are thus always fairly valued. In our previous discussion on behavioural finance however, we challenged the notion that the market is perfectly rational 100% of the time, and if we accept that the markets are perfectly efficient, then how do we explain the outperformance achieved by history’s great investors?
Warren Buffet is a long standing critic of the efficient markets hypothesis, little surprise given his strict adherence to value investing principles, and the strong returns he has been able to achieve throughout his career. If Buffet was the only investor to have shown such outperformance, it would be arguable that he was simply an outlier, a statistical anomaly in the distribution of returns. In 1984 this idea was posed to him in a debate with a professor of finance, Michael Jensen, who naturally was a strong believer in the efficient markets hypothesis. Jensen used the example of conducting a coin tossing experiment, arguing that given successive flips it is inevitable that some people in the experiment are likely to win a few times in a row, even though successive coin flips are independent and purely down to chance. This he argued, was effectively what had happened in the financial markets, Buffet had just become very lucky with his coin flips over his career, and his performance was in no way attributable to any sort of skill.
Buffet’s reply to this was to continue the analogy of the coin flipping experiment, saying that yes, in that example it’s entirely likely that strong performance will emerge from random chance as a statistical anomaly. If however, of those successful coin flippers 40% of them came from the same town in Omaha Nebraska (assuming the flippers were sourced from all over the United States), that would probably warrant further investigating. Producing the investment records of several successful investors, he argued that the long term outperformance these investors had achieved was down to their investment philosophy, given that this group of investors all hailed from the school of value investing, and had implemented the strategy themselves. These investors had little in common, their portfolios were comprised of different stocks, and varied in size, the only thing connecting them was an adherence to the principles of value investing, and a personal connection to Buffet (not too surprising given the common investment philosophy). The Investment records listed by Buffet can be found in the table below.
The article was written by Buffet in 1984, as such the most recent time period in the table is 1984. Also worth mentioning is the performance of Peter Lynch, from 1977-1990 the Magellan fund he managed at Fidelity Investments achieved annual returns of 29.2%, another example of strong performance from an investment manager influenced by value investing. The returns exhibited volatility of course, they had their good years and their bad years. But what is striking is the level of outperformance they achieved over a number of years, seemingly at odds with the efficient markets hypothesis.
Should Value Investing Be More Wide-Spread?
Earlier, we made the comment that as profitable strategies are identified in the markets, their effectiveness should disappear over time, due to the low barriers of entry in the stock market. Assuming this, and given the strong performance of value investors we have outlined above, it makes sense that value investing shouldn’t be profitable, and yet as time goes by, Warren Buffet continues to generate excess returns at Berkshire Hathaway. Why is this the case? Warren Buffet addressed this himself, saying that theoretically, by drawing attention to the successes of value investing he is limiting the excess returns he can earn in the future. Yet despite the principles of value investing being first highlighted in 1934 (Security Analysis), and then drawn upon again in 1949 (The Intelligent Investor), there was no material uptake in value investing amongst the general investing populace. While there were the few managers that did adhere to its principles, the vast majority of investors failed to pick up on it. In the words of Warren Buffet “There seems to be some perverse human characteristic that likes to make easy things difficult.”
Part of the problem with value investing is that it requires a very disciplined approach to investing, strong mental fortitude to follow through on the investment thesis, and the ability to be comfortable with taking a contrarian approach. An adherence to value investing will often see an investor taking a contrarian position and going against the views of the general market, as a security trading at a discount to its intrinsic value is by definition a security which the market either hasn’t noticed yet, or one which the market doesn’t like. To this end, the value investor has to be comfortable listening to other people telling them that they are wrong, and have the conviction to stick with the investment throughout the process, until it bears fruit. Perhaps this is why traditional value investing was never commonplace, it requires a strength of mental character not present in every investor. Despite this, we believe that an adherence to the principles of value investing, that is careful security analysis and thorough research, can yield strong performance for the individual investor, and that value investing - investing in quality businesses which offer both good value and a margin of safety to the investor - will never truly go out of style.
This article is intended to provide general advice only and has been prepared without taking into account your objectives, financial situation or needs. Therefore, before acting on any information contained in this article, you should consider its appropriateness having regard to your objectives, financial situation and needs.