09-Feb-2006

>Traditions in Value Investing

In a great book and a must-read for investors, “What is Value Investing?”, the author, Lawrence A. Cunningham, writes about the many traditions of value investing.


“Value investing is partly a state of mind. It is characterized by habitually relating the price of a stock to the value of the under­lying business. Basic principles of fundamental analysis are the tools. They arise from three traditions.

Benjamin Graham's margin of safety principle is the first one. It requires assurance that a stock's price is substantially below its esti­mated value. The test requires conducting a full business analysis. To begin, value investors use simple filters that narrow the range of can­didates to those that an investor understands and can evaluate (com­monly known as a circle of competence).


John Burr Williams refined value investing's second core tradition. This quantitative tradition requires estimating a company's intrinsic value measured by the present value of its probable future cash flows, conservatively estimated using current data. This principle captures the intuition that a dollar in hand today is worth more than a dollar paid in the future.


Philip A. Fisher added value investing's third tradition. This qual­itative tradition requires the diligent investor to find a company exhibiting strong long-term prospects. These are indicated by charac­teristics creating a business franchise, such as consumer loyalty, unmatched brand-name recognition, and formidable market power. Also relevant are high-quality managers who can be counted on to channel the franchise's rewards to the company's shareholders.


Warren E. Buffett is the consummate and best-known integrator of these three traditions. Buffett practices a comprehensive method of value investing. He refers to the exercise simply as investing, viewing the modifier "value" as redundant. Other disciples weight the compo­nents differently, producing a range of value investing styles. All are united by appreciating the difference between price and value.


GRAHAM: THE FATHER OF VALUE INVESTING

Benjamin Graham's The Intelligent Investor is the classic work on value investing by the philosophy's chief architect and greatest exponent. Many have read the book, originally published in 1949 and in several subsequent editions. The key idea is to protect against error by devel­oping a long-term strategy and stock selection framework.


Graham's more detailed 'Security Analysis, coauthored with David L. Dodd, elaborates the deeper architecture (devotees regard the sec­ond edition, published in 1940, as the most informative version). Emphasis is on the balance sheet (assets and liabilities) to determine business value. Current editions of that classic, written by others, also stress analyzing the income statement (revenues and expenses) to appraise value.


Debate centers on whether these texts are timeless classics or out­dated. Neither extreme position is correct; in fact, they are both partly right. Critics complain that the original editions are outdated because they emphasize businesses of the day such as railroads, utilities, and heavy manufacturing, and Graham focused on the balance sheet and asset values; today's businesses depend on greater contribution from nonphysical assets, and the investment community focuses more heav­ily on the cash that assets generate rather than the values assigned to them on balance sheets.


Today's economic environment encompasses more varied busi­nesses ranging from on-line music to pharmaceuticals, enlarging the domain beyond Graham's favored business illustrations. Contemporary businesses use a wider variety of asset classes and varying degrees of reliance on hard assets versus intangible assets. Values in copyrights and patents often surpass those of traditional industrial assets.


Still, Graham's key principles endure. The bedrock principle remains the "margin of safety" -paying a price far enough below value to avoid major capital market losses. The main objective is to preserve capital. Paying too much risks the excess to marketplace hazards and the vagaries of a company's business. This principle is akin to the over­ riding tenet of medicine, first do no harm (primum non nocere)-first, lose no money.


Graham defined investments as economic positions which, upon analysis, promise safety of principal and an adequate return (at least equal to the rate of inflation). Anything else is speculation, he thought. The philosophy opposes speculation, in favor of good businesses for the long term. It requires evaluating companies, whether Anheuser­Busch, Microsoft, or Zeneca. The principles generally do not work over short time horizons but can be very rewarding over generations.


Graham furnished a 10-point analytical screen for investment selection. Half-measured financial strength and half-measured risk aspects. Critical on the financial strength side were a high ratio of cur­rent assets to current liabilities and sparing use of long-term debt compared to book value and liquidation value. To reduce risk, Graham limited prudent selections to firms with returns measured by earnings at least twice that of high­ grade corporate bonds and whose current price-to-earnings level is less than half the highest such level over the past five years.


Graham knew that luck, good and bad, plays a role in investing (and life), but that luck does not control everything. The goal is to limit Lady Luck's downside. Contemporary violators are day trading, momentum tactics, and market timing. All are high-risk practices intended to exploit market movements using nonvalue criteria. Current strategies embracing the traditional philosophy include slowly, carefully building a collection of a manageable number of understandable investments, as well as dollar-cost averaging (the practice of investing set dollar amounts in a particular security at designated intervals).


Graham divided the investor universe into two broad categories: defensive and enterprising. For either, however, minimizing losses is more important than maximizing gains. With losses minimized, average gains generate above-average results.


FISHER: PIONEER OF GROWTH EMPHASIS

Graham focused on financial analysis of companies, paying less atten­tion to management quality or business environment. Fisher enlarged fundamental analysis by focusing on these qualitative aspects. Management is important to growth companies, and assumes greater importance for all companies amid accelerated business change and given innovation in risk management and business strategy.


Fisher appreciated such business tactics as brand-name develop­ment and product packaging that create value, economic goodwill, and the ability to generate returns on equity greater than industry or peer averages. That power can be leveraged in a globalizing world where brand name can be established worldwide and used as a launching pad for additional product lines or extensions. Examples include enter­tainment companies marketing multilingual versions of a product in print, cinematic, VIIS, DVD, and Web formats.


Fisher narrowed the number of value investment candidates by emphasizing that even companies priced below intrinsic value could be lousy investments. Businesses can be underpriced for valid reasons, such as poor management. Attractively priced investments also turn mediocre when they become fully priced, in his view.


In Fisher's era, investment wealth arose either from traditional value investing (buying underpriced securities and holding them until fairly priced or overpriced) or fairly-priced businesses poised to grow so rapidly in sales and earnings (today we would add cash flows) that profits arise from that growth. The former describes traditional Graham-based pure value investing. The latter is Fisher's pioneering sense as a growth rather than a value investor and leads to the distinc­tion (somewhat false) between the two.


Fisher furnished a 15-point checklist to identify a growth company. It includes whether the company's potential markets are large enough to enable many years of sales growth. Consider the difference in reaching a market-saturation point between automobile manufacturers and mak­ers of car batteries. Amid globalization, market expansion is greater for global companies able to distribute existing products worldwide and respond with new products ideally tailored to regional tastes.


WILLIAMS: CASH FLOW'S ROLE

The value of a business, a share of stock, or any other productive asset is the present value of its future cash flows. Williams elaborated this point, emphasizing what developed into discounted cash flow (DCF) analysis, today's most popular valuation methodology. Its popularity, however, hides the important reality that value is easier to define than to measure (easier said than done). The tools Graham and Fisher developed remain crucial in this exercise.


One hazard of undue reliance on DCF analysis is a temptation to classify stocks as either value stocks or growth stocks: Many profes­sionals, including those at mutual funds, try to differentiate their products from others using this distinction. But it is a distinction with limited difference.


Valuing a business (or any productive asset) requires estimating its probable future performance and discounting the results to present value. The probable future performance includes whatever growth (or shrinkage) is assumed.

So growth (or lack of it) is integral to a valuation exercise. This supports the point that the phrase value investing is redundant: Investing is the deliberate determination that one pays a price lower than the value being obtained. Only speculators pay a price hoping that through growth the value rises above it.


Despite this nomenclature confusion, value investing is conven­tionally defined as buying companies bearing low ratios of price-to-­earnings, price-to-book value, or high dividend yields. But these metrics do not by themselves make a company a value investment. It isn't that simple. Nor does the absence of such metrics prevent an investment from bearing a sufficient margin of safety and qualitative virtues to justify its inclusion in a value investor's portfolio.


Growth doesn't equate directly with value either. Growing earn­ings can mean growing value. But growing earnings can also mean growing expenses, and sometimes expenses growing faster than rev­enues. Growth adds value only when the payoff from growth is greater than the cost of growth. A company reinvesting a dollar of earnings to grow by 99 cents is not helping its shareholders and is not a value stock, though it may be a growth stock.


BUFFET: INTEGRATOR

Warren Buffett brings these points together. Value investing consists of analyzing businesses within one's circle of competence to find those whose return on incremental capital is high, compared to what capital costs, and then investing in those that can be bought most cheaply. Table 1 summarizes value investing's key figures and their major contributions.


Table 1 – Value Investing’s Architects

FIGURE

ROLE

KEY POINTS

WRITINGS





Graham

Father of value of investing

Margin of safety; focus on balance sheet; 10-point checklist

The Intelligent Investor; Security Analysis; The Interpretation of Financial Statements





Fisher

Qualitative dimension, growth role

Scuttlebutt; focus on earnings; 15-point checklist

Common Stocks and Uncommon Profits





Williams

Discounted cash flow analysis

Focus on cash

The Theory of Investment Value





Buffett

Integration

Circle of competence business analysis

The Essays of Warren Buffett: Lessons for Corporate America

(Compilation of annual letters)


VARIATIONS ON THE THEME

There are many variations on the-value investing theme. The philos­ophy permits particular applications that vary to suit individual taste and ability. Leading value investors employ a range of styles.


Fisher is a good example. Many contrast Graham, the father of value investing, and Fisher, the father of growth investing. But because value investing and growth investing are really cousins of one another, Fisher is better understood as developing a variation on value investing's themes. The difference is more a matter of style and emphasis than fundamentals.


Among the most famous published accounts of success reported by students of Graham-Dodd's teachings is Buffett's essay The Superinvestors of Graham-and-Doddsville. He documents a range of value investors who adopted varying styles of the philosophy. Some diversify investments widely while others allocate wealth to a concen­trated group of stocks. Most place a high premium on understanding the particulars of any business before investing, yet some will invest while holding only a reasonable level of expertise on a business.


Columbia University Business School professor Bruce Greenwald published a series of essays updating and elaborating Buffett's Superinvestors theme. He highlights numerous value investors to under­score slight variations of approach. Some refine valuation methods to define value as what informed industrialists would pay to own a business's equivalent assets. Some relate historical price fluctuations to intrinsic business value. Others combine this innovation with more traditional valuation metrics to enhance investment discipline. Some emphasize the role of catalysts such as takeovers and bankruptcy reorganizations that can transform underpriced businesses into realized investment results.


Of the variety of value investors and their styles, those most closely aligned to Graham might be called pure value investors. Those giving more weight to other traditions or contemporary influences might loosely be described as modified value investors. However described, the fusing theme among value investors is appreciating the difference between stock price and business value. All also believe in the gospel of the margin of safety. A common characteristic is superior investment results.


THE REST OF US

Value investing is challenging. Ascertaining business quality and estimating value are difficult. Many curious investors who learn what value investing requires opt for the busy person's version of contem­porary intelligent investing: the index fund. As index investing's lead­ing exponent John C. Bogle has quipped, value investing is the second most promising investing philosophy. For those lacking requisite dis­cipline to conduct value investing, Bogle's quip is apt. For those pos­sessing knowledge of value investing, there is no better method.


Compare the returns on two of America's most prominent invest­ment options in the past few decades: the Magellan Fund, made famous by Peter Lynch's growth variation on value investing, and the S&P 500, representing Bogle's famous index approach to investing. Between 1971 and 2000, Magellan outperformed the S&P index in the most years, usually by significant margins. In the handful of years when the S&P index outperformed Magellan, it generally did so mod­estly.


Requisite intelligence for value investing is moderate, not requir­ing Mensa-level genius. However, it requires common sense and good judgment. Exercising those faculties, in turn, depends on a refined intellectual framework that helps an investor resist emotional tempta­tions. Practitioners should adapt and incorporate the framework to meet their particular needs.


Value investing partakes of a certain intellectual curiosity. Devotees tend to be interested in ideas. They read books on business analysis and investing, an important exercise considering that no sin­gle book (this one included) can furnish everything required on any given subject (investing included).


Some high-profile value investors are also inclined to write about their craft. Graham, Fisher, and Williams all wrote books explaining their trade. Others emulate Buffett's practice of writing letters to investors elaborating their philosophies.


Reading and rereading quality investment books and essays expands one's perspective. (thats why i many times shame-less-ly copy paste :p) In addition to the writings of the investors and authors mentioned above (and this book's author), reliable treat­ments of value' investing include the books written by Robert G. Hagstrom, Janet C. Lowe, Timothy P. Vick, and Martin J. Whitman. Experience enriches a reader's investment knowledge, it becomes increasingly clear that value investing is a foundation philos­ophy. Studying its' principles through a cool, calculating, logical method produces an outlook and frame of mind that's more of a phi­losophy than a toolbox. Tools are important-and this book mentions the key ones-but an intellectual foundation remains the distinguish­ing hallmark.


Value investors are open-minded. They are not technicians and do not practice a how-to shop. They know how to select the right tool for the job. This knowledge requires a sense of history, business, account­ing, good judgment, basic human psychology, and specific knowledge necessary to understand particular businesses (actuarial science for insurance, consumer preferences for fashion goods, informational appetites for media companies).”

>10 Value Investing Tenents

In a good book that all investors should read “What is Value Investing?”, the author, Lawrence A. Cunningham, summarizes the ten principles of value investing.

“Value investing is ultimately common sense applied to capital allocation. Its general philosophy and key tools summarized in previous chapters can be distilled further. Worth extracting are the following 10 value-investing tenets.

MR. MARKET PRINCIPLE

Value investors make a habit of relating price to value. They recognize that stock markets rise and fall. The prices of individual stocks likewise swing widely. In the case of stocks and stock markets, a bull exhibits excessive optimism, a bear excessive pessimism. Dreary rationality, where value investors live, lies in between. There are stocks priced above what the underlying business is really worth and stocks priced below that. While over long periods of time the process evens out, the ideal strategy is to search aggressively for investment prospects priced below value.


BUSINESS ANALYST PRINCIPLE

Value investors do not guess when the market or a stock is at its peak, trough, or specific points in between. There will nearly always be times when some positions are priced attractively compared to value and others when the opposite is the case. During periods characterized by bullishness, as the late 1990s, there are fewer value opportunities; during bearish times, as in the early and mid-2000s, there are more. The universe of prospects enlarges as markets fall and contracts as they rise. Tendencies in either direction reinforce themselves, as pes­simism or optimism spreads. This requires knowledge of business, accounting, and valuation principles.


REASONABLE PRICE PRINCIPLE

It is never worth the value investor's time or effort to forecast when tops and bottoms are reached. If price is a fraction of value, value investors buy, knowing that there is a chance that the price will fall lower. Over long periods of time the gap will narrow and often reverse.


PATSY PRINCIPLE

Patsies lose money in stock investment. Market timers and others with the inability to assess the underlying value of businesses should not even participate in the art of stock selection and investment. Those so afflicted are like the patsy in poker, the person unaware that his funds will shortly be held by someone else. Poker and stock-picking are tricky enterprises, not for the overconfident.


CIRCLE OF COMPETENCE PRINCIPLE

Value investors make hardheaded 'assessments of their competencies. If they doubt their skill in stock selection, they steer clear. Value investors know their limits, thickly drawing the boundaries of their circle of com­petence. They avoid investment prospects beyond those boundaries as well as anything even close to the boundaries. This rules out broad seg­ments of industry, enhancing prospects and economizing on time and resources devoted to studying businesses. Those who cannot even iden­tify a circle of competence should avoid stock picking altogether.

For those who feel a need to allocate a portion of their wealth to stocks, choose vehicles other than individual stocks, such as mutual funds, index funds, or do so through a diversified retirement account. However, these operate as subparts of the broader market, and there­fore can be over- or underpriced. This means applying the same ten principles of disciplined investing, but perhaps less rigorously so.


MOAT PRINCIPLE

Market gyrations, price-value discrepancies, and risks of overconfi­dence warrant exercising extraordinary caution in selecting an investment. In focusing on the business, value investors ascertain whether the business itself is substantially insulated from adversity. Value investors avoid businesses threatened by product market downturns, recessions, competitive onslaughts, and technology shifts. The busi­ness itself must be fortified by a moat, a defensive barrier to these ill effects such as arise from brand-name ubiquity, staple products, mar­ket strength, and adequate research and development resources. Franchise value is exhibited by high, sustainable returns on equity.


MARGIN OF SAFETY PRINCIPLE

Value investors worry that they might be wrong when complying with these first five principles. So they add a belt in addition to these sus­penders. Drawing on the point that prices are different than values, value investors insist on as large a favorable margin of difference between them as possible. Doing so produces a margin of safety against judgment error. While none of these 10 principles should be ignored, this is the most fundamental and universal. Obeying this one promotes obedience to the others as well.


IN-LAW PRINCIPLE

The headline-grabbing accounting scandals of the early 2000s under­score the age-old importance of trust in investing. Value investors invest only in the stock of companies known to be run by faithful stew­ards of investor capital. They seek proven track records of good judg­ment and fair treatment. History is not always reliable, but any hints of malfeasance in a manager's record are enough to disqualify his employer. Value investors imagine managers of companies they are considering as prospective in-laws. If they would not want their child to marry a company's top manager, they don't invest money in that company.


ELITISM PRINCIPLE

Few stocks or other investments live up to these principles rigorously applied. Value investors treat companies as applicants to an exclusive club they run and wish to keep exclusive. It is far safer to make the error of omission than to make the error of inclusion. Those invited to join a value investor's portfolio after applying this elitist exclusion­ary policy can be invited often, more of their stock bought as circum­stances warrant. It is far more important to diversify across asset classes-having a savings account, some bonds, real property, and stocks-than it is to diversify across stocks.


OWNER PRINCIPLE

The cumulative effect of these principles is a characterization of the value investor's role in corporate investing as the owner of not just stock, but a business. Hence the principles of business analyst, moat, margin of safety, and son-in-law. It requires appreciating stock selec­tions in the same way the owner of a small business treats decisions concerning his store, farm, or firm. It requires a long-term view and means avoiding the rapid-fire share turnover characteristic of so many shortsighted market traders. That's what value investing is.”