My 2 Cents on Value Investing
“Though business conditions may change, corporations and securities may change and financial institutions and regulations may change, human nature remains essentially the same. Thus, the important and difficult part of sound investment, which hinges upon the investor’s own temperament and attitude, is not much affected by the passing years.”
What is Value Investing?
Benjamin Graham, also coined the “Father of Value Investing”, started working on Wall Street in 1914. His primary focus was on the value on companies, as opposed to the speculation on stocks showed it was possible for regular people to invest wisely without getting swept up in market hysteria. In the last 40 years, Graham’s profile has been boosted by billionaire investor Warren Buffett, who was tutored by Graham at Columbia University and then worked at his Graham-Newman brokerage business.
This “value” investing approach requires a long-term horizon, the ability to tune out market noise in the interim and having enough confidence in your own investing choices that you will not be rattled by a correction, crash and recession. It relates more to the character of someone who is not looking for a quick profit, but with a long-term view minded to conserve their capital, who can be firm about their investing principles in the face of an emotion-driven market. It is one upon thorough analysis, promises safety of principal and a satisfactory return.
A Speculation Problem
Operations not meeting the requirements stated above are speculative. With speculation or “trading”, you are either right or wrong, the latter often disastrously so. An investor, in contrast, considers themselves a part owner in a large enterprise, looking mainly at its results and the quality of its management. If an investor starts “swimming with the speculative tide”, particularly during a bull market when it seems easy to make money, they will lose sight of the companies they are investing in and focus only on the price of stocks. Long-term prospects of a company can only ever be an educated guess. If those prospects are clear though, they will already be reflected in the company’s stock price. This is why “growth” stocks are often expensive and why there is rarely good value to be found in the “sexy” companies that everybody likes. Real money to be made in the stock market is not buying or selling, but in having discipline to hold and own, earning dividends and waiting for perceptions of the value of a company to align with reality. To do this obviously requires a degree of psychological strength and thus intelligent investment is more a matter of mental approach than it is of technique.
Sentiment is a critical determinant of performance. Broadscale sentiment shifts like how flu spreads. The first is the degree of contagiousness — how easily an idea spreads. The second is the degree of interactions — how much people bump into one another. If the flu is very contagious but carriers don’t interact with others, it will not take off. If there’s a lot of interaction but the flu strand is not contagious, it will not take off. But combine both and you got an epidemic.
“Value standards don’t determine price; prices determine value standards.” — Ben Graham
Individuals do not construct value standards based on intrinsic principles but rather are influenced by what other people do (herding). Stock prices reflect the collective actions of others but we all do not have equal potential to be influenced, instead, we have an adaptive threshold which is defined by how many other people must engage in an activity before we join in. Market extremes push the sentiment beyond the adoption threshold of nearly all investors and it can create the conditions for a sentiment reversal. Thus, it is difficult to predict sentiments of the market.
In network theory, ideas can cascade through social clusters (degree of connectedness with one node to another) faster than ever — mass media reinforces our interconnectedness. Warren Buffett states that price and value may diverge from one another, but investors who focus too much on price may have an emotionally difficult time distinguishing between the two. The good news is that if you are a value investor, psychology spikes tend to smooth out into a trend when taking a step back and looking from a long term perspective.
Value Investing Risk Management
Looking from a risk management point of view, value investors look out for “margins of safety” — evidence of a company’s earnings above what is required to service its interest of debt, particularly in the event of a significant sales or market decline. This buffer enables investors to have a margin in case their accuracy is lower than actual estimates of a company’s future.
How to Value Invest
There are two ways to go about value investing — the predictive or protective approach. The predictive approach is how well you think a company will do within its market given its management, products and so on; and the protective approach, which involves looking only at the statistics of a company, such as the relationship between selling price and earnings, assets and dividends payments. Value investors favor the second as it is based not on optimism but on arithmetic.
For instance, Joel Greenblatt, famous for his “magic formula”, also follows the Buffett and Graham approach, specifically arithmetic value investing. He believes in the asymmetric returns from value investment by looking at the earnings yield (ratio of EBIT to EV) to represent cheapness and return on capital goodness. He believes that if you pay a cheap price for something, you have asymmetric returns on the upside because you can’t lose that much, but you still have large profit potential.
We were not looking for the cheapest companies nor the best companies. We were looking for the best combination of both. This is known as the magic formula.” — The Little Book that Beats the Market by Joel Greenblatt
Our Current Reality
However, in today’s investment landscape, the power of value investing flies in the face of anything taught in academics. Buffett, Graham and Greenblatt believe that value is the way stocks are eventually priced. It requires the perspective of patience as the market will eventually gravitate towards value.
Value investing does not always work as the market does not always agree with you. Over time, value is roughly the way the market prices stocks, but over the short term (can be as long as 2–3 years), there are periods it does not work. But that is a good thing. The fact that the value approach does not work over periods of time is precisely the reason why it continues to work over the long term. It forces you to buy out-of-favor companies, stocks that no one who reads a newspaper would think of buying and hold a portfolio consisting of these stocks that, at times, may underperform the market for those periods. In fact, the most important feature of value investing is in its fundamental research in stock picking compared to factor and statistical modelling in quantitative approaches. Most people can’t stick with a strategy like that.
Why? It is because most people cannot just keep buying during a recession or a crash (one of the many examples). Put yourself on the trading desk during the 1987 crash and ask yourself, “Can I keep buying?” If you are a value investor, you must not be afraid. You have to stay focused on the value of a business and see past exogenous crises events. Stocks get cheaper than fair value. It may be painful to buy into a panic over the short run, but over the long run, it can pay off if you are buying stocks well below their value. Start looking for companies that are somewhat obscure, not covered by Wall Street, or have a niche business inside the company that no one is focusing on. Stocks of interest would be picked from their financial metrics (EV / EBITA, FCF, P/E, EV / EBIT) from an accounting perspective.
The Key to Value Investing
Focus on companies you are familiar with — Buffett calls this the “circle of competence”. Avoid difficult to understand industries with short and unpredictable life cycles. Look for good businesses. A good business is one that provides a necessary service or product and has a balance sheet and cash flow that can sustain it through difficult periods. In addition, look for companies that other companies might like to acquire due to their market share, intellectual property, distribution network or real estate value. It would be good to look for reports covered by analysts (even if it is a little dated). This is because it provides a great background on the company and the industry it competes in. Frequently, these reports include some background on the company’s competitors, as well as tables that compare the company’s profitability versus its competitor.
The general principle is that when there is a major discrepancy between similar companies, the profit potential can result in a takeover or be realized by the market. Then when the stock reaches a reasonable valuation, you sell it and move onto the next investment. Good ideas do not come that often. But the wider you cast your net through reading, screening and speaking with others, the greater the likelihood that you will succeed in finding good ideas.
However, it’s important to recognize that value investing comes with a significant drawback known as the “value trap.” This occurs when numerous companies are identified as inexpensive, but their low valuation is justified by their poor quality. Consequently, the market accurately assesses and maintains their low price.
I do believe it is easy to avoid value traps. The trick is to stay away from companies that are unable to grow their cash flow and increase intrinsic value. If the business is a “melting ice cube” like newspapers, yellow pages and video rentals etc. (to name a few bad businesses), then do not invest in it, no matter how cheap it is. Conversely, if investing in a business that can be purchased at a discount to its intrinsic value, and that value is growing, then all you have to do is wait and be patient.
“Time is the enemy of the poor business and the friend of the great business” — Warren Buffett
You always need to keep in mind that stocks are units of ownership in a business. If you buy a stock at a good valuation and the price goes down, unless something has changed with the business or business outlook, you should stay the course, or possibly even buy more. Conversely, don’t get carried away if the stock goes up. You should use the same valuation discipline to decide where you’re going to sell. If the stock reaches what you think is fair value, take your profits and go onto the next one. Sentiment drives the short time while value drives the long term.
The lesson to take away is that investors should try their best to maintain perspective and avoid groupthink (herding) in the short term. In particular, reflecting on history and carefully considering multiple scenarios can be helpful to provide necessary calibration. Buffett, with an emphasis on how easy it is to get swept up in emotion and a dismissal of overly quantitative approaches, comments that good business judgment with an ability to insulate thoughts and behavior from the super contagious emotions that swirl around in the marketplace will make a good investor.
Final Thoughts
There are numerous avenues for generating profit in the market, and among them is value investing. Investment strategies aren’t one-size-fits-all; however, I advocate for value investing, especially for retail investors. Its simplicity and intuitive nature make it accessible (think: buy low, sell high — a classic yet effective mantra). Furthermore, this approach prioritizes long-term gains, offering a more conservative alternative to frequent market trading (which also reduces transaction costs). By focusing on a company’s financial stability rather than speculative potential, value investing steers clear of the volatility inherent in market booms and busts. Lastly, in today’s busy world, value investing requires less attention compared to more complex methods like quantitative modelling, making it a practical choice for many investors. Nonetheless, choose an approach that suits you best.
Like what Edward Thorp believes in:
“Try to figure out what your skill set is and apply that to the markets. If you are really good at accounting, you might be good as a value investor. If you are strong in computers and math, you might do best with a quantitative approach.” — Edward Thorp, Hedge Fund Market Wizards
References:
[1] Hedge Fund Market Wizards: How Winning Traders Win — Jack D. Schwager
[2] The Intelligent Investor — Benjamin Graham
[3] Journey of a Value Investor — Guy Spier
[4] More Than You Know: Finding Financial Wisdom in Unconventional Places — Micheal J. Mauboussin
