Wednesday 1 September 2010

Value investing is, on average, successful in the long run.

Value investing

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Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham & David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis. Although value investing has taken many forms since its inception, it generally involves buying securities whose shares appear underpriced by some form(s) of fundamental analysis.[1] As examples, such securities may be stock in public companies that trade at discounts to book value or tangible book value, have high dividend yields, have low price-to-earning multiples or have low price-to-book ratios.

High-profile proponents of value investing, including Berkshire Hathaway chairman Warren Buffett, have argued that the essence of value investing is buying stocks at less than their intrinsic value.[2] The discount of the market price to the intrinsic value is what Benjamin Graham called the "margin of safety". The intrinsic value is the discounted value of all future distributions.

However, the future distributions and the appropriate discount rate can only be assumptions. For the last 25 years, Warren Buffett has taken the value investing concept even further with a focus on "finding an outstanding company at a sensible price" rather than generic companies at a bargain price.

 

Contents

History

Benjamin Graham


Benjamin Graham
Value investing was established by Benjamin Graham and David Dodd, both professors at Columbia Business School and teachers of many famous investors. In Graham's book The Intelligent Investor, he advocated the important concept of margin of safety — first introduced in Security Analysis, a 1934 book he co-authored with David Dodd — which calls for a cautious approach to investing. In terms of picking stocks, he recommended defensive investment in stocks trading below their tangible book value as a safeguard to adverse future developments often encountered in the stock market.

 

Further evolution

However, the concept of value (as well as "book value") has evolved significantly since the 1970s. Book value is most useful in industries where most assets are tangible. Intangible assets such as patents, software, brands, or goodwill are difficult to quantify, and may not survive the break-up of a company. When an industry is going through fast technological advancements, the value of its assets is not easily estimated. Sometimes, the production power of an asset can be significantly reduced due to competitive disruptive innovation and therefore its value can suffer permanent impairment. One good example of decreasing asset value is a personal computer. An example of where book value does not mean much is the service and retail sectors. One modern model of calculating value is the discounted cash flow model (DCF). The value of an asset is the sum of its future cash flows, discounted back to the present.

 

Value investing performance

Performance, value strategies

Value investing has proven to be a successful investment strategy. There are several ways to evaluate its success. One way is to examine the performance of simple value strategies, such as buying low PE ratio stocks, low price-to-cash-flow ratio stocks, or low price-to-book ratio stocks. Numerous academics have published studies investigating the effects of buying value stocks. These studies have consistently found that value stocks outperform growth stocks and the market as a whole.[3][4][5]

Performance, value investors

Another way to examine the performance of value investing strategies is to examine the investing performance of well-known value investors. Simply examining the performance of the best known value investors would not be instructive, because investors do not become well known unless they are successful. This introduces a selection bias. A better way to investigate the performance of a group of value investors was suggested by Warren Buffett, in his May 17, 1984 speech that was published as The Superinvestors of Graham-and-Doddsville. In this speech, Buffett examined the performance of those investors who worked at Graham-Newman Corporation and were thus most influenced by Benjamin Graham. Buffett's conclusion is identical to that of the academic research on simple value investing strategies--value investing is, on average, successful in the long run.

During about a 25-year period (1965-90), published research and articles in leading journals of the value ilk were few. Warren Buffett once commented, "You couldn't advance in a finance department in this country unless you taught that the world was flat."[6]

 

Well-known value investors

Benjamin Graham is regarded by many to be the father of value investing. Along with David Dodd, he wrote Security Analysis, first published in 1934. The most lasting contribution of this book to the field of security analysis was to emphasize the quantifiable aspects of security analysis (such as the evaluations of earnings and book value) while minimizing the importance of more qualitative factors such as the quality of a company's management. Graham later wrote The Intelligent Investor, a book that brought value investing to individual investors. Aside from Buffett, many of Graham's other students, such as William J. Ruane, Irving Kahn and Charles Brandes have gone on to become successful investors in their own right.

Graham's most famous student, however, is Warren Buffett, who ran successful investing partnerships before closing them in 1969 to focus on running Berkshire Hathaway. Charlie Munger joined Buffett at Berkshire Hathaway in the 1970s and has since worked as Vice Chairman of the company. Buffett has credited Munger with encouraging him to focus on long-term sustainable growth rather than on simply the valuation of current cash flows or assets.[7] Columbia Business School has played a significant role in shaping the principles of the Value Investor, with professors and students making their mark on history and on each other. Ben Graham’s book, The Intelligent Investor, was Warren Buffett’s bible and he referred to it as "the greatest book on investing ever written.” A young Warren Buffett studied under Prof. Ben Graham, took his course and worked for his small investment firm, Graham Newman, from 1954 to 1956. Twenty years after Ben Graham, Prof. Roger Murray arrived and taught value investing to a young student named Mario Gabelli. About a decade or so later, Prof. Bruce Greenwald arrived and produced his own protégés, including Mr. Paul Sonkin—just as Ben Graham had Mr. Buffett as a protégé, and Roger Murray had Mr. Gabelli.

Mutual Series has a well known reputation of producing top value managers and analysts in this modern era. This tradition stems from two individuals: the late great value mind Max Heine, founder of the well regarded value investment firm Mutual Shares fund in 1949 and his protégé legendary value investor Michael F. Price. Mutual Series was sold to Franklin Templeton in 1996. The disciples of Heine and Price quietly practice value investing at some of the most successful investment firms in the country.

Seth Klarman is a Mutual Series alum and the founder and president of The Baupost Group, a Boston-based private investment partnership, authored Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor, which since has become a value investing classic. Now out of print, Margin of Safety has sold on Amazon for $1,200 and eBay for $2,000.[8] Another famous value investor is John Templeton. He first achieved investing success by buying shares of a number of companies in the aftermath of the stock market crash of 1929.

Martin J. Whitman is another well-regarded value investor. His approach is called safe-and-cheap, which was hitherto referred to as financial-integrity approach. Martin Whitman focuses on acquiring common shares of companies with extremely strong financial position at a price reflecting meaningful discount to the estimated NAV of the company concerned. Martin Whitman believes it is ill-advised for investors to pay much attention to the trend of macro-factors (like employment, movement of interest rate, GDP, etc.) because they are not as important and attempts to predict their movement are almost always futile. Martin Whitman's letters to shareholders of his Third Avenue Value Fund (TAVF) are considered valuable resources "for investors to pirate good ideas" by another famous investor Joel Greenblatt in his book on special-situation investment You Can Be a Stock Market Genius (ISBN 0-684-84007-3, pp 247).

Joel Greenblatt achieved annual returns at the hedge fund Gotham Capital of over 50% per year for 10 years from 1985 to 1995 before closing the fund and returning his investors' money. He is known for investing in special situations such as spin-offs, mergers, and divestitures.

Charles de Vaulx and Jean-Marie Eveillard are well known global value managers. For a time, these two were paired up at the First Eagle Funds, compiling an enviable track record of risk-adjusted outperformance. For example, Morningstar designated them the 2001 "International Stock Manager of the Year" and de Vaulx earned second place from Morningstar for 2006. Eveillard is known for his Bloomberg appearances where he insists that securities investors never use margin or leverage. The point made is that margin should be considered the anathema of value investing, since a negative price move could prematurely force a sale. In contrast, a value investor must be able and willing to be patient for the rest of the market to recognize and correct whatever pricing issue created the momentary value. Eveillard correctly labels the use of margin or leverage as speculation, the opposite of value investing.

Christopher H. Browne of Tweedy, Browne was well known for value investing. According to the Wall Street Journal, Tweedy, Browne was the favorite brokerage firm of Benjamin Graham during his lifetime; also, the Tweedy, Browne Value Fund and Global Value Fund have both beat market averages since their inception in 1993.[2] In 2006, Christopher H. Browne wrote The Little Book of Value Investing in order to teach ordinary investors how to value invest.[3]

 

Criticism

An issue with buying shares in a bear market is that despite appearing undervalued at one time, prices can still drop along with the market.[9] Conversely, an issue with not buying shares in a bull market is that despite appearing overvalued at one time, prices can still rise along with the market.

Another issue is the method of calculating the "intrinsic value". Two investors can analyze the same information and reach different conclusions regarding the intrinsic value of the company. There is no systematic or standard way to value a stock.[10]

 

Value investing books and resources

 

See also

 

Value Investors at Wikiquote

 

References

  1. ^ Graham, Benjamin (1934). Security Analysis New York: McGraw Hill Book Co., 4. ISBN 0-07-144820-9.
  2. ^ Graham (1949). The Intelligent Investor New York: Collins, Ch.20. ISBN 0-06-055566-1.
  3. ^ The Cross-Section of Expected Stock Returns, by Fama & French, 1992, Journal of Finance
  4. ^ Firm Size, Book-to-Market Ratio, and Security Returns: A Holdout Sample of Financial Firms, by Lyon & Barber, 1997, Journal of Finance
  5. ^ Overreaction, Underreaction, and the Low-P/E Effect, by Dreman & Berry, 1995, Financial Analysts Journal
  6. ^ Joseph Nocera, The Heresy That Made Them Rich, The New York Times, October 29, 2005
  7. ^ Warren Buffett's 1989 letter to Berkshire Hathaway shareholders
  8. ^ The $700 Used Book. (2006, Aug. 7). BusinessWeek, Personal Finance section. Accessed 11-11-2008.
  9. ^ When Value Investing Doesn't Work
  10. ^ [1]
  11. ^ Graham and Dodd. 1934. Security Analysis: Principles and Technique, 1E. New York and London: McGraw-Hill Book Company, Inc.
  12. ^ Graham and Dodd. 1940. Security Analysis: Principles and Technique, 2E. New York and London: McGraw-Hill Book Company, Inc.
  13. ^ Graham et al. 1951. Security Analysis: Principles and Technique, 3E. New York: McGraw Hill Book Company, Inc.
  14. ^ Graham et al. 1962. Security Analysis: Principles and Technique, 4E. New York: McGraw-Hill Book Company, Inc.
  15. ^ Graham and Dodd. 1988. Security Analysis: Principles and Technique, 5E. McGraw-Hill Professional
  16. ^ Graham and Dodd. 2008. Security Analysis: Principles and Technique, 6E. McGraw-Hill Professional


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