This article, intended for the reader with no prior background, will lay out some history and principles of value investing. We intend to write subsequent articles on how you can implement such a strategy in your investing.
Background
The concept of value investing originated from a business course taught by Benjamin Graham and David Dodd at Columbia Business School. Their views were deeply influenced by the Wall Street Crash of 1929 at the outset of the Great Depression, in which many who invested in businesses were wiped out financially. In response to the crash, they focused on investments which would limit losses during future crashes. This is seen in their definition of investing:
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.
Graham and Dodd (1934), in Security Analysis
Let us break this definition down. The three parts are:
- Thorough analysis;
- Safety of principal; and
- Satisfactory return.
First, we need to ensure that we do due diligence and invest only in what we fully understand (Buffett calls this our ‘circle of competence’). Second, we need to minimise risk in our investments, so as to avoid losing our initial investment sum. Third, investments should have a good chance of a generous return. Naturally, true value investing satisfies these three criteria.
In addition to the course that they taught at Columbia Business School, Graham and Dodd wrote Security Analysis in 1934, and Graham wrote The Intelligent Investor in 1949. Both remain important books in value investing today.
What exactly is value investing?
Graham and Dodd, in Security Analysis (1934), describe value investing as searching for discrepancies between the intrinsic value of a business and the price at which shares in that business are traded on the market.
concerned with the intrinsic value of the security and more particularly with the discovery of discrepancies between the intrinsic value and the market price.
Graham and Dodd (1934), in Security Analysis
The intrinsic value of a business refers to the price at which they would be willing to buy the business whole. Theoretically, the market capitalisation of a company (share price multiplied by number of shares outstanding) should be close to its intrinsic value, since market capitalisation is the overall valuation that market participants assign the company. However, situations frequently arise in which there is a significant gap between intrinsic value and market capitalisation (in either direction). Graham and Dodd described value investing as buying shares when the current market price is significantly less than the intrinsic value.
Graham himself described this approach as buying a dollar for 50 cents.
If gold dollars without any strings attached could actually be purchased for 50 cents, plenty of publicity and plenty of buying power would quickly be marshalled to take advantage of the bargain.
Benjamin Graham (1932), in Should Rich but Losing Corporations be Liquidated?
If someone offered to sell a dollar to you for anything less than a dollar, would you take up the offer? Most of us would, as it gives you an instant gain. This is the basic tenet of value investing. If a company has $100,000 in cash and no debt, surely it should be worth at least $100,000? If it were trading on the stock exchange at a market capitalisation of $50,000, would you buy shares in this company? This is akin to buying a dollar for 50 cents.
We will now elaborate on a few topics related to value investing.
Fundamental versus technical analysis
Value investing is a form of fundamental analysis, which is the analysis of the business which underlies the stock. A fundamental analyst looks at a company’s financial statements to form an understanding of the business model and thereby estimate its intrinsic value.
Technical analysis, on the other hand, refers to the studying of past movements in share price. Technical analysts attempt to spot patterns and profit from them by predicting the subsequent price movements. Technical analysis totally disregards the underlying business and treats shares only in terms of one number – their price. Technical analysis is used by individual traders as well as banks and hedge funds (some of which use high-powered computers for algorithmic high-speed trading).
Considering that this is an article on value investing, I am indeed promoting fundamental analysis. For some evidence that it can work, see The Superinvestors of Graham-and-Doddsville, a famous article by Warren Buffett. The other question is, does technical analysis work? As far as I can tell, there is no conclusive evidence to settle this question.
Personally, it makes sense to me that technical analysis may work now and then due to other people following similar technical strategies of trading. These therefore form self-fulfilling prophecies, which I would call mini bubbles. Clearly, this would entail a significant risk as you could be the last one holding on to the security when the bubble bursts. Technical analysis might also capitalise on advances in behavioural finance, which utilises studies in human instinct to predict how other market participants will react to specific price movements.
Even though I think that technical analysis might work occasionally, I have never dabbled in it. Recalling Graham and Dodd’s definition of a sound investment operation, I find that technical analysis does not satisfy the requirements as the principal is not very safe.
Margin of safety
How does one promise ‘safety of principal’? Is it really possible to guarantee that barring extreme unforeseen circumstances, one will not lose money in an investment? Graham and Dodd certainly thought so. Their method was to ensure a margin of safety in their investments. Warren Buffett uses an analogy to explain this concept:
When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it.
Warren Buffet (1984), in The Superinvestors of Graham-and-Doddsville
The idea here is that the investor should not blindly buy shares in a company trading at any price less than the intrinsic value. Rather, the investor should only buy shares in a company if those shares are trading significantly below the intrinsic value. This buffer allows for possible minor errors in the valuation process as well as unexpected future developments. By requiring a sizeable margin of safety, we can significantly reduce the chances of losing money on our investments in the long-run.
If you buy a dollar bill for 60 cents, it’s risker than if you buy a dollar bill for 40 cents.
Warren Buffet (1984), in The Superinvestors of Graham-and-Doddsville
How large a margin should you aim for? It is impractical to decide on a fixed percentage to be applied on all investments. Buffett, extending his analogy of the safety of bridges, said that the margin of safety depends on the specific circumstances of each case. You might not require such a large margin for a small bridge over a shallow stream, but you would certainly want a very large margin for a suspension bridge over a deep valley.
Applying this to the investment context, smaller companies with less solid financials or resilient industry dynamics should be assigned larger margins of safety, while larger companies with more solid financials or resilient industry dynamics can be afforded smaller margins of safety. There is no hard and fast rule, but rather, the investor needs to make their own judgement for each investment.
Definition of value
The story so far is reasonably straightforward. If a company with 100 shares outstanding has an intrinsic value of at least $100,000, then each of the shares has an intrinsic value of at least $1,000. If the shares are trading on the stock market for $500 each, then this is a good value investment because the intrinsic value exceeds the market price by a large margin of safety. In other words, you can reasonably expect that the share price will not fall too far below $500 (‘safety of principal’), yet you have a good chance of realising the intrinsic value of $1,000 (‘satisfactory return’).
The tricky part comes with calculating a company’s intrinsic value, which is the value of the company based on sound fundamental analysis of its balance sheet, cash flows, business model, and management.
that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses.
Graham and Dodd (1934), in Security Analysis
Graham and Dodd’s initial focus was that intrinsic value primarily arose from tangible assets. For instance, Graham, in his 1932 article Inflated Treasuries and Deflated Stockholders, analysed a company called White Motors and found it to be valued by the market at “only one-fifth of the net quick assets”. Net quick assets are today called net current assets, which is basically the value of assets that can be easily converted into cash within a year (including cash itself) minus all debt. The general idea is that buying a company at a steep discount to net current assets is an almost fail-safe investment because even if the company is liquidated (ceases business operations and sells of assets), the amount of money left after paying back debt would still be enough to give each shareholder a profit on the initial investment.
The view then moved towards valuations based on earnings (profits). This view is still held by many fundamental analysts today who use discounted cash flow (DCF) to value businesses. This approach entails looking at past earnings of the company and making guesses as to future profits. The higher the predicted future profits, the greater the intrinsic value of the company.
While I do not use rigorous DCF calculations in analysing businesses (I opine that such precise estimates of profits years from now are quite pointless), I do find earnings to be much more important than assets in the valuation process. An asset-based approach to valuing companies may have been more relevant in the relatively-distant past when big companies (e.g. railway companies or manufacturers) relied heavily on physical capital (railway tracks and trains or factories, respectively). Therefore, physical capital was a good measurement of the profits and value of the company then. Today, however, big, successful companies tend to be relatively asset-light. They earn outsize profits due to brand loyalty (Apple or Peleton), technological know-how (Tesla or Intel), monopolistic positions (Google or Facebook), or massive economies of scale (Netflix or Amazon). These characteristics do not necessarily involve physical equipment or buildings. Therefore, using tangible assets to value these companies would not give accurate estimates of intrinsic value.
I will expound my process of business valuation in a later post. It is important to note, however, that the process of valuing businesses will always be more of an art than a science. There is no fixed formula that can be applied on all companies.
To sum up
- A sound investment involves thorough analysis, minimal chances of losses, and a probable decent profit.
- Value investing involves “buying dollar bills for forty cents”, i.e. buying companies at steep discounts to intrinsic value.
- When buying undervalued companies, ensure a sufficient margin of safety.
Further reading
Online articles
- Series of three Forbes articles by Benjamin Graham in 1932: here, here, and here
- The Superinvestors of Graham-and-Doddsville (1984) by Warren Buffett
- What has Worked in Investing (1992) by Tweedy, Browne Company LLC
Books
- Security Analysis (1934) by Benjamin Graham and David Dodd
- The Intelligent Investor (1949) by Benjamin Graham
- Common Stocks and Uncommon Profits (1996) by Philip Fisher
- One Up on Wall Street (2000) by Peter Lynch
- The Little Book of Value Investing (2006) by Christopher Browne
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