Value Investing is a Blast from the Past (and Present)

Value Investing is a Blast from the Past (and Present)

Does an investment strategy need to be a high-flying, adrenaline-inducing circus act in order to be effective? Not quite. Each generation of Wall Street enthusiasts should take a step back now and then to study what has gone before. So it is with value investing, a strategy certainly popularized by Warren Buffett and his incredible multi-decade track record of success with Berkshire Hathaway.

What some might be interested to learn is that Buffett didn’t create value investing. He actually learned it from a couple of men he considered to be giants in the investment arena beginning way back in 1934. Here’s their story.

Value investing is an investment paradigm derived from the ideas on investment that Ben Graham and 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 of fundamental analysis. 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, argue that the essence of value investing is buying stocks at less than their intrinsic value. The discount of the market price to the intrinsic value is what Benjamin Graham called the “margin of safety”. Graham never recommended using future numbers, only past ones. 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.

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.

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’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. 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.

Performance of 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.

Value stocks do not always beat growth stocks, as demonstrated in the late 1990s. Moreover, when value stocks perform well, it may not mean that the market is inefficient, though it may imply that value stocks are simply riskier and thus

require greater returns.

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. 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”. Some analysts believe that two investors can analyze the same information and reach different conclusions regarding the intrinsic value of the company, and that there is no systematic or standard way to value a stock. But there is no ambiguity in the calculated value in value investing as taught by Benjamin Graham. The stock selection procedures given by Benjamin Graham himself are very specific and are intended to avoid exactly this kind of subjectivity by focusing on documented and objective past numbers, instead of subjective and predicted future ones. The ambiguity arises only when investors use formulas not given by Graham or use subjective predicted numbers against Graham’s recommendations.

Which is not to say value investing has no critics…

Criticism
Value stocks do not always beat growth stocks, as demonstrated in the late 1990s. Moreover, when value stocks perform well, it may not mean that the market is inefficient, though it may imply that value stocks are simply riskier and thus require greater returns.

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. 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”. Some analysts believe that two investors can analyze the same information and reach different conclusions regarding the intrinsic value of the company, and that there is no systematic or standard way to value a stock. But there is no ambiguity in the calculated value in value investing as taught by Benjamin Graham. The stock selection procedures given by Benjamin Graham himself are very specific and are intended to avoid exactly this kind of subjectivity by focusing on documented and objective past numbers, instead of subjective and predicted future ones. The ambiguity arises only when investors use formulas not given by Graham or use subjective predicted numbers against Graham’s recommendations.

And now you know about value investing.

The Young Wealth Team

 

 

 

 

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The Young Wealth Team

The Young Wealth Team

The Young Wealth Team

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