2. Value Investing

What is Value Investing?

Value investing was born in 1928, the year Benjamin Graham began teaching a security analysis course at Columbia University. The teachings of his course were later published in his 1934 book ‘Security Analysis’, which he wrote together with David Dodd. In 1949, Graham followed up with his second book ‘The Intelligent Investor’, in which he emphasized the emotional framework, the principles, and the attitudes of an intelligent investor. As the books became bestsellers, so became value investing. Many will hence agree that Benjamin Graham is the father of value investing.

The fundamental idea behind value investing is that securities have an economic value which is different from their actual market price. The difference between real value and market price allows investors to buy stocks which are undervalued and sell stocks which are overvalued¹.

An essential part of professional value investing is to calculate the actual economic value of a company, which is called the intrinsic value. If the current market price of a stock is significantly below the calculated intrinsic value, the investor buys the stock and will – eventually – achieve superior returns². The superior return of selecting and investing in value stocks is called the value premium. 

This model of intrinsic value is crucial for value investors, as it allows them to buy stocks at an advantageous price below its actual value. The value investor then profits, when the market corrects the price of the stock to its actual value. How far below the intrinsic value an investor bought his position in a company also determines the success of his investment. The lower the price he paid, the higher are his returns. The higher the price paid, the lower are the returns of the value investor. 

Benjamin Graham called the difference between the market price of a stock and the intrinsic value of the business the margin of safety. The concept of the margin of safety makes clear that it is essential for a value investor to never pay too much for a given stock. The larger the margin of safety, the less risk is the value investor exposed to.

The concepts of intrinsic value and the margin of safety conflict with the efficient market hypothesis, which states that the market price always adequately reflects the value of a business. A higher return is only possible with either a higher risk or pure luck – both of which the professional value investor wants nothing to do with.

Quantitative and Qualitative Value Investing

Before we dig deeper, we first have to differentiate between two different approaches to value investing. Value investing as it is referred to in the scientific literature is not the same value investing as practiced by real-life value investors. Both approaches can be quite different.

Quantitative Value Investing

The scientific community uses a quantitative value investing approach, also index funds apply this approach. The quantitative approach to value investing became popular shortly after Fama published the efficient market hypothesis in 1970. Researchers started to use low price-earnings-ratios and low price-to-book-ratios to challenge the validity of the hypothesis.

Today, low price-earnings-ratios and low price-to-book-ratios – among others – are used to identify undervalued companies, also called value stocks.

Large investment companies like Oppenheimer & Co and Tweedy, Browne, indexes like the S&P 500/Citigroup Pure Value Index, and index funds like the Vanguard Value Index Fund show that a mere quantitative approach to value investing can already outperform the market.

Qualitative Value Investing

The most successful value investors use quantitative screening tools only as a preliminary step in the investment process, and not as a basis for making a final investment decision. Filtering the stock market for low price-to-book (P/B) ratios helps them to narrow down the vast universe of stocks. They then research low P/B companies further by examining the potential growth outlook, competitors, a company’s earnings power, and many other criteria. This is also called the fundamental analysis. The goal is to get an accurate picture of each potential company, its industry and to come up with an own intrinsic value of the businesses. If the calculated intrinsic value of a business is below the market price, a value investor buys the stock.

While all investors have their preferences in how they are doing a fundamental analysis, what they all have in common is that they analyze not only the financials of a company, but the entire company – from the financials, to the industry, to the management.

Only by working with an accurate intrinsic value, investors can make sure that they invest in businesses with a large enough margin of safety.

Therefore, value investing itself should not be understood nor restricted to the quantitative method to find undervalued stocks. For value investors, the term ‘value investing’ instead represents an entire investment philosophy. As Seth Klarman points out³, the value investment philosophy teaches investors “the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology.”

What Seth Klarman means with resisting crowd psychology is for one the awareness that humans and institutions have psychological flaws – as described earlier – and second, the skill to overcome these biases. The second book of Benjamin Graham, The Intelligent Investor, focuses precisely on this aspect by providing a framework for overcoming the crowd psychology bias.

To gain an understanding of why some companies are undervalued, it is helpful to understand all the psychological misjudgments and all biases which are distorting the investment environment.

Identifying Value Stocks

Even though only a small minority of the overall market follows value investing principles, value investing is still a popular approach to investing. The total amount which is invested according to value investing principles has risen to a total amount which Seth A. Klarman estimates⁴ in the trillions of U.S. dollars. Still, there are rarely overlaps of specific value investments. Different investors follow different valuation methods and invest in different markets, industries, and sectors.

Let’s look at a few examples of how different investors and scientists approach value investing.

Benjamin Graham

The first value investing strategies were introduced by Benjamin Graham in the early 20^th century. He introduced his historical net-nets and net-net-working-capital (NNWC) strategies in his first book Security Analysis, which he wrote together with David Dodd. What Graham called Net-Net is today called Net Current Asset Value or NCAV⁵.

Net Current Asset Value (NCAV)

The net current asset value is calculated by subtracting total liabilities from a company’s current assets. The net-net strategy, therefore, evaluates companies solely on their net current assets.

What Graham calls net-nets are companies which are selling below the value of all their current assets minus all their liabilities⁶.

The basic idea of Benjamin Graham was to find out what a company would be worth in the case of liquidation.

By only looking at current assets – which are cash or assets which can be converted quickly and easily into cash – an investor would acquire all fixed assets the company possesses, such as buildings, plants, machinery, or goodwill, for free. Because of this, investing in companies which are selling below their net current asset value can be considered extremely safe. Even in the case of bankruptcy, the company should be able to liquidate at least the sum of its net current asset value. As a result, investing in net-nets provides a significant margin of safety. Ben Graham suggested that investors should focus on stocks selling at least one-thirds below their net-current-asset value.

Net-Net-Working-Capital (NNWC)

Benjamin Graham and David Dodd went one step further and used their market observations to develop the concept of the net-net-working-capital (NNWC).

The NNWC is a result of Grahams observation⁷ that, in the case of a liquidation, cash and cash equivalents realize all of their value, accounts receivables are converted to cash 75% of the time, and companies can sell and turn half of the inventory into cash.

Concluding, the NNWC is calculated as follows:

NNWC = cash +marketable securities + (receivables 0.75) + (inventories 0.5)-total liabilities

In his book The Intelligent Investor, Graham described⁸ how he applied the method in his Graham-Newman investment partnership. His strategy was to buy as many stocks as possible – often more than 100 at once – at 2/3 or less of their net current asset value. The fact that Graham invested in over one hundred stocks shows that investing in net-nets nonetheless requires a diversified portfolio.

The researcher Henry Oppenheimer found out⁹ that in the period between 1970 and 1983, portfolios selected from the NCAV method showed higher returns than the market. He also showed that those portfolios whose companies were the most undervalued tended to outperform the markets the most.

In 2008, other researchers updated Oppenheimer’s findings with an empirical analysis of the London Stock Exchange in a period from 1981 to 2005¹⁰. They, too, showed that stocks with NCAV/MV <1.5 displayed high returns over a holding period of five years.

However, according to Glenn Greenwald, the NCAV approach might have been a solid strategy in the industrial age, when Benjamin Graham developed his net-net approach¹¹. According to Greenwald, today it is nearly impossible to buy attractive and profitable businesses at NCAV prices. One might come up with a few companies by screening for stocks which are selling below their NCAV, but those are very likely companies with “serious difficulty, perhaps on the verge of bankruptcy.”

The investment principles Graham taught might still be true today, but we must remember that his valuation methods and strategies in the 1930s and 1940s were limited. Today’s investors have access to Excel spreadsheets and stock screening software like Bloomberg Terminal or Eikon. They no longer have to rely on pen and paper to evaluate securities – as Benjamin Graham did. As a result, today’s investors can find companies which are selling below their NCAV within seconds, and thus a possible undervaluation is corrected quickly. 

Although Benjamin Graham is known as the father of value investing, today’s investors should approach the NCAV approach with care, considering the changed investing environment. Precisely as Warren Buffett does.

Warren Buffett

Warren Buffett is today probably the best known value investor in the world. He frequently acknowledges the influence Benjamin Graham had on his investment success. Nevertheless, his investing approach today is different from the net-net approach Graham taught. Warren Buffett recognized that today’s business conditions are different from the past, and that a net-net investment approach is not as effective as it once was.

In his 2010 letter to shareholders, he explained the aspects, he and his partner Charlie Munger are looking for in companies: First, Warren Buffett and Charlie Munger only look at companies they thoroughly understand. Then, if the long-term outlooks of the business are looking positive, they check whether the management is “able and trustworthy”. Then, the last thing Munger and Buffett look at is the price of the business¹².

In other words, Buffett and Munger try to identify value stocks by the following sequence: 

Products

1. Customers
2. Management
3. Price (Margin of Safety)

It is worth noting that Buffett places price as the last criteria he looks at. Benjamin Graham, on the other hand, looked foremost for cheap and undervalued stocks. According to Hagstrom¹³, this is one example where one can observe the influence of Philip Fisher and Charlie Munger on Warren Buffett.

Philip Fisher was a famous American investor, best known for his book “Common Stocks and Uncommon Profits” which Warren Buffett called a “very, very good book”. Fisher is considered as one of the first growth investors, whose investment philosophy also influenced Warren Buffett. Already in 1992, Warren Buffett underlined¹⁴ that today he prefers “good businesses at fair prices rather than fair businesses at good prices.” Which is close to the investment advice of Philip Fisher.

Calculating an Intrinsic Value

Buffett still considers it important to calculate an intrinsic value to make sure he buys stocks with a sufficient margin of safety. According to Hagstrom¹⁵, Buffett looks at financial metrics which are easily measured. First, Buffett looks at the return on equity of a company. Secondly, Buffett calculates owner earnings to get a better impression of the value of the business.

Calculating Owner Earnings

Buffett calculates owner earnings as follows: net income plus depreciation, depletion, and amortization minus capital expenditures and any additional working capital¹⁶.

Adjusting the P/E Ratio

To get a real picture of a company, Buffett adjusts the P/E ratio by (1) valuing all marketable securities at cost, and (2) excluding all capital gains/losses and other extraordinary items that increase or decrease operating earnings¹⁷. Another critical investment criteria for Buffett are  high-profit margins.

In the end, Buffett uses his own intrinsic value calculation to make an investment decision.

Magic Formula Investing

Joel Greenblatt founded the company Gotham Asset Management – a company offering value investment funds. In 1999, he introduced the concept of formula investing in his book The Little Book that Beats the Market ¹⁸. It is interesting to mention that Greenblatt originally wrote the book for his five children, to teach them how to make money themselves. The language of the book is simple so that it is easily understood by children and people who are not familiar with finance and investing. The fact that Greenblatt originally wrote his book for children and teenagers makes it even more astonishing that the techniques and his magic formula showed a compounded annual growth rate of 23.76% from 1988 to 2004 versus 9.55% of the S&P 500.

The purpose of Greenblatt’s magic formula is to rank companies based on return on capital and earnings yield. Greenblatt calculates the return on invested capital (ROIC) as follows:

ROIC = EBIT / (Net Working Capital + Net Assets)

Joel Greenblatt argues that this formula has several advantages to return on equity – which Warren Buffett and many researchers use. First, EBIT is used to compare different companies’ independent of their debt and tax rates. Second, tangible capital employed is used to consider how much cash the company needs to conduct its business. The earnings yield is calculated as follows:

EY = EBIT / (market value of equity + net interest – bearing debt)

Greenblatt prefers EBIT/Enterprise-Value over the price-earnings-ratio, as it expresses the business earnings relative to the purchase price of the company.

Magic Formula Technique

Using Greenblatt’s magic formula technique to identify value stocks works as follows:

1. The stock market is limited to common stocks with a market capitalization of $50 million or more. These stocks are then filtered and put into two lists based on their return on invested capital (ROIC) and their earnings yield (EY). This results in two lists with stocks ranked from high to low.
2. The two lists are combined into one ranking.
3. Utility companies, financial companies, and foreign (non-U.S.) companies are removed from the list.
4. The investor then buys the five to seven best-ranked companies from the remaining list with 20 to 33 percent of the total money intended to invest.
5. Every 2-3 months, the screening process is repeated, and an additional 5-7 companies are added to the portfolio.
6. As soon as a stock has been held for one year, it gets sold.

For investors who do not want to use his specific magic formula technique, Greenblatt suggests screening the stock market for companies with a return-on-assets of at least 25%. The remaining stocks with the highest return-on-asset should then be filtered to those with the lowest price-earnings (P/E) ratio¹⁹.

A back test²⁰ showed a lower compounded average growth rate than the numbers stated by Greenblatt, which may be ascribed to the lack of slippage and fees in Greenblatt’s calculations. However, even the back test showed that the use of the magic formula technique resulted in a compounded average growth rate of 13.74% from 1999 to 2009 which is 12.87 percentage points higher than the compounded annual growth rate of the S&P 500 average during the same period.

Value Metrics

Not only investors but also researchers rely on specific metrics to downsize the vast universe of the entire stock market into a smaller selection of potential value stocks.

The Price-to-book and price-to-earnings ratios are the most common metrics used by investors, researchers, and large investment funds to identify potential value candidates²¹. But which specific metric is used depends mostly on the individual investor or researcher and his personal preferences.

As mentioned before, Warren Buffett uses an adjusted form of return on equity to filter the stock market for value stocks. Joel Greenblatt prefers a combination of return-on-assets and price-earnings ratio.

It is important to mention that the ratios of P/B (price-to-book) and M/B (market-to-book) constitute the same underlying calculation; while the P/B ratio looks at the values on a per-share basis, and the M/B ratio looks at the values on a company-wide basis – nevertheless the result is the same. The same is respectively true for B/P (book-to-price) and B/M (book-to-market) ratios. 

Furthermore, the reversed ratios represent the same underlying calculation. When one researcher uses the price-to-book (P/B) ratio to identify stocks, he will find value stocks in the low end of his list. If another researcher uses a book-to-price (B/P) ratio, he merely finds the value stocks reversed on the top end of his list.

For this book – a low P/B and – vice versa – a high B/P ratio indicate an undervalued stock.

The Value Premium

Value investing is all about finding undervalued stocks. In other terms, value investors try to find and invest in companies which are trading below their actual intrinsic value. The difference between the theoretical intrinsic value and the current market price may be called a value premium. But in investing circles, the term value premium mostly refers to the greater risk-adjusted returns of value stocks over growth stocks – which we look at now.

Growth Investing

The price-earnings ratio and the price-to-book ratio are not only used to find value stocks. They are also used to find so-called “growth stocks” and to separate them from value stocks.

Generally, stocks with a low P/E or P/B ratio are considered value stocks, and those with a respectively high ratio are considered growth stocks.

Growth investing describes a different investment method than value investing. In general, growth stocks are expected to grow faster than all other companies in the stock market. This growth might be achieved by revenue, cash flow, or profits and leads in the best case to a substantial capital gain for the growth investor. Therefore, growth investors are willing to pay a potentially overvalued price just to gain from a potential further appreciation of the stock price. The nature of growth stocks makes them very attractive for the average investor. Growth companies usually offer very innovative products which are thought to have a large market and thus growth opportunities in front of them.

Proof of the Value Premium

Many studies of the last decades have tested whether the returns of growth stocks are higher than the return of value stocks, how both compare to the market index, and which investment strategy in the end leads to higher returns.

In 1977, Sanjoy Basu²² was one of the first researchers to reject the efficient market hypothesis. He examined stocks with low and high price-earnings ratios and found out, that during the period from 1957 to 1971, portfolios with low P/E ratios (value stocks) have earned higher returns than their counterpart with high P/E ratios (growth stocks).

According to the efficient market hypothesis, the information contained in the low P/E ratio should have been observed and corrected by the market immediately. Ergo, it should’ve been impossible to achieve higher returns.

Because of this, Basu rejected the efficient market hypothesis. He argued that the indices of the P/E ratio have not been taken into the stock price as quick as the efficient market hypothesis claimed. 

In 1983, Sanjoy Basu²³ updated his research by examining stocks from 1963 to 1980. He again provided evidence that value stocks earned on average “higher-risk adjusted returns than the common stock of low E/P firms.”

In 1991, Louis Chan, Yashushi Hamao, and Josef Lakonishok²⁴ showed that in the Japanese stock market, the performance of stocks was greatly correlated to the company’s book-to-market and earnings-to-price ratio. In their study, high E/P stocks (value stocks) outperformed low E/P stocks (growth stocks) – the same was true for high B/M and low B/M ratios.

The publication of Fama and French in 1992²⁵ was then the ground-breaking ceremony of a large selection of research into the topic of growth versus value stock returns. In their article called The Cross-Section of Expected Stock Returns, Fama and French showed that real-world returns of companies do not correlate to a company’s beta (its stock volatility). Rather, their results suggested that the size of a company and the book-to-market equity ratio are great indicators for the “cross-section of average stock returns.”

Fama and French agreed that one can pick value stocks according to their book-to-market ratio, to improve one’s investment return. However, they also argued that picking stocks with a high book-to-market ratio leads to a portfolio with higher exposure to risk²⁶. By insisting that the risk is higher, they indirectly defended the efficient market hypothesis.

In 1994, the researchers Lokonishok, Shleifer, and Vishny²⁷ showed that portfolios consisting of value stocks outperform growth stock portfolios. They also tested the value stocks on risk, with the surprising result that – in contrary – value stocks are less risky. Thus, the above-average performances cannot be explained with higher risk.

To explain their observations, they introduced the term glamour stocks. They argued that investors tend to have a bias for growth stocks over unpopular value stocks. One reason might be that value stocks do not offer individual investors the possibility to get rich quick. Institutional investors are also biased towards growth stocks because value strategies usually need five years to pay off – meanwhile, they might underperform the market and thus lose their job or their clients.

An explanation why value stocks outperform the market was offered by Bauman and Miller in 1997²⁸ who examined the earnings growth rates of growth and value stocks. The extraordinarily high-growth rates of growth stocks typically diminish over time to a lower average level. In contrast, the smaller growth rates of value stocks tend to increase over time. They calculated that during a period of one year, the earnings growth rate of growth stocks often declines by 0.5% while the earnings growth rate of value stocks increases by around 3.5%.

In 1998, Fama and French²⁹ proved even more decisively the existence of a value premium in the United States. The value premium is not only observable when looking at high book-to-market stocks, but a similar value premium is achieved when screening companies according to earnings-to-price, cash-flow-to-price, and dividend-to-price ratios.

Also, Piotroski demonstrated in 2000³⁰ that screening companies for a high book-to-market value could result in a significantly higher return for the investor.

In 2004, Chan and Lakonishok³¹ reviewed previous research and concluded that “value investing generates superior returns.” But not because value investors are exposed to a larger risk, but rather as the result of different behavioral traits and biases of investors.

Researchers K. Anderson and Brooks approached the previous research with more skepticism. In their 2007 study³², they showed that the superior performance of value portfolios is the result of a “small group at the extreme end of the P/E range.” According to that, the highest returns can be achieved by holding a small number of carefully selected value shares.

In 2012, Fama and French³³ doubled down on their research on the value premium. They looked at international stock markets – among them North America, Europe, Japan, and Asia Pacific – to see if a value premium could be recognized. And indeed, they showed evidence that the value premium exists in all four regions.

What is the ideal holding period to maximize the value premium? The usual procedure of scientific research on value stocks is to assemble a portfolio based on pre-defined criteria and look at the differences after one year. However, the holding period of one year is an intolerantly chosen period and might not reflect the optimal holding period of investors.

It usually takes three up to five years for value strategies to work for average investors under real market conditions³⁴. In 2003, the researchers Rousseau and Van Rensburg³⁵ showed that the returns of value portfolios increase and become more reliable the longer the holding period. Warren Buffett and Charlie Munger go one step further as they say that their favorite holding period is forever³⁶.

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