By Adam Tabor, 2012 J.D., Creighton University School of Law
Bruce Greenwald’s book, Value Investing – From Graham to Buffett and Beyond, is an excellent book for anyone interested in value investing. The book is based on the legendary teachings of Benjamin Graham and David Dodd, the fathers of value investing. In his book, Greenwald addresses some of the basics of value investing. Specifically, he discusses: What is value investing? Does it work? How risky is it? And, how is it done? In addition to some illustrations of value investing, Greenwald provides profiles of successful value investors. This book review will attempt to summarize some of the important points discussed by Mr. Greenwald.
WHAT IS VALUE INVESTING?
Like any investment strategy the goal of value investing is to buy low and sell high. What makes value investing unique is the manner in which securities are selected for purchase. As first described by Benjamin Graham and David Dodd, value investing rests on three theories: (1) The price of securities may move up or down without any underlying change in the fundamentals of a company. (2) Many companies have underlying intrinsic values that are different from what the market is offering and these intrinsic values may be determined through thoughtful analysis. (3) Lastly, buying securities when the market value is sufficiently below the company’s intrinsic value will produce superior results.
Thus, value investing is simply finding a company, determining its intrinsic value through fundamental analysis and comparing that value with the market price for the security. If the market value is sufficiently below the intrinsic value, research shows that there is a good opportunity to make a profit with such an investment.
The most difficult part of value investing is determining a company’s intrinsic value. There are a number of valuation methods that may be used and each has differing degrees of reliability. Value investing seeks to base valuations on the most reliable information available. As a result, value investors focus on assets, cash flows, and recent earnings. As opposed to growth investors, value investors do not historically pay for the prospect of growth because of the unreliability inherent in estimating growth. Before discussing how value investors value an investment, it is worth determining whether such an investment strategy actually works and how risky it is.
In order to determine whether an investment strategy is successful one must compare the returns produced by the strategy to the returns produced by the market as a whole. If the investment strategy cannot match the market, investors would be better off just investing in the market. Generally, in any given year, seventy percent of professional managers underperform the market. When considering annual returns over a multi-year period, the number of money managers who are able to beat the market drops significantly. So how do value investors compare to the market?
Historically, value stocks may loosely be defined as stocks with low price-to-book or low price-to-earnings ratios. Since the 1920s, research has shown that a portfolio of low price-to-book or low price-to-earnings stocks has outperformed the market by 3 to 5 percent a year. As some value investors point out, the prolonged superior returns of value stocks is evidence that markets are not perfectly efficient. In addition to statistical research, a look at some famous value investors proves the merits of value investing.
Many students of Benjamin Graham have done very well for themselves year in and year out. Warren Buffett, Graham’s most famous student, has average over a twenty percent return annually for a number of decades. Glenn Greenberg, partner at Chieftain Capital Management, has achieved a compound annual growth rate of twenty-five percent a year from 1984 to 2000. Michael Price began his career in 1975 working for a fund managing $5 million. Overtime the fund grew to $15 billion in assets. This increase was made up of additional capital as well as returns on investments of twenty percent a year. Lastly, Walter Schloss and his son Edwin managed a compounded annual return of fifteen percent from 1956 to 2000. During the same period of time the S&P returned eleven and a half percent. Put another way, a dollar invested with Walter in 1956 grew to $662 by 1973 compared to the $118 the S&P would have returned.
The bottom line is that value investing works. The research shows that the strategy works and the outstanding returns by value investors actually practicing value investing also proves the strategy works.
ARE THE EXTRA RETURNS PRODUCED BY VALUE INVESTING DUE TO EXTRA RISK?
Value investors and modern portfolio theorist disagree as to whether the returns produced by value investing are merely rewards for increased risk. The disagreement arises because both parties completely disagree on the proper metric for determining risk. Academics and modern portfolio theorists define risk as the volatility of the stock price, also known as beta. Value investors define risk as the possibility of loss. The difference can be illustrated by a story from Warren Buffett.
In 1973 Warren Buffett purchased a large amount of shares of the Washington Post Company. By Buffett’s calculation the company was worth at least $400 million. Since the stock market was in shambles and prices were down significantly, the market capitalization of the company was merely $80 million. Addressing the risk issue, Buffett asked what would happen if the market price dropped even more resulting in a market cap of $40 million? According to modern theorists the stock would be more risky because of the increased volatility in stock price. However, in Buffett’s eyes, the investment became less risky. Why? Because now the investment had an even larger margin of safety. The stock price fell but there was no change in the underlying fundamentals of the company. As a result, one could by the same $400 million company for an even lower, less risky price.
Related to risk is the issue of portfolio diversification. Modern investment theorists rely heavily on the belief that diversification is achieved by purchasing stocks that have negative correlation. Theoretically, it is thought that this method of portfolio construction erases unsystematic risk. Although most value investors disagree with this theory, there is not one value investor who puts all their eggs in one basket. However, it is not uncommon for value investors to have portfolios with much fewer stocks than those of their modern investment theory counterparts. The reason value investors have much fewer stocks is because value investing requires a margin of safety to be built in to every investment. This margin of safety allows for value investors to occasionally make mistakes without sinking their entire portfolio.
On balance, it appears value investors have the more persuasive argument when it comes to risk and diversification. In the eyes of value investors the most important numbers are the ones driving their valuations. Price volatility merely presents opportunities to purchase securities below their intrinsic value and have nothing to do with risk of loss.
HOW DOES VALUE INVESTING WORK?
At the heart of value investing is fundamental analysis. Fundamental analysis is the practice of calculating a value based on information found on the company’s financial statements. Based on the financial information provided in the financial statements, value investors consider three elements of value: (1) the value of the assets, (2) the earnings power value, and (3) the value of growth.
Valuing the Assets
In determining the value of the assets, a value investor must first consider the economic viability of the industry in which the company operates. If the industry is not economically feasible going forward the value of the assets should be based on their liquidation value. Alternatively, if the industry is in good shape then the company should be valued based on an asset valuation of the company.
When determining liquidation value, value investors start at the top the balance sheet. Assets closer to the top of the balance sheet will most likely be discounted less than those assets further down the balance sheet. For example, the liquidation value for cash does not require any adjustments whereas accounts receivable will have to be discounted because of the risk of nonpayment. For inventory, as a rule of thumb, inventory that is more commodity-like will not have to be discounted as much as inventory that is more specialized. Greenwald uses the example of a t-shirt versus cotton. The t-shirt will have to be discounted more than the cotton. The same is true for property, plant, and equipment. The more specialized the asset the more likely it will have to be discounted in order to be sold during liquidation.
On the other hand, where the industry is in good shape there are few different valuation methods that may be used. First is the traditional Graham and Dodd net-net approach. Here, one simply subtracts the liabilities from the current assets and if there is sufficient room between the two than there is a good investment. The primary problem with this approach is that these investments simply do not exist anymore. Next, an investor could simply take the value of the assets stated on the balance sheet and compare it to the market price; if there is a sufficient margin of safety than there is a good investment. The problem with this approach is that the accounting value of the assets may vary significantly from their true value. The best approach is a reproduction cost approach in which the investor analyzes the assets and liabilities of the company and makes adjustments in order to better represent what a new entrant into the industry would have to spend in order to recreate the assets of the company. This approach is the best but it requires a significant amount of work in order to properly justify the adjustments that must be made to the balance sheet.
Earnings Power Value
Greenwald states that the goal of the earnings power value is determine the distributable cash flows of the company by adjusting the earnings figure and then figuring a valuation based on those cash flows. Basically, in order to determine this value, the value investor will start with the operating income of the company and “smooth” out the earnings by adjusting for one time charges, depreciation and amortization, and adjusting for fluctuations caused by the business cycle. Once the investor determines a cash flow amount, the cash flow is multiplied by one over the cost of capital. The result is the earnings power value of the company.
Comparing the earnings power value to the asset valuation may provide valuable insight to the investor. If the earnings power value is below the asset value than it is likely that management is not using the assets efficiently. Alternatively, if the earning power value is much higher than the asset value, it may indicate that the company enjoys some kind of advantage over its competitors.
The Value of Growth
As stated before, value investors do not like to pay for growth because estimating growth is not a reliable metric. However, growth may increase the value of a company where it is real growth. As Greenwald points out, most investors view growth in sales or growth in earnings as a good thing, but this may not always be the case. Growth only creates value when the capital necessary to fund the growth creates more profit than what was required to fund it. Meaning, growth only creates value where a dollar used to fund the growth creates more than a dollar in profit. If growth creates less than what is required to fund the growth, than the company is actually destroying value.
After analyzing these three metrics of value, the value investor is able to determine a value for the company solidly based on the company’s financials. This valuation is then compared to the market price of the stock. The value investor builds in a margin of safety and determines whether it is a good investment. The valuation methods discussed here are the traditional ones developed by Graham and Dodd, but there are number of different variations that have been developed by different value investors for use in different situations. No matter what valuation method is used the extensive knowledge required by the investor remains the same and as long as the valuation is based on conservative and sound fundamentals, the value investor can purchase the investment with confidence.
Without a doubt Value Investing is a quality book for advancing ones knowledge of investing. The book provides insight in to the theory and reasoning underlying value investing. That being said, this book is not for the beginner. One must have a working knowledge of finance, accounting, and investment theory in order to understand some of the more complicated portions of the different valuation techniques. Furthermore, Greenwald’s explanation behind the algebra underlying the formulas used in the book is lacking at times. Most often, it seems Greenwald glosses over the math portion when it would be more helpful to have a detailed explanation of the formula and results. Despite what Greenwald leaves out, conducting some outside research will allow a diligent reader to grasp the underlying concepts described by Greenwald.
Adam Tabor graduated with a B.S. from Creighton University where he majored in Finance. In May of 2012, Adam received a J.D. from the Creighton University of School of Law. Upon completion of the Iowa Bar Examination, Adam will be practicing at The Law Offices of Gallner and Pattermann, P.C., in Council Bluff, Iowa.