- Value investing involves buying stocks which are selling at less than their worth.
- Value investors need to maintain a high "margin of safety".
- One must keep a long term horizon in value investing.
Value investing is an investment philosophy which involves buying securities whose intrinsic value is higher than the current market value. In other words, paying lower price for higher value. Value investing as an investment philosophy was first propagated by Benjamin Graham and David Dodd in their 1934 text “Security Analysis”. Since then “Security Analysis” has been considered as the bible for a serious value investor.
Value investing assumes that markets are not efficient. There are wide fluctuations in market prices which are not justified by the company fundamentals. Markets can be wrong in their judgment which creates an opportunity for investors to earn profits. The value investor hopes to make a profit from markets eventually realizing their mistakes and correcting the price of the security.
Tenets of Value Investing
Value investing involves thorough analysis of fundamentals and the management of the company. The financials of the company should be like a fortress. An investor should check the financial statements including the disclosures made by the company, because sometimes even big companies can as cheat on financials. Investors should also analyze relevant ratios from balance sheet, income statement and cashflow. One should analyze the company as though one is going to be the owner of the business, which one will be by owning equity stocks.
Management Track Record
The management should have a proven track record and should comprise of individuals of impeccable integrity. Warrant Buffett judges the quality of management by the returns generated by the company on retained earnings.
Margin of Safety
Value investors seek to buy a security whose intrinsic value is much higher than the current market price. According to Graham margin of safety should be anywhere from 30% to 50%. Margin of safety increases the likely return and reduces the risk. Graham advises to have a high margin of safety because it is almost impossible to accurately price a security. A value investor does not buy a stock which has a value of $100 but selling at $95. He would buy it if the price was $70. High margin of safety allows an investor to mitigate the risk arising out of less than accurate valuation of stock.
Long Investment Horizon
Value investors should be ready to lock in their investments for a considerable period of time, for the stock market may take a very long period of time to correct itself. Daily volatility of the stock price should not be a cause of worry to value investors. Investors need to think beyond quarters. In fact, famous value investor Warren Buffet's mantra is "Our favorite holding period is forever".
Identifying Value Stocks
Benjamin Graham had built a screener for identifying value stocks. The screener consists of the following ten points.
- PE of the stock has to be less than the inverse of the yield on AAA rated corporate bonds.
- Debt-Equity Ratio (Book Value) has to be less than one.
- PE ratio of the stock has to be less than 40% of the average PE over the last 5 years.
- Current Assets > Twice Current Liabilities.
- Historical Growth in EPS (over last 10 years) > 7%.
- Dividend Yield should be greater than two-thirds of the AAA Corporate Bond Yield.
- Price should be less than two-thirds of Book Value.
- Price < Two-thirds of Net Current Assets.
- Debt < Twice Net Current Assets.
- No more than two years of negative earnings over the previous ten years.
Henry Oppenheimer, an Associate Professor of Finance at the State University of New York at Binghamton, conducted a study on performance of portfolio based on Graham’s screener, in which he examined the returns of the portfolio over a 13-year period from December 31, 1970 through December 31, 1983. The study showed that the return from the portfolio based on Graham’s screener generated a return of 29.4% per annum versus NYSE-Amex index which gave a return of 11.5%. One million dollars invested in the net current asset portfolio on December 31, 1970 would have increased to $25,497,300 by December 31, 1983. By comparison, $1,000,000 invested in the NYSE-AMEX Index would have increased to $3,729,600 on December 31, 1983.
In the run up to the dotcom bubble many value investors’ portfolios under-performed the market, fund managers practicing value investing were questioned about under performance of their portfolios. Value investors faced severe criticism. Even Warren Buffett was not spared. From end of June 1998 to end of February 2000 the overall stock market rose by 32% while Berkshire Hathaway’s share price declined by 44%. Buffett was criticized for failing to understand “the new economy”. However the subsequent collapse of the market proved them right. In value investing there will be times when the market will outperform your portfolio. The value investor must retain faith in himself and his investment.
Market can remain irrational longer than one can remain solvent
One of the biggest danger facing a value investor is that a security can remain mispriced for a considerably long period of time. Sometimes the spread between intrinsic value and market value can even widen. This can not only lead to erosion of self-confidence of the investor but serious portfolio value loss too. If the investor is, by some unforeseen circumstances, forced to exit from the investment, then the book losses crystallize, leading to real loss of money.
Long Term Capital Management (LTCM) was a hedge fund founded by Noble laureates and star traders which invested in arbitrage deals i.e. investment in mispriced securities. Since markets eventually caught up, this strategy yielded considerable returns. However in 1998, because of unforeseen events and the Russian debt default, the securities not only remained mispriced but the spread widened. This resulted in very high notional loss for the fund, almost eroding the entire net worth of LTCM. The fund was taken over by a group of investment banks in order to save it from chaotic bankruptcy and preventing market collapse. Eventually the market caught up and the spread declined, yielding very high profits to the investment banks. Unfortunately, LTCM was not around to see its investment make profit.
With advances in high powered computing and increase in financial analysts, it has become difficult to find value stocks, specially based on Graham’s screener. In the days of Graham, when computers were less powerful and not ubiquitous, it was relatively easier to locate value stocks. In fact Graham used to buy securities of companies whose market value was less than total current assets. In today’s world such companies are very rare to find.
Value investing and its proponent Benjamin Graham’s claim to fame comes from the performance of his students like Warren Buffett and Walter Schloss, and other value investors.
Warren Buffett, who was Graham’s student and worked with him is considered one of the greatest investor of all times. He has consistently outperformed the market since the 1970s. Berkshire Hathaway has given a compounded annual return of 19.7% to its shareholders for the last 49 years compared to 9.8% from the S&P 500 with dividends included for the same period. In his talk given at Columbia University, commemorating the fiftieth anniversary of “Security Analysis” written by Benjamin Graham, Buffett recounts investing records of nine investors who have taken the value investing approach to investing. All of them have beaten the market consistently and considerably.