Why value investing works

Value Investing Works

"In the world of investing, being correct about something isn't at all synonymous with being proved correct right away”                Howard Marks

Price Vs Value

Share prices don't exist in a vacuum. Instead, they represent what it costs, at one point in time, to buy a tiny proportion of a company listed on the stock exchange - a company that employs people, produces goods or services and, hopefully, generates revenue, profit and cash flow. Alongside this quoted stock price, value investors also take account of a company's underlying, or "intrinsic" value. 

Unlike the stock price, you can never get an exact fix on this figure but you can sometimes make a reasonable estimate by undertaking "fundamental analysis", which involves looking at a company's financial statements over time and making an assessment of its management, markets and growth potential. Share prices, you may have noticed, vary enormously over the course of a year. But a business's revenue, profit and cash flow rarely change anything like as much as that. The reason for this is that the price of a company's shares is only a reflection of what people are willing to pay for them at any given time. 

Sometimes, usually when prices are rising, they're greedy. When prices fall, they become fearful and rush for the exits. All this emotion can push the share price a long way from the intrinsic value of the underlying business. Value investors aim to benefit from this by buying shares when they're trading at significantly less than their intrinsic value. Or, to put it another way, buying a dollar's worth of value for 50 cents.

Why value investing works

If value investing works so well, why doesn't everyone jump on the bandwagon? Not everyone is able to view movements in stock prices with the detachment that's required of a value investor; if they could, then the share market extremes caused by fear and greed would not occur. This paradox is one of the keys to the success of the value approach: the concepts are extremely simple to grasp but can be very difficult to put into action. Why? Human psychology. Most stocks tend to be priced about right much of the time. Something significant usually has to happen for a stock to become under or overpriced; a profit warning or a competitor releasing a super-duper new product, for example. In other words, an attractive opportunity for value investors is very often caused by bad news, while good news is very often the signal to head for the exits. So value investors have to be contrarian, looking for the positives when everyone else is looking at the negatives (and vice versa). Humans are hard-wired to follow the crowd, but that's usually an unprofitable course of action in the share market.

The other reason is related to retail investors’ emotional biases. Few retail participants in Bursa are interested in dull stocks with not much of trading activities. There is no fun watching it with little or no movement in share prices of these stocks every day. Most of them just listen to hot tips and rumours to speculate in the market without having any knowledge about investing. 

Those retail investors with better knowledge and experience will have an advantage. There is also this institutional imperative. Most institutional investors have no mandate investing in small capitalized firms. Fund managers are more concern about their career risks if following a winning strategy if it involves enduring long stretches of relative underperformance which does happen in the short term, but usually not in the long term. They feel that it is safer to be wrong when everyone else is losing money than to be wrong when everyone else is making money which the formula can do.

Value investing is extremely simple in theory, but tougher in practice.  If you compare the price of a stock with a confident valuation of its true worth (intrinsic value) and find you can buy it at a considerable discount (margin of safety) then you may be onto a winner. But value investing is much harder than it looks for two reasons, firstly the real intrinsic value of a company can be tricky to calculate but also the practice of buying beaten down stocks also runs contrary to almost all human instincts.  Who wants to be the guy holding the boring power generation stocks MFCB when everyone else is buying the hot stock KNM? But it’s precisely these tendencies that lead to so many investors over-reacting,  driving prices down so low that value stocks become so profitable in future.

How Profitable is Value Investing?

Benjamin Graham is widely regarded as the dean of value investing as well as the whole industry of Security Analysis.  This influence stems not only from his published works but also from the eventual fame and fortune of the pupils that he taught at Columbia University who included Warren Buffett.

 It is thanks to Graham that we have a whole catalogue of quantitative bargain stock strategies at our disposal with such obscure titles as ‘Net Net Bargains’ and ‘Net Current Asset Value Bargains’ as well as a whole ream of other concepts that we’ll explore in our course including Margin of Safety.

In a paper titled “The Super Investors of Graham and Doddsville”, Warren Buffet showed the track records of each of nine disciples of Benjamin Graham showing that they all generated annual compounded returns of between 18% and 29% over track records lasting between 14 to 30 years. 

Is it likely that these individuals from the same school of thought could all beat the market over a generation if the stock market was a place of luck? Warren Buffett doubted it most eloquently when he said “I'd be a bum on the street with a tin cup if the market was always efficient”.  Let’s have a look at their profit history...

Investor	No. of Yrs	Annualised     Return	S&P / Dow     Return
Buffett Partnership	13	29.5%	7.4 % (Dow)
Walter Schloss	28	21.3%	8.4%
Tweedy Browne	16	20%	7%
Bill Ruane	14	18.2%	10%
Charlie Munger	14	19.8%	5.0% (Dow)
Pacific Partners	18	32.9%	7.8%
Perlmeter Investments	18	23%	7.0 % (Dow)

The value investing camp splits into two on this topic. Fundamental value hunters who follow Warren Buffett tend to fall into the ‘focus portfolio’ camp believing that you should put all your eggs in just a few baskets and watch them like a hawk. 

 An alternative approach is that espoused by the more ‘quantitative’ value farmers who seek to ‘harvest’ the value premium from the market. Graham recommended owning a portfolio of 30 bargain stocks to minimise the impact of single stocks falling into bankruptcy or distress, while Joel Greenblatt recommends a similar level of diversification in his Magic Formula strategy. 

Making Sense of Value Investing Principles

What should be clear now is that while intrinsic value and margin of safety make perfect sense in the context of value stock selection, defining precisely how to execute each principle requires some careful thinking and the acceptance that some nuances can only be decided by the interpretation and preference of each investor. 

By kcchongnz