Patrick Lawlor 04-Aug-2017
The term “value investing” is frequently used, but not always understood. We delve a little into investment philosophy, as defined and practised by two of its most famous exponents, Benjamin Graham and Warren Buffett.
This week, our editor Patrick Lawlor gives us a great piece on a topic that is often debated but as investors it’s good to be reminded of these key tenets of investing. People often see value investing as buying the old beaten up Volksie in the used car lot and restoring it to its former glory. The cost of restoring that old Volksie may often exceed the cost of buying a brand spanking new Caravelle for that well deserved family holiday and in investing parlance we may call this a ‘value trap’. At W&I we consider valuation to be a core pillar of our investment philosophy but are cautious when it comes to deep value and prefer to marry value with growth. Most investors fail to see that value and growth are intrinsically linked and as Pat notes in this piece, this is a philosophy that we at W&I share with the Warren’s of the world.
The term “value investing” is frequently used, but not always understood. We delve a little into investment philosophy, as defined and practised by two of its most famous exponents, Benjamin Graham and Warren Buffett.
Graham is widely considered to be the inventor of value investing approach to investing, publishing two books on the topic – Security Analysis and The Intelligent Investor. Buffett, a famous investor in his own right and a student of Graham and former employee of Graham’s investment partnership Graham-Newman, has elaborated on Graham’s principles in his own writings.
His overall conclusion was that the evidence suggested that the practice of buying stocks when there is a material discount between the value of a business and the price of a business was the reason for these investors’ success and that this practice would likely prove to be successful in the future.
We briefly examine below the key principles of the value investing framework as described by Buffett in his writings and interviews and to provide a brief description of how the practice of value investing has evolved over time.
The key principles of value investing
– Warren Buffett, The Warren Buffett Way, Robert Hagstrom, 2005
The above quote from Warren Buffett describes the three key principles of value investing. 1. Stocksaspiecesofbusinesses:Focusonthefundamentalsofthebusiness
“In the short run, the market is a voting machine but in the long run it is a weighing machine.” – Benjamin Graham
The value investing approach to investing thinks of stocks as ownership stakes in a business rather than as pieces of paper or chart formations. Value investors seek to justify the purchase of a stock based on an assessment of the value of a business’s assets and / or future financial performance. A good test to assess whether or not an investor is thinking of a stock as a piece of a business is to ask the following question: if markets were to be closed tomorrow for five years, would it materially affect one’s decision to buy the stock? If not, one is probably thinking about the stock as a business. If it would, one is probably thinking about the stock as a piece of paper.
Ben Graham taught us to look at stocks as businesses, use the market’s fluctuations to your advantage and seek a mar-gin of safety. A hundred years from now, these will still be the cornerstones of investing.”
2. Invest with a margin of safety: Value should be greater than the price
“If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.” – Warren Buffett, The Super Investors of Graham – and – Doddsville, Warren Buffett, 1984
The value approach to investing distinguishes between the value of a business and the price of a business. The objective in value investing is to buy a business for substantially less than it is worth. Risk and reward are often positively correlated. However with value investing the relationship between risk and reward is inversely correlated – as the price of an investment declines relative to its value, the risk of loss declines and the potential for gain increases. This gap between value and price is called the ”margin of safety”.
3. Use the markets fluctuations to your advantage
“Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
“Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
“Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behaviour, the better for you.
“But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t
belong in the game. As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’” – Warren Buffett, Berkshire Hathaway 1987 Annual Report
Conclusion
At its heart value investing is a helpful framework to use to think about investing. The primary measure of value – the discounted cash flow – is by definition a subjective calculation which requires long-term assumptions for growth, inflation / interest rates and taxation. Practical application of this methodology requires an estimate of a business’s future performance and the likely course of inflation / interest rates and taxation far into the future – the long term nature of these assumptions make them very challenging and they need to be applied with industry knowledge, conservatism and humility – as the future is always uncertain. Aside from the skill of valuing businesses the value approach also requires discipline and patience – it is important to use the market’s fluctuations, to one’s advantage as opposed to chasing after the market.
To end with, value investing is often contrasted with growth investing, which can create some confusion about the nature of value investing. This issue is best explained by Buffett himself, who made the point that in his opinion all investing is value investing and that growth is simply a component in the calculation of value:
“In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).“ – Warren Buffett, Berkshire Hathaway 1992 Annual Report.
https://www.investec.co.za/about-investec/what-we-do/wealth-and-investment/Financial-Service- Providers/friday-fix/lessons-from-the-greats-in-value-investing.html