Value Investing: From Graham To Buffett and Beyond
Value Investing: From Graham To Buffett and Beyond
Value Investing: From Graham To Buffett and Beyond
Value Investing
From Graham to Buffett and Beyond
by Bruce C.N. Greenwald, Judd Kahn, Paul D. Sonkin and Michael
van Biema
These excessive reactions cause stock prices to move above or below their real
or intrinsic value and the core theme of value investing is to buy stocks when their
prices are below their intrinsic values. Graham called the gap between price and
value the "margin of safety." A large margin of safety both increases the potential
return and reduces the risk of loss. Basically, the secret to superior returns is to
buy stocks that are priced well below their real value.
Finding Value
First, the investor must be aware of the limits of his or her own knowledge or
competence. Buffett always looks for businesses that he can understand such as
media companies and consumer goods firms. This way he can distinguish
between genuinely under-priced securities and ones that are simply cheap.
Secondly, value investing requires patience. In a bull market it may take time to
find undervalued stocks, and once a security is purchased, patience is also
required while waiting for the price to rise to its true value. "After all," writes
Greenwald, "you bought it because it was out of favor. The market's estimate of
its worth doesn't change overnight."
Biases
Given value investing's superior track record, why haven't investors caught on,
bought more value stocks, and created the demand to drive prices up out of
value territory? The answer is "biases" and they identify fertile ground in the
search for under-priced stocks. Understanding biases and qualities that steer
many investors away from value stocks (thus lowering demand and prices) can
narrow the field of stocks to investigate in greater detail.
Institutional Biases
Many institutional funds have restrictions on what investments they can make:
Personal Biases
Human psychology
People remember recent events better than distant ones and often generalize
from a few memorable cases rather than incorporate all available data. The
problem is that market leadership is transient: over a 2-3 year period winners tend
to become losers and vice versa. People dislike risk and hate losing money. We
become emotionally biased against stocks that have dropped in price, even
though their lower prices have already discounted the negative events that
caused the drop in the first place.
Valuation
Of course the trick in value investing is to determine the real value of a security.
Only then can you tell if the stock is undervalued or not. So how do we determine
the value of a security?
Greenwald states that value can be determined in three ways. The first and most
accurate measure is asset value, next is the current earnings power and finally,
the third is potential growth. It is important to consider each of these methods
Asset Value
To determine asset value we begin with the balance sheet and adjust or accept
the values of each asset group. Then we do the same with the liabilities. Lastly,
we subtract liabilities from assets to arrive at the current net asset value. There is
virtually no forecasting or discounting.
Values in liquidation
The more specialized the asset, the harder it will be to sell, and the more its book
value should be reduced. The following are suggested guidelines for adjustments
to book values:
Generally, adjustments made to current assets will not be substantial; little time
has elapsed for the book and reproduction values to diverge. Fixed assets are
quite different in this regard.
Property: Land does not depreciate and may be worth much more than its
book value. Even if a competitor wouldn't need to spend as much as the
market value of a firm's land, that surplus value (like excess cash) should
be included.
Plant: Big adjustments from book values to replacement costs may be
required here due to depreciation and inflation.
Equipment: Case by case; could be an increase or decrease.
Goodwill
This could represent real value or no value at all. If a firm possesses "hidden
assets" like loyal customers and established sales channels add a multiple
(generally 1-3 years) of the annual sales.
The second most reliable measure of a firm's intrinsic worth is the value of its
current earnings, properly adjusted. The equation we use to determine this is:
If the EPV is substantially below its asset value, the firm is either being
mismanaged or is in an industry with excess capacity; either way, a value investor
will use the lower earnings figure. If the EPV and asset value are roughly equal,
there are no competitive advantages. If the EPV is much higher than the asset
value, the firm must enjoy significant barriers to entry that can offer protection well
into the future. The difference between the asset value and the EPV is the value
of the firm's franchise i.e., that which allows it to earn more than its cost of
capital.
Potential Growth
The value of growth, the third and last measurement of a firm's value is rarely
considered. Greenwald writes, "For most companies in a competitive market
economy, all the value of the growth will be consumed to pay for the additional
capital that is necessary to fund the growth." Growth is the most uncertain source
of value and is therefore the most discounted.
The authors present the following equation to determine the present value (PV) of
a growing firm:
where ROC is the return on capital, G is the growth rate, and R is the cost of
capital.
This measurement tool is useful when valuing those rare companies that possess
a sustainable competitive advantage and repeatedly exceed market-level
earnings on the reproduction value of the assets.
The essential task of the successful value investor is to determine intrinsic value
with enough accuracy to take advantage of the market's mispricing. By using
these three methods, Asset Value, Current Earnings Power and Potential Growth
you will be able to measure the financial situation of a company which will put you
on very firm ground when valuing companies.
Now that the authors have given you the tools to determine a company's value,
they share insights from the masters.
Benjamin Graham laid the foundation for value investing but over time many
successful investors have added to his ideas and created their own styles of value
investing. Here are some of the key ideas of the most successful value investors.
Warren Buffett
Mario Gabelli
Favors private market value (PMV) i.e., "the value an informed industrialist
would pay to purchase assets with similar characteristics."
Looks for assets and earnings hidden by GAAP (generally accepted
accounting principles).
Focuses on domestic franchise businesses that generate cash.
Michael Price
own valuation.
Values companies based on comparable transactions.
Likes bankruptcy investing (once the price falls to 30-40% of the firm's
value). He tries to own enough stock to have a voice in bankruptcy
negotiations but not enough to be an official creditor committee member.
Paul D. Sonkin
Conclusion