Value Investing is a branch of fundamental analysis of stocks (as opposed to trading or behavioral finance) adhering to the belief that there exists an ascertainable, intrinsic value for any security, and that an intelligent investor should buy securities trading at a discount to this appraised value (the gap making up for what is called the margin of safety).
While pioneered by Benjamin Graham in the 1930s, this investing philosophy has given birth to several schools of thoughts, from the “safe and cheap” approach at Third Avenue Funds to Joel Greenblatt’s metrics. Whether they admit it or not, all these investors trace their roots back to Graham.
The preceding comes courtesy of The Enterprising Investor.
What is Value Investing?
Different sources define value investing differently. Some say value investing is the investment philosophy that favors the purchase of stocks that are currently selling at low price-to-book ratios and have high dividend yields. Others say value investing is all about buying stocks with low P/E ratios. You will even sometimes hear that value investing has more to do with the balance sheet than the income statement.
In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffet wrote:
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).
Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.
Buffett’s definition of “investing” is the best definition of value investing there is. Value investing is purchasing a stock for less than its calculated value.
Tenets of Value Investing
1) Each share of stock is an ownership interest in the underlying business. A stock is not simply a piece of paper that can be sold at a higher price on some future date. Stocks represent more than just the right to receive future cash distributions from the business. Economically, each share is an undivided interest in all corporate assets (both tangible and intangible) – and ought to be valued as such.
2) A stock has an intrinsic value. A stock’s intrinsic value is derived from the economic value of the underlying business.
3) The stock market is inefficient. Value investors do not subscribe to the Efficient Market Hypothesis. They believe shares frequently trade hands at prices above or below their intrinsic values. Occasionally, the difference between the market price of a share and the intrinsic value of that share is wide enough to permit profitable investments. Benjamin Graham, the father of value investing, explained the stock market’s inefficiency by employing a metaphor. His Mr. Market metaphor is still referenced by value investors today:
Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
4) Investing is most intelligent when it is most businesslike. This is a quote from Benjamin Graham’s “The Intelligent Investor”. Warren Buffett believes it is the single most important investing lesson he was ever taught. Investors ought to treat investing with the seriousness and studiousness they treat their chosen profession. An investor should treat the shares he buys and sells as a shopkeeper would treat the merchandise he deals in. He must not make commitments where his knowledge of the “merchandise” is inadequate. Furthermore, he must not engage in any investment operation unless “a reliable calculation shows that it has a fair chance to yield a reasonable profit”.
5) A true investment requires a margin of safety. A margin of safety may be provided by a firm’s working capital position, past earnings performance, land assets, economic goodwill, or (most commonly) a combination of some or all of the above. The margin of safety is manifested in the difference between the quoted price and the intrinsic value of the business. It absorbs all the damage caused by the investor’s inevitable miscalculations. For this reason, the margin of safety must be as wide as we humans are stupid (which is to say it ought to be a veritable chasm). Buying dollar bills for ninety-five cents only works if you know what you’re doing; buying dollar bills for forty-five cents is likely to prove profitable even for mere mortals like us.
What Value Investing Is Not
Value investing is purchasing a stock for less than its calculated value. Surprisingly, this fact alone separates value investing from most other investment philosophies.
True (long-term) growth investors such as Phil Fisher focus solely on the value of the business. They do not concern themselves with the price paid, because they only wish to buy shares in businesses that are truly extraordinary. They believe that the phenomenal growth such businesses will experience over a great many years will allow them to benefit from the wonders of compounding. If the business’ value compounds fast enough, and the stock is held long enough, even a seemingly lofty price will eventually be justified.
Some so-called value investors do consider relative prices. They make decisions based on how the market is valuing other public companies in the same industry and how the market is valuing each dollar of earnings present in all businesses. In other words, they may choose to purchase a stock simply because it appears cheap relative to its peers, or because it is trading at a lower P/E ratio than the general market, even though the P/E ratio may not appear particularly low in absolute or historical terms.
Should such an approach be called value investing? I don’t think so. It may be a perfectly valid investment philosophy, but it is a different investment philosophy.
Value investing requires the calculation of an intrinsic value that is independent of the market price. Techniques that are supported solely (or primarily) on an empirical basis are not part of value investing. The tenets set out by Graham and expanded by others (such as Warren Buffett) form the foundation of a logical edifice.
Although there may be empirical support for techniques within value investing, Graham founded a school of thought that is highly logical. Correct reasoning is stressed over verifiable hypotheses; and causal relationships are stressed over correlative relationships. Value investing may be quantitative; but, it is arithmetically quantitative.
There is a clear (and pervasive) distinction between quantitative fields of study that employ calculus and quantitative fields of study that remain purely arithmetical. Value investing treats security analysis as a purely arithmetical field of study. Graham and Buffett were both known for having stronger natural mathematical abilities than most security analysts, and yet both men stated that the use of higher math in security analysis was a mistake. True value investing requires no more than basic math skills.
Contrarian investing is sometimes thought of as a value investing sect. In practice, those who call themselves value investors and those who call themselves contrarian investors tend to buy very similar stocks.
Let’s consider the case of David Dreman, author of “The Contrarian Investor”. David Dreman is known as a contrarian investor. In his case, it is an appropriate label, because of his keen interest in behavioral finance. However, in most cases, the line separating the value investor from the contrarian investor is fuzzy at best. Dreman’s contrarian investing strategies are derived from three measures: price to earnings, price to cash flow, and price to book value. These same measures are closely associated with value investing and especially so-called Graham and Dodd investing (a form of value investing named for Benjamin Graham and David Dodd, the co-authors of “Security Analysis”).
Conclusions
Ultimately, value investing can only be defined as paying less for a stock than its calculated value, where the method used to calculate the value of the stock is truly independent of the stock market. Where the intrinsic value is calculated using an analysis of discounted future cash flows or of asset values, the resulting intrinsic value estimate is independent of the stock market. But, a strategy that is based on simply buying stocks that trade at low price-to-earnings, price-to-book, and price-to-cash flow multiples relative to other stocks is not value investing. Of course, these very strategies have proven quite effective in the past, and will likely continue to work well in the future.
The magic formula devised by Joel Greenblatt is an example of one such effective technique that will often result in portfolios that resemble those constructed by true value investors. However, Joel Greenblatt’s magic formula does not attempt to calculate the intrinsic value of the stocks purchased. So, while the magic formula may be effective, it isn’t true value investing.
Joel Greenblatt is himself a value investor, because he does calculate the intrinsic value of the stocks he buys. Greenblatt wrote "The Little Book That Beats The Market" for an audience of investors that lacked either the ability or the inclination to value businesses.
Simply put, you can not be a value investor unless you are willing to calculate business values. To be a value investor, you don't have to value the business precisely - but, you do have to value the business.
Related Reading
Value Investing Encyclopedia: Joel Greenblatt
Deep Wealth
The average rate a business is taxed on its pre-tax earnings.
Effective Tax Rate = Tax Charges / Taxable Income
Example: In 2004, Journal Communications (JRN) had pre-tax earnings of $130.9 million and tax charges of $52.3 million. Journal Communications’ effective tax rate was 40%.
The structure of a business' long - term financing. This includes the mix of debt and equity (among other things).
The combined market value of a business' debt and equity.
Enterprise Value = Market Cap + (Debt - Cash)
(The above is an overly simplistic equation in some cases)
Free cash flow as a percent of sales.
(Operating Cash Flow - Cap ex) / Sales
Earnings Before Interest, Taxes, Depreciation, and Amortization.
Earnings Before Interest and Taxes.
Generally agreed upon term for merger arbitrage which is buying the stock of the accquiree while shorting the stock of the acquirer in a pre – announced deal.
The term arbitrage is sometimes used much more broadly, even including simultaneous actions in empirically correlated securities. Sometimes, there is not a strong logical basis for why this correlation must always exist (there is merely the knowledge that, in the past, it has almost always existed). This type of activity, especially when highly leveraged, can (and has) resulted in devastating losses.
A change in a company’s capital structure (but you probably got that).
Two of the most common reasons for a recapitalization are often done against the interests of long – term shareholders: 1) a company may recapitalize to avoid liquidation (in instances in which these bankrupt companies held lots of real estate the original shareholders would often have been better off demanding total liquidation) 2) a company may recapitalize to avoid a hostile takeover. For various reasons, today, businesses of any real size are not liquidated. In some cases, this has allowed a third party to gain control of the reorganized company by buying the bonds of the bankrupt company.
Special situations include: mergers, spin-offs, bankruptcies, and risk arbitrage.
Otherwise, this is a somewhat ambiguous term occasionally used to describe a fund as in “Smith & Smith’s Special Situations fund”. More often used to describe one of several permissible activities for a money manager to engage in as in “Smith & Smith’s Sylvan Brook fund seeks long term capital appreciation through investing in 1) domestic equities 2) foreign equities and 3) special situations.”
Special situations investing is sometimes called “event – driven investing” or “(risk) arbitrage investing”. Note that some funds consider temporarily shorting a stock in anticipation of bad news to be a special situation.
Joel Greenblatt’s “You Can Be a Stock Market Genius” is all about special situations.
What a rational investor is willing to pay today in order to receive a cash flow on a future date. DCF projections generally consist of two parts: the time value of money and the risk premium.
Personally, I do evaluate risk when purchasing a stock, but I never do so by assigning a risk premium.
When evaluating an expected long – term commitment, which a stock purchase usually is, I believe an appropriate discount rate is neither less than eight percent nor more than twelve percent. When evaluating a shorter term commitment, I believe an appropriate discount rate is no less than four percent and no greater than the yield on the applicable US Treasury debt instrument.
The four percent figure is simply an absolute floor on what money would be lent out at absent government intervention. There are estimates made by economists of what the natural rate of interest is. However, I simply use the four percent figure based on what little is known about lending in pre – modern times, and assume the rate has been pretty constant throughout human history (this is actually a groundless assumption; logic suggests the rate is lower today than it was a few thousand years ago, but I won’t bore you with the explanation – and it hardly matters; four percent is still a reasonable estimate).
When most people use the term profitable growth, they mean profitable according to GAAP. When I use the term, I mean economically profitable growth. That is, the return on capital exceeds the readily available return on capital (e.g., the average return on capital throughout the economy, the long – bond yield, etc.). Truly profitable growth only occurs when a business earns an extraordinary return on capital.
Generally Accepted Accounting Principles as determined by the Financial Accounting Standards Board (FASB).
(Investors have a strange fascination with four letter acronyms – and three letter acronyms, and five letter acronyms, and…)
Anyway, GAAP is an accrual method of accounting, which means income is reported when earned and expenses are reported when incurred. This better represents economic realities than cash basis accounting, but also leaves a little room for some creative interpretation of when certain transactions ought to be recognized.
Depends on context. Either a business whose sales do not grow faster than the rate of inflation or a business whose earnings do not grow faster than the rate of inflation. More often than not the term is used to describe an industry or line of business rather than a particular company. For example: "Dog food is a slow growth or no growth business". (The financial media has yet to see a rhyme they didn’t like).
Defined by Warren Buffet in Berkshire Hathaway’s 1996 owner’s manual as: “the discounted value of the cash that can be taken out of a business during its remaining life”.
This is the correct definition. You will sometimes see intrinsic value defined as “the discounted value of all future cash flows” – which is wrong.
Remember, a shoe box with a thousand bucks in it is worth a thousand bucks even though it doesn’t pay interest. Likewise, the intrinsic value of a business includes the excess cash currently held and takes into account the liquidation value of the business. Even a cash flow neutral business starts to look cheap when it’s got a hundred million in the bank and a market cap of ninety million.
A return on capital greater than the average return on capital available in an economy as a whole or the average return on capital in an industry as a whole depending on context. Simply put, an extraordinary return on capital is an above average return on capital; it is literally an “extra” “ordinary” return on capital. Pretty simple, huh?
A situation in which only one company can produce a specific product but many companies can produce separate products within the same class.
Every intellectual property is essentially a mini – monopoly. For instance, Lucasfilm has a mini – monopoly in Star Wars. Likewise, all video games, TV series, and books are mini – monopolies. For this reason, there is not as much direct competition in these industries, despite all appearances to the contrary. In fact, the size of the market for a product class like movies, video games, TV series, or books is partially determined by the demand for each mini – monopoly and thus is indirectly determined by the quality of the various products within the product class.
Simply put, if you want to know why movie sales are down, it’s probably because the movies being put out suck individually and thus movies sales in the aggregate suck as well. Ditto for video games.
Actually, even more so for video games. There’s a complicating factor here. The unspecified demand for movies is far higher relative to the specified demand for movies than the unspecified demand for video games is relative to the specified demand for video games.
Let me put that into English. People often make the choice to see a movie without first deciding upon which movie to see. No one (except a well meaning grandmother buying a Christmas gift) decides to buy a video game without first deciding upon which video game to buy.
Demand in markets made up entirely of mini – monopolies can not be analyzed to the same extent as demand in markets made up entirely of undifferentiated products. A drop in video game sales or box office receipts is not necessarily indicative of the unspecified demand for video games or movies; it is merely indicative of the specified demand for the particular video games and movies currently available for purchase.
Turning down a piece of moldy bread doesn’t mean you’re on the Atkins diet. Nor does foregoing a god awful movie mean you’ve become a shut in. That’s why the demand for mini – monopolies must be evaluated on a case by case basis.
A situation in which two firms control nearly all of the market for a product or service.
Duopolies can be surprisingly competitive. If you remember that the price of a product or service is determined solely by the highest losing bid price and the lowest losing ask price, you’ll realize why a duopoly can be so competitive. A large number of inefficient competitors will have almost no affect on prices in the long run unless someone (either a government or a group of idiotic investors) is willing to continually finance unprofitable operations in an unprofitable industry (think airlines).
Of course, there is always the fear of a price fixing scheme in a duopoly. Generally, however, that fear is unfounded. Human nature suggests a price fixing scheme is far more likely to occur in an oligopoly than a duopoly. Humans weight the fear of loss far more heavily than the greed of gain when making calculations about the future. In a duopoly, mistrust increases the fear of loss inherent to any price fixing scheme (namely, the other guy will screw you). In an oligopoly, the diffusion of power and the lack of excess capacity at any one firm makes price fixing very attractive. Price fixing in an oligopoly is a much safer bet than price fixing in a duopoly.
There are, of course, other reasons why a duopoly is very unlikely to result in a price fixing scheme. In addition to a healthy does of fear, there is an often unhealthy does of hate in duopolies. There is always just one scapegoat in a duopoly. Hatred is a personal emotion; if spread over too many objects it tends to wane away. Finally, there’s the simple fact that both competitors in a duopoly are likely really big, really agile, really cutthroat players. The process leading up to a duopoly tends to be a sort of wolfing run, in which two pups are separated from the runts.
Having said all that, price fixing is possible in a duopoly. Some duopolies are not the result of competition but of nationalization and privatization, although this is relatively rare since a nationalized monopoly won’t often result in a lasting duopoly (it will either remain a monopoly once privatized or get crushed by new, private competitors).
Finally, a price fixing scheme always makes more sense in a commodity business. After all, any product differentiation limits the degree to which general demand is applicable to specific competitors’ products. For example, Coke and Pepsi are highly differentiated products, at least when purchased in their specific packaging (physical differences or similarities are immaterial here; it is only the buyer’s belief that matters). I drink Pepsi, and I can assure you (however irrational it sounds) that no drop in the price of Coke would be sufficient to get me to stop buying Pepsi. There is almost no other tangible good about which I could say the same. So, clearly Coke and Pepsi are differentiated products, and there’s very little chance of an effective price fixing scheme between them.
A franchise is the area (literally or figuratively) in which a business enjoys a durable competitive advantage. To an investor, the terms franchise and brand are not interchangeable.
Many brands that have a lot of cachet aren’t franchises; while many brands that don’t have any cachet are franchises. For instance, some cellular phone service providers now have highly recognizable brand names. Unfortunately, that doesn’t do them a lot of good. They have to compete on price, and even if they didn’t someone else could come along and advertise. Because their services are undifferentiated, every company willing to spend enough on advertising should realize about the same results. If they provided a unique product or service (or could consistently provide the lowest price) their advertising would prove far more effective in building a franchise.
True franchises have really sticky customers. Often, this comes from a combination of having a unique product or service, spending lots of money on advertising, and customer complacency. Of these three factors, spending lots of money on advertising is by far the least important.
Examples of true franchises built on some or all of the above factors would include some seemingly very different companies such as: Microsoft, Google, eBay, Amazon, WD – 40, Clorox, Church & Dwight, Wrigley, Disney, Lucasfilm, The New York Times, GEICO, and Mars.
If you test each of these companies for the three aforementioned factors, you’ll see that in each case a unique product or service (usually artistic content or a brand name) or customer complacency is the reason for the company’s success.
Anything that prevents a business’ extraordinary return on capital from being whittled down to mediocrity by the ravages of competition. Where a business enjoys a durable competitive advantage it is said to have a franchise.
Sometimes, a business will have a durable competitive advantage without earning an extraordinary return on capital in the aggregate. In a few cases, a business will have a durable competitive advantage without earning an extraordinary return on capital in any line of business. It is even possible for a currently unprofitable business to have a durable competitive advantage. But, this is a very special case.
For instance, an unprofitable business may have a durable competitive advantage if it is the low – cost operator in an inefficient, highly fragmented industry, if and only if, the sole cause of unprofitability is inadequate sales volume.
This is most likely to be true in an industry where efficient, low cost operations can only be carried out after a substantial infrastructure investment and can not be sustained at a low sales volume. In such a case, it would not be surprising to see the established, efficient (and unprofitable) business secure a dominant share of the fragmented industry and earn an extraordinary return on capital once sales volume has increased. Where a marginal sale is ridiculously profitable, advertising costs will serve to entrench the position of the business with the highest volume and the lowest costs.
Now you know why you see so many GEICO ads on cable TV.
The return on the next (or last) dollar invested. Can also be called the marginal return on capital.
It is a critically important concept. A business’ stated return on capital does not necessarily bear any resemblance to the return on capital possible on the next dollar. In fact, the return on capital number is an aggregate, usually including some highly profitable activities as well as some painfully unprofitable ones.
Some outstanding businesses earn an extraordinary return on capital; but, do not earn an extraordinary incremental return on capital. Such a business has likely expanded as far as it can within its franchise, or at the very least would incur prohibitive costs to expand the franchise. When placing a value on a business’ future growth (by determining its growth factor), the return on incremental capital is more important than the business’ stated return on capital.
The return on incremental capital is a construct of the investor's mind; it can never be stated with the confidence and precision of the return on capital figure.
A business’ growth factor consists of two parts: the return on capital and the amount of unrealized growth within the franchise. The former governs profitability; the later governs growth.
Only a company that earns an extraordinary return on capital and can deploy additional capital within the franchise can be said to have a truly profitable growth factor. If a business’ return on capital is less than or equal to the average return on capital in the economy, then it does not have a positive growth factor regardless of its earnings growth rate. A company with a very high return on capital and no room left to deploy capital within the franchise will likewise not have a positive growth factor.
(Return on Capital – "Ordinary" Return on Capital)* Franchise Growth = Growth Factor
Short for market capitalization. It is the market value of the firm’s equity (stock). It does not include the firm’s debt (bonds). Investment professionals and the financial media often speak of micro cap, small cap, mid cap, large cap, and mega cap stocks. This simply refers to what the equity in the firm would be worth if every share was valued at the market price (i.e., the price of the last trade).
Remember, market cap does not directly measure the size of a business in any meaningful sense: sales, profits, employees, etc. Market cap can be viewed as the price tag on a business (as can enterprise value). Aside from this purpose, I have never found market cap to have any utility whatsoever.
Return on Equity (ROE) is equal to after – tax income divided by book value. It represents the return on owner’s equity, and is therefore comparable to the accounting measures return on partner’s equity and return on owner’s equity used in the financial analysis of partnerships and sole proprietorships respectively.
Although, in the long – run return on equity is what matters, ROE is often a very poor predictor of future profitability among businesses with different debt loads. Screening for ROE alone tends to unnecessarily penalize small, highly profitable businesses that do not employ debt. You would think the size of the business shouldn’t affect ROE, but it does – indirectly.
Highly profitable, small businesses tend both to be largely owned by management and unable to raise large amounts of debt at low rates despite their levels of free cash flow. For these reasons, they are more likely to favor waiting to finance expansion with cash flow from operations rather than taking on debt that could not be paid off for an extended period.
In the long – run, ROE is an excellent measure of profitability (and managerial performance). In the short run, it can reward companies that take on excessive debt (and will eventually leave their shareholders with nothing). When evaluating a business’ profitability you should always look at all three measures of profitability (ROA, ROC, & ROE).
In theory, a measure of how productive each dollar of capital invested in the business is. That is, a business with a 17% return on capital earns seventeen cents for every dollar invested in the business.
In practice, there is more than one formula for return on capital. Often, the after tax operating income is used in computing return on capital even though the pretax number would better facilitate comparisons. Also, determining what capital is invested within the business and what capital isn’t (e.g., cash) can not be done with precision (some of the cash represents an investment in the business).
Personally, I’ve always believed the generally accepted measure of a firm’s profitability should be the pretax return on non cash assets. It hardly matters though. In most cases, return on capital (however computed) is a good indicator of the relative profitability of various firms.
Return on capital is also known as return on invested capital, and abbreviated as either ROC or ROIC. The fact that a source uses the term “return on capital” (or ROC) rather than “return on invested capital” (or ROIC) is not a good indication that cash assets are being counted as capital. For this reason, ROC and ROIC are interchangeable terms for all practical purposes.