Value Investing: Your Ultimate Guide to The Best Returns
This article on value investing was written by Luis Sánchez. Luis is a lawyer and investment manager based in Bogotá, Colombia, who is primarily focused on net net stocks. Net net investing was Ben Graham's strategy of choice and even helped Warren Buffett earn the best returns of his career. Download Your Essential Net Net Stock Guide for FREE. Click Here. Article image (Creative Commons) by Dan Zen, edited by Net Net Hunter.
What’s value investing?
For my money, Charlie Munger provided the best definition when he said that all intelligent investing is value investing.
But, what is it about?
Let’s say value investing is, at its core, buying something for less than what it’s worth.
Buy securities — stocks and bonds, mostly — for a price well below their intrinsic value, wait, and sell them when they reach full value.
Doing this repeatedly for a long time promises rates of return above the market average.
However, depending on how you measure “intrinsic value,” you’ll get different approaches to value investing. We’ll focus on the main branches here: classic and modern value investing.
Most value investors today argue that modern value investing is the best investing strategy. For small private investors, this may not be true.
But let’s start with the basics.
Benjamin Graham and the Principles of Value Investing
Benjamin Graham was born in 1894 in London, but his family moved to New York when he was a kid.
Because his father died shortly after they arrived in America, he and his brothers grew up in relative poverty.
Upon graduating from college, he went to Wall Street to work as a brokerage-house runner in 1915. In a few years, he became a well-respected analyst there.
What he found by studying the US stock market at the time was that investors didn’t have a strong analytical frame to back up their investment decisions; they just followed trends and charts.
Graham partnered with Jerry Newman in 1926 and ran an investment company for almost forty years, all throughout the Great Depression.
While the market had an almost null inflation-adjusted return from the years 1926 to 1950, Graham managed to earn a 20% compound annual return in the same period.
How exactly did he do that?
He developed and applied the principles of intelligent investing, or as we call it today: value investing.
Value Investing Principles: Mr. Market Is Your Servant, Not Your Master
A stock gives the stockholder ownership over a “piece” of a business.
That business is worth something — it has an intrinsic value, and so does your stock.
However, Graham found that when stockholders could buy and sell their shares at will in the stock market, their decisions focused more on anticipating future price movements than on assessing business value.
Focusing on price exacerbated emotions of greed and fear in market participants — luring them to buy what seemed like it was going up and sell what was expected to fall.
This herd behaviour created periods of mania when stock prices climbed frantically on expectations of future price increases and subsequent periods of depression when prices tanked because the market expected future declines.
“Mr. Market," as Graham calls it in Chapter 8 of The Intelligent Investor, is like a partner in a private business who offers to buy or sell his shares to you every day, depending on his mood. One day he thinks business prospects are dire, and he offers to sell his shares at a very cheap price. Then, a week later, he is very optimistic about the future and offers to buy your shares for a very high price — one above the business’ intrinsic value.
You can buy or sell pieces of your business from and to Mr. Market, taking advantage of his mood. But you don’t have to buy if the price is too high nor sell if the price is too low.
Value Investing Principles: The Margin of Safety
In Graham’s opinion, an investor couldn’t put enough emphasis on downside protection.
Remember, he grew up in relative poverty and lived through the Great Depression. In his view, the future was something to guard against.
How could you guard against the future while investing in the stock market?
The answer to this question is the central concept of value investing: margin of safety.
What’s the margin of safety?
When engineers build a bridge, they make sure that it can stand a couple of times the actual weight it will normally endure. The difference between the bridge’s weight capacity and the actual weight it endures daily is its margin of safety. For investors, the margin of safety is the difference between the intrinsic value of a stock and its market price.
Paying a price above intrinsic value is speculating; paying a price well below intrinsic value is value investing — i.e., intelligent investing.
Buying with a margin of safety places the odds of winning on the side of the investor.
Value Investing Principles: Emotional Intelligence
You probably need a very high IQ to be a successful theoretical physicist, a brain surgeon, or a tax lawyer.
But you don’t need a high IQ to beat the market.
Graham once said that “the investor’s chief problem — even his worst enemy — is likely to be himself."
This all boils down to the idea of emotional intelligence.
As a value investor, you are betting against the market — i.e. against the majority. You need courage to do that.
Also, value investing is a long-term game. You can’t be in this game for the quick buck.
Value Investing: Ben Graham’s Famous Students
Graham lectured at Columbia University in New York from 1928 to 1955.
Many of the most successful value investors of the 20th century either attended his classes, worked for him, or both, including Warren Buffett, Walter Schloss, Bill Ruane, and Tom Knapp, to name just a few.
Buffett entered Columbia University in 1950 and worked at Graham-Newman from 1954 until Graham retired a couple of years later.
Back in Omaha, Buffett ran his famous partnerships, managing money for family and friends, returning an impressive 24.5% compounded annual rate to his partners — 29.5% before fees.
He closed his partnerships by the mid ’60s and has been running Berkshire Hathaway since 1965, achieving a 20% compounded annual return for his shareholders.
Schloss didn’t go to college. He went to Wall Street in 1934 to work as a clerk and took some courses on security analysis with Graham.
He worked with Graham from 1946 until Graham retired in 1957. Then, he started his own investment partnership, returning an impressive 16% after fees to his partners over a 40-year period.
Knapp, who founded Tweedy, Browne, also worked for Graham. Tweedy, Browne’s funds have outperformed the market since its inception.
Graham’s students had, at least, one thing in common — they all beat the market.
Graham died in 1976. Since then, value investing has branched into at least two different approaches: classic and modern value investing.
Let’s take an in-depth look at each style.
Classic and Modern Value Investing
The main difference between classic and modern value investing lies in their approach to business valuation — i.e., how they determine intrinsic value.
Up until now, I’ve mentioned intrinsic value without telling you exactly what it is.
Like I said before, every business is worth something.
At its core, any business is just a group of assets organized to generate revenue.
After paying suppliers, creditors, debt, and taxes, the result is profit or loss for the owners.
Well, assets, liabilities, revenues, costs and earnings are all recorded in the company’s financial statements.
Thus, financial statements are the starting point to find out what the business is worth.
Classic Value Investing: The Question of Conservatism
As we’ve seen, Graham’s approach to investing was very conservative.
While accounting rules allow for different ways to record revenues and costs at management’s discretion to a large extent, asset values are more dependable. If the balance sheet states the company has $50 million in cash, it most certainly does, whereas if you see a $3 million net profit, you have reasons to question that number.
Graham knew this, and for that reason his value assessment started with the balance sheet, giving only marginal attention to earnings.
A stock selling below book value was more interesting to him than one selling at two times book value, for example, even if the latter had higher profit margins than the former.
Graham regarded stocks selling for prices way above book value and at high PEs as “speculative” because it meant paying for future growth expectations that could either materialize or not.
Graham’s favourite stock picks were the ones selling below liquidation value or net nets — i.e., the value of current assets like cash, receivables, and inventories less all its liabilities.
Buying a group of these net nets was a “foolproof” method — in Graham’s words — to beat the market.
On that matter, he wrote:
“At this point let me consider briefly an approach with which we were closely identified when managing the Graham-Newman fund. This was the purchase of shares at less than their working capital value. That gave such good results for us over a forty-year period of decision making that we eventually renounced all other common-stock choices based on the regular common stock procedures, and concentrated on these ‘sub-asset stocks.’ ” [The Decade 1965-1974; Its Significance For Financial Analysts, Benjamin Graham, 1975.]
Buffett followed Graham’s conservative investing approach during his years running the partnerships.
He was managing relatively small sums then, and he found enough net nets to stack up his portfolio and earn extraordinary profits for a while.
Buffett called these stocks “cigar butts” because they resembled a soggy cigar butt left on the street from which you could smoke the last puff for free. It was disgusting, but it was all profit.
However, soon Buffett had too much money to invest — net nets being so profitable — and those bargains became too small for him to take advantage of them.
Modern Value Investing: How the Future Wasn’t Scary Anymore
Graham designed his investing strategy as a protection against the future and regarded any price paid for future earnings as speculation.
Buffett’s business partner, Munger, had something to say about that.
Ever since the publication of John Blurr Williams’ book The Theory of Investment Value in 1938, most analysts have come to the conclusion that the value of any business equaled the present value of its future cash flows.
Munger believed Graham was an outstanding thinker, but that his worldview was somewhat skewed by his painful experience in the Great Depression. In Munger’s opinion, you could pay a price above book value for some businesses — and still have a margin of safety — so long as the business had some very specific qualitative traits that made its future cash flows fairly predictable.
In those cases, you could actually profit from the future, instead of just guarding against it.
Modern Value Investing: Moats and Intrinsic Value Redefined
Very profitable businesses are to competitors as honey is to the bees. As new competitors enter the market, they drive prices down, and extraordinary profits eventually disappear.
That’s why Graham didn’t like paying for future earnings.
Take a look at the following table of hypothetical Company A:
Company A faces no competition during the first three years. Then, competition breaks in, and both revenue and profit decline. That’s the nature of the game.
Now, take a look at the following table of hypothetical Company B:
Company B faces no competition for over 10 years, and so its earnings just kept growing and growing.
However, chances are Company A will sell for a very low multiple of earnings in year 10 — or even for a price below book value — while Company B trades for a high multiple of earnings.
Both Graham and Munger would regard Company A as a mediocre business and Company B as a wonderful business, but Graham wouldn’t think the wonderful business was an intelligent investment because there was no margin of safety — i.e., a discount to asset values — while Munger wouldn’t mind paying a price above book value for it as long as it could keep growing earnings and profits for a long time.
So, how do you know if the business will keep growing in the future as it did in the past?
The answer is moats.
Buffett likens wonderful businesses to castles protected by deep, wide, and dangerous moats. These businesses earn extraordinary returns on capital for as long as the moat stays in place.
If you find a business that can grow indefinitely and profitably in the future — i.e., a business with a moat — you can discount its future cash flows to the present and arrive at an estimate of intrinsic value.
In short, Buffett and Munger redefined the concept of “intrinsic value.”
Buying these wonderful businesses at fair prices was the margin of safety.
Buffett and Munger have returned a 20% compounded annual rate since 1965 with their new approach.
The question is, should you try to do the same?
Why Classic Value Investing Is Better for Small Private Investors
Because Buffett is the most successful investor of all time, many people feel tempted to emulate him on his current hunt for wonderful businesses at fair prices.
That’s what we’ve called falling into the Buffett trap.
The thing is, most of his followers are small private investors who could benefit from Buffett’s early investment strategy — classic value investing — more than they can benefit from his current investing strategy.
Buffett himself has said what’s better for the small private investor — and it’s not wonderful businesses and moats:
“If I were working with small sums, I certainly would be more inclined to look among what you might call classic Graham stocks, very low PEs and maybe below working capital, and all that, although … and, incidentally, I would do much better — percentage-wise — if I were working with small sums. There are just way more opportunities. If you’re working with small sums, you have thousands and thousands of potential opportunities, and when we work with large sums we have relatively few possibilities in the investment world that can make a difference in our net worth. So you have a huge advantage over me if you’re working with very little money…”
Check out the video here.
So, Buffett believes small private investors have an edge.
Exactly why is that?
Well, the average mutual fund has $1 billion in assets under management. This means they have to look for companies worth $200 to $400 million if they hold 20 or 30 stocks at a time.
True, a $1 billion fund has nearly 5,000 stocks to choose from, but there are nearly 14,000 mutual funds — nearly three mutual funds for every stock!
The small private investor is clearly at a disadvantage in this playing field.
However, in the universe of stocks with market caps of around $100 million, the small private investor faces almost no competition from professional money managers. They just can’t waste their resources analyzing tiny stocks.
This is, then, a highly inefficient corner of the stock market.
Small sums are, indeed, a structural advantage.
You probably won’t find many wonderful businesses at fair prices among small and micro caps — but you’ll certainly find fair businesses at wonderful prices there.
What I mean is if you are a small private investor, you should fish where the fish are.
Classic Value Investing: Expected Returns for the Small Private Investor
So, where are the fish then?
Before I tell you that, I should probably show you exactly why classic value investing is probably better for you than looking for moats.
Most studies that compare value investing strategies show that buying a basket of stocks selling at low price to book (P/B) value yields about a 13% compounded annual growth rate (CAGR). Impressive, but by incorporating additional selection criteria for low P/B stocks, you can boost performance to around 25% CAGR.
You could also buy stocks with very low PEs following Graham’s Simple Way strategy, with expected returns of around 15% CAGR. Additional criteria could boost these returns to between 20 and 25% CAGR.
Find out more about these strategies at Broken Leg Investing.
But let’s talk about Graham’s favourite and most profitable stock picks: net nets.
Not only well-respected value investors like Graham, Buffett, and Schloss testified to how powerful net nets are. Academic research also shows that a basket of net nets massively outperforms the market in the long run.
Take Oppenheimer, which studied a 12-year period starting in 1970 and found that a basket of net nets outperformed the market during that period by a factor of two, for a 31% CAGR.
In 1981, Joel Greenblatt, Richard Pzena and Bruce Newberg published a paper that concluded that buying a basket of stocks at prices below liquidation value — i.e., net nets — had a CAGR of around 40% for the period studied (1972 to 1978). Because in this study the portfolio became fully invested near the bottom of the market cycle, a more realistic expectation of long term returns would be between 25 and 30%.
James Montier, a renowned deep value investor, also published a paper on Japanese net nets, studying their performance from 1985 to 2007. During that period, the Japanese stock market returned a lousy 5% CAGR, while Japanese net nets gave an impressive 20% CAGR — this was during one of the longest and deepest bear markets in modern history!
While this is a lower return for Japanese net nets compared to US net nets, both beat the market by nearly the same amount.
Although past returns are not predictors of future returns, the case for a net net strategy is solid enough as it is.
You won’t find many net nets in American stock markets today, though. You have to look around the globe for them.
That’s where the fish are.
Now that you’ve read the ultimate guide to value investing, it’d be worth your while to download Your Essential Guide to Net Net Investing, with more tips to stock your portfolio with the highest quality net nets worldwide.
Want to learn more? Join Net Net Hunter now and find high-quality net nets to stock your portfolio and boost your long-term returns.