American Idol kicked off a long line of copy cat reality competition shows with no end in sight.
All of these shows are all focused on the entertainment business. I think it’s time the investment management business had its own reality competition show.
I’d call it “So You Think You Can Be a Value Investor.”
Since every good reality competition show needs celebrity judges, I’d have Warren Buffet, Charlie Munger, and David Hasselhoff on the panel.
Why Hasselhoff? Because I think adding the Hoff to a panel on value investing would lead to score of 11 on the unintentional comedy scale. Besides, I hear Charlie Sheen is busy these days.
If you really want to be a value investor, keep your ear to the ground as open auditions might be coming to a city near you soon. Meantime, read this primer on value investing and get a step up on the competition.
No discussion about value investing can begin without talking about Ben Graham. The man is the widely considered to be the father of value investing. Heck, he even had an influential role in turning investing into a profession that previously consisted of mostly speculators. Considering that you owe your future career’s existence to Ben Graham, you should now understand why he’s so important.
At its roots, value investing is simply a framework for investing that involves buying stocks for less than their underlying value. As Warren Buffet says,
“Price is what you pay, value is what you get.”
The value investing framework exists to ensure that the price you pay is less than the value you get. It’s really that simple. Unfortunately, it’s not always easy to implement and takes rigorous fundamental analysis.
The value investing philosophy goes back to when Ben Graham was just starting out on Wall Street. Before Ben Graham wrote his seminal book Security Analysis, investing focused primarily on bonds as common stocks were viewed as too speculative. As a result, very little financial analysis was performed on common stocks. Of course, this created many opportunities to invest in profitable situations.
Ben Graham’s analysis and ability to find profitable investing ideas earned him a solid reputation as an up-and-comer on Wall Street. This led him to venture out on his own and start the Graham-Newman Partnership in 1926.
About this time, Ben Graham also decided that he wanted to write a book that outlined his investment knowledge. However, wanting to first test out his ideas in front of an audience, he decided to start teaching a night course on investing at his alma mater, Columbia. Given his reputation, the class was a near instant hit with students and even those who already worked on Wall Street.
Using his lectures as a guide, Ben Graham and Columbia professor David Dodd put together the book Security Analysis in 1934. The publication of this book is considered to be the moment value investing was born as it brought Ben Graham’s teachings to the world. The book is sometimes called the “Bible” of Graham & Dodd.
He followed up later with The Intelligent Investor which was meant to bring his investment philosophy to the masses. Warren Buffett described this book as “the best book about investing ever written.” I can’t say I disagree.
Ben Graham’s students and employees in the Graham-Newman Partnership went on to have phenomenal careers on Wall Street simply by applying his value philosophy. In 1984, Warren Buffett published a speech called The Superinvestors on Graham-and-Doddsville that detailed the amazing records of some of these offshoots from Ben Graham.
Value Investing Today
Now that you have a little bit of history on value investing, it’s time to discuss value investing as it exists today. In employing value strategies, it’s easiest to think of the various forms on a continuum from passive to aggressive.
On one end, you have passive value strategies that simply buy cheap stocks and wait for the value to be recognized by the market. On the other end, you find activist investors who buy cheap stocks and then attempt to make the market realize the value of a company by trying to create change at the company itself. In the middle, contrarian investing encompasses the vast majority of value investors.
Passive Value Investing
Passive value investing involves screen for undervalued stocks based on certain financial criteria, such as Price/Book (P/B) or Price/Earnings (P/E) ratios. In Ben Graham’s day, these screens were often simple and involved P/B ratios or comparisons of market value to net cash.
When you think about it, if you could find a stock selling for less than the net cash (cash minus debt) on its balance sheet, then chances are your downside is minimal unless management is so incompetent that they can destroy value. This is the process Ben Graham used with great success for many years.
Of course, great success begets imitators and the stocks trading below net cash eventually disappeared. Other value screens have popped up over the years, most famously as part of the Fama-French factors.
Eugene Fama and Ken French are proponents of Modern Portfolio Theory, which is the antithesis of value investing as it espouses the markets as efficient. However, they noted a factor that generates outsized returns over time is that value stocks outperform growth stocks.
Their efficient market explanation for this is that value stocks are riskier and so the extra return is required to compensate for the greater risk. This contrasts with the value investors’ view that value stocks are actually less risky since the downside risk is lower given the discounted valuation.
Whatever your take is on the issue, the simple fact is that value screens outperform over time. Sometimes the value metrics change, but the value philosophy of buying discounted stocks remains the same and continues to outperform.
Contrarian Value Investing
Contrarian value investing is the most common type of value investing. Most of the big names in value investing, from Warren Buffett to Seth Klarman to Marty Whitman, are of the contrarian type. Contrarian value investors take delight in zigging when the market is zagging. These investors like to buy stocks on the cheap that have been left for dead by Mr. Market.
The idea behind contrarian investing is that Mr. Market too often overreacts to news or events. There is academic evidence that supports the validity of contrarian investing. For example, studies have shown that buying a portfolio of stocks that underperformed the prior year outperforms a portfolio of stocks that outperformed the prior.
The key to contrarian investing is patience. Once you find a stock that is undervalued and has been left for dead, don’t expect the stock price to go up just because you bought it. It can take time for Mr. Market to realize the error in his ways.
Another way to think about value investing is through the old value investing cliché that “Good companies don’t always make good investments.” What this means is that great companies that the market loves are often priced as such. As Warren Buffet has said,
“You pay a very high price for a cheery consensus.”
In the end, contrarian value investing is simply buying when the market is selling and patiently waiting for the true value to be recognized. The key word is patience. If you need instant gratification, then value investing is not the place for you.
Activist investing is a lot like contrarian investing, except the target companies are cheap companies where the management team can realize the value through action. Here’s how it works:
The activist investor identifies an undervalued company and identifies the reason why the company is undervalued. If actions by management can make that value realized, they will acquire the stock. Some examples of potential management actions that can create value include spinning off subsidiaries, using cash to buy back stock, sell the company to a private equity firm or another public company, etc.
Typically, though not always, the activist investor will meet with the management team of the company acquired and try to convince the management of needed change. Discussions usually end here as public company CEOs often do not want to disrupt the status quo given their exorbitant pay packages.
This is where the activist investor usually must make their case public. After acquiring a large portion of the company, usually greater than 5%, the activist investor will often publicly lobby the Board of Directors to adopt their proposed changes.
If management teams and Boards continue to resist change, this can lead to a proxy fight that would make Sir Larry Wildman quiver. In this case, the activist investor brings their proposed changes to a vote of shareholders and attempts to get the other investors in the company on their side.
The whole process can take months if not years. Activist investors need to be patient, persistent, and have lost of capital. Patience is a virtue for all value investors. I can’t emphasize this enough. Persistence is required because management teams will often defend the status quo at all costs. You have to keep banging on the door to affect change. Finally, lots of capital is required because you need to control a significant portion of the company to be noticed. Boards and management teams are not going to take you seriously if you only own 0.001% of the shares outstanding.
Keys to Breaking In to Value Investing
If you want to become a value investor, your key to breaking in will be determined by your investing mindset. You need to demonstrate that you have the patient, value-oriented mindset that is common to all value investors.
In an interview, you will probably be asked to discuss how you look at stocks and decide whether to buy or sell. In addition, you might be asked a seemingly unrelated question about your retail shopping habits or something similar.
Sound strange? It’s not. All of these questions are designed to understand your investing mindset. For example, if you are asked about how you buy clothes at the mall, how would you answer?
If you don’t know the right answer by now, I’m afraid you don’t have the value investing mindset. (The answer is: “On sale. I buy only when what I want is on sale.”)
Lucky for you, the mindset of the value investor is forever memorialized in Ben Graham’s The Intelligent Investor. Read and re-read this book if you want to better understand the value investing mindset. The tools and analyses may change over time, but the mindset remains the same.
There you have it. Read The Intelligent Investor, wait for the Hoff to come to a city near you, and one day you might become a famous value investor.
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