Ben Graham is generally recognized as the grandfather of Value Investing. Graham was a lecturer and money manager, who in 1934 published Security Analysis, a foundational book that detailed an investment methodology that later became known as Value Investing. In short, the methodology revolved around searching for stocks of public companies that appeared cheap by means of a quantitative assessment of the companies financial statements.
In order to understand what something is, it can be helpful to take a look at what it isn’t. A book from that era considered one of the classics on investing and financial markets is a fictional account of the life a legendary securities trader called Jesse Livermore. The book, published in 1923, tells the story of a fictional character called Larry Livingston and his experiences during the early days of stock trading. In the Reminiscence of a Stock Operators, Larry Livingston earns his name and fame, by anticipating the movements of stock prices and to some extent, affecting the movement of market prices. The operating concept here is price fluctuation.
When trying to explain price fluctuations in stock markets in 1936, the famed economist John Maynard Keynes likened the market with a beauty contest, where the participants are not trying to vote for the most handsome contestant, nor for the contestant that they think will be perceived as most handsome by the majority of the other voters, but for the contestant that they believe most participants will perceive as being seen as the most handsome one by other participants.
When Ben Graham and his co-author David Dodd, published Security Analysis, they described a fundamentally different approach to stock picking and investing in corporate securities by proposing that the investor should refrain from trying to anticipate price movements entirely. Instead, the investor should try to estimate the true Intrinsic Value of the underlying asset. Given time, the Intrinsic Value and market value would converge. Graham would later follow up with The Intelligent Investor, a book covering the same topic but written for a more mainstream audience.
This way of looking for fundamental cheapness meant that the Value Investor would often find himself on the other end of the trade with Keynes’s beauty contest participant, that is by buying something that has gone out of favour. As an illustration of this, Graham is attributed to have coined the phrase that “in the short term the market is a voting machine, but in the long run, it is a weighing machine”.
A central concept in both Security Analysis and The Intelligent Investor is the idea of Margin of Safety or the difference between the price of a security and its Intrinsic Value. The lower the ratio of price to Intrinsic Value, the higher the Margin of Safety. Needless to say, the notion of Margin of Safety requires a cautionary approach and careful analysis of both income statement and balance sheet.
Net-Nets and Intrinsic Value
One formula used frequently by Ben Graham to find cheap stocks is the Net Current Assets value, which he defined as “current assets alone, minus all liabilities and claims ahead of the issue”:
Net Current Assets = Current Assets – (All Liabilities + Preferred Stock)
Current assets are assets that are expected to be as converted into cash in the next twelve months. The equity of a company, trading at less than the Net Current Asset value of the underlying stock, would effectively be trading at less than liquidation value. In a bankruptcy, the current assets alone would suffice to pay off all creditors and recoup the investment for the investor. The non-current assets would be a pure upside for the investor.
Investing in Net-Nets, as they were called, does not come without risks, though. In a normal environment, a company doesn’t trade at those levels without a reason. Grahams argument, however, had nothing to do with the quality of the underlying businesses. His argument was that in these fringe situations, the market tends to overreact. To counter the risk of a single stock living up to its pessimistic expectations, he argued for diversification and holding up to 40 Net-Nets at a time. Grahams most recognized disciple, Warren Buffett, likens Net-Nets to cigar butts lying on the street. They may be soggy, but they’re free and they have at least one puff left in them.
The environment that Ben Graham operated in was very different from today. In those days, screening stocks would have been a very manual process. You would literally have to get your hands on the financial statements of the company that you would be researching and calculate manually per share values to compare with the market prices. Therefore, one could argue that the market was much less efficient in those days.
One could also argue that Graham’s approach benefitted hugely from timing as he operated in the backdrop of the depressed markets caused by the 1929 stock market crash. Nonetheless, backtests show that even in later periods a Graham-style Net-Net strategy would have outperformed the market significantly. One study showed that “from 1970 to 1983, an investor could have earned an average return of 29.4% by purchasing stocks that fulfilled Graham’s requirement and holding them for one year“.
But as often happens with opportunities, once they become known, the trade becomes crowded and the arbitrage ebbs away. With financial statements moving into online databases, information is processed quicker. Use a stock screener today and you are not likely to find an abundance of the Graham-style Net-Nets. Hence, Value Investing has had to evolve with time.
Value investing today necessitates finding information that a quantitative screener would miss. It means delving deeper into the financial statements and requires more focus on qualitative factors. One could also posit, that in today’s world, more of corporate values are intangible and reside some cases outside of balance sheets.
Other investors make the case that the definition of current and noncurrent assets require existentialist questions.
Value Investing beyond Graham & Dodd
With time, the term Value Investing has become quite generic and is often put into a category that pits it against Growth Investing. Describing Value Investing as investing in undervalued securities, does little to help us understand the practices of the early value investors. In fact, aren’t all investors, irrespective of their labelling, trying to pick undervalued assets?
It is worth noting that the techniques described in Security Analysis and The Intelligent Investors focuses strictly on investing from the perspective of an outside minority shareholder in listed securities. Many of the investors that today are recognized as value investors, such as Warren Buffett and David Einhorn, are in many cases venturing in areas well outside of the scope of Value Investing as originally covered by Graham and Dodd, such as activist and control investing.
There is no doubt that Value Investing as a concept existed long before Graham & Dodd’s work. What Graham & Dodd proposed was that one should approach the stock market in the same way a business person would approach the valuation of a private company.
In his literature, Ben Graham concentrates on four key concepts:
- Intrinsic Value: Any corporate security has an Intrinsic Value or value which is justified by facts (assets, earnings, dividends and prospects).
- Margin of Safety: The lower the price of the security relative to its intrinsic value, the higher the Margin of Safety is.
- Mr Market. You should view market prices as if being in business with a manic-depressive partner. Repeatedly your partner offers to either sell or buy shares at prices strongly linked with his mental state at each time, ranging everywhere from highly pessimistic to wildly optimistic.
- Diversification. For risk management purposes you should carry at least 40 different stocks at each time.
Warren Buffett, Charlie Munger and Berkshire Hathaway
The is no shortage of information about the Warren Buffett, Charles Munger and the story of Berkshire Hathaway. Therefore, in this article, only brief mention will be made of the contribution of Buffett and Munger to the evolution of Value Investing.
Warren Buffett was an early disciple of Ben Graham, being the only student to receive an A+ in Graham’s investment course that he taught at Columbia. Buffett later became an associate at Graham’s investment company, before moving back to his hometown of Omaha where he set up the now infamous Buffett Partnership. After dissolving the Buffett Partnership in 1969, Buffett along with his partner Charlie Munger devoted himself to the partnerships biggest investment, Berkshire Hathaway.
Although being one of Graham’s most fanatic disciple, Warren Buffett different from Graham in style. This difference in style accentuated with time. Whereas Graham was extremely focused on the margin of safety and diversification, Buffett was willing to be much more concentrated in his investments and applied a more qualitative assessment of the Margin of Safety concept than Graham.
In the Buffett Partnership, Warren would split his investments into two distinct categories:
- Generals were traditional Cigar Butt type investments where the stocks where severely underprices compared to the underlying asset values. Buffett later split the Generals category in two, adding a group of companies of higher quality than the Cigar Butts.
- Workouts were special situation investments categorized by short-term catalysts. This could range from merger arbitrage, spin-offs and such.
- Read Warren Buffett’s annual letters to shareholders
- Also, read Charlie Munger’s letters to Wesco shareholders
The Superinvestors of Graham and Doddsville
In 1984, Warren Buffett wrote an article that he called The Superivestors of Graham and Doddsville. In the article, Buffett tracks the performances of 7 different disciples of Ben Graham and his Value Investing philosophy. He notes that although the investors would carry vastly different stock portfolios, all seven of them significantly outperformed the market of a long period of time.
The investor mentioned in the article are:
- WJS Partnership (Walter Schloss)
- Tweede, Brown Inc. (Tom Knapp)
- Buffet Partnership, Ltd.
- Sequoia Fund, Inc (Bill Ruane)
- Charles Munger
- Pacific Partners, Ltd. (Rick Guerin)
- Perlmeter Investments (Stan Perlmeter)
Other Value Investors with Long Term Track Records
- Mario Gabelli
- Joel Greenblatt
- Seth Klarman
- Irving Kahn
- Marty Whitman
- Howard Marks