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Last year my Dad issued a challenge for me to start reading investment books. After completing 4 books last year, the challenge is back with a new list of books this year.
The second book on the list is “Value Investing: From Graham to Buffett and Beyond,” by Bruce Greenwald.
The book is broken into three parts. Part one discusses what value investing is and what value investors are looking for. In part two, the author gives a deeper dive into how to determine value and do the analyses on specific securities. Lastly, part three is a compilation of examples from 8 different value investors, including Warren Buffett. For the purpose of this post, I’ll be focusing solely on the first two parts of the book.
Part 1 – What is value investing?
As discussed in The Intelligent Investor, value investing is about looking beyond the share price and instead focusing on a company’s intrinsic value. Value investors try to find the intrinsic value of a business through research. They compare this to the share price, and then purchase stock when a gap exists. This gap is called the “margin of safety,” and it helps absorb various risks.
Despite the ups and downs of the market, the underlying value of many businesses is relatively stable and can be determined with proper research. Buffett explains that buying stocks with a margin of safety will produce superior returns in the long run.
More Than Stock Picking
It’s important to note that value investing is very different than stock picking or active trading, which are both methods that will likely lead to inferior returns. Buffett calls value investing an intellectual discipline. Value investors should stick to their circle of competency, and need to be patient in buying and selling shares.
“In Warren Buffett’s useful analogy, investing is like batting without called strikes. You can take as many pitches as you want until you spot the one you like. Then you swing, and if you have done the analysis intelligently, your chances of success are high.” (Greenwald).
This analogy works perfectly, because the value investor can sit back and wait for the right stock at the right price.
The book goes into detail on the search strategies that value investors can go through including spin-offs, targeting smaller companies, institutional biases (legislative actions limiting all information from pricing), and behavioral biases (paying too much for popular stocks and too little for stocks that have fallen out of public favor).
As I discussed in my recap of The Myth of the Rational Market, markets aren’t always rational. Sometimes prices are too high or too low. This means there are still opportunities out there for value investors.
Part 2 – Three Sources of Value
The standard approach to valuation is discounted cash flow analysis. Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates. (Investopedia)
Benjamin Graham and David Dodd consider this method of valuation to be seriously flawed for two main reasons:
“First, present value is the sum of individual cash flows from now into the distant future. It may be possible to make correct projections for the next few years; as the time lengthens, the projections invariably become less accurate. Second, the present value approach relies on information that is often simply not knowable, especially in the far distant future.” (Greenwald)
Instead, Graham and Dodd offer a three element approach to valuation: assets, earnings power, profitable growth
Assets: To determine the value of a company’s assets, you can view its most recent balance sheet. Liabilities are subtracted to obtain the current net asset value. For companies with no substantial competitive advantage, their asset value equals their intrinsic value.
Earnings Power: The second calculation is the Earnings Power Value (EPV), which is essentially the expected value the business will generate over time. To do this, you take the earnings power (or the expected cash flow that can be earned in the future) divided by the current cost of capital.
This calculation should roughly be equal to the asset value for a company with no competitive advantage. If the EPV is greater than the asset value, this is the franchise value for the business.
Profitable Growth: Franchises are powerful. Buffett has been quoted saying that economic franchise only arises when a product is needed/desired, doesn’t have a close substitute and is not subject to regulation.
“The only growth that creates value is growth in markets where the firm enjoys a competitive advantage. Only franchise value creates growth value. Thus, judging the existence and sustainability of a company’s franchise/competitive advantages/barriers to entry is central to assessing the value of future growth.” (Greenwald)
A value investor wants to identify a company that has a franchise, which is a competitive advantage.
Risk
The last key takeaway from the book was the concept of risk for a value investor. For the value investor, business value is the basis for determining risk. They consider it more risky to pay too much than to pay with a margin of safety. Risk is reduced with a lower price relative to the “sticker price.”
Final Thoughts
Overall, the concepts in this book were helpful to my knowledge of investing. Parts of the book involved various calculations that started to get difficult. I will probably end up reading this book again some point. Value investing is an interesting topic to learn about. I could see myself implementing various value investing strategies with 5-10% of our portfolio in the future.
It’s important to note that I would NOT advocate doing this with your whole portfolio, or even a large percentage of your portfolio. As I’ve written about many times, the majority of our net worth is invested in index funds, and that will continue for the long-term.
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