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VALUE TALK: Buying at a Discount... The Classic Approach... The Mixed Approach... The Contemporary Approach... Conclusion

November 03, 2007
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Charles Mizrahi

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For the past 10 years, I have participated in a fantasy baseball league. [1] The cost per team is $700 and the five teams with the highest points at the end of the season win money - as much as $5,000 for the first-place team. That was enough to get me interested. Not knowing much about fantasy baseball, I started to do extensive research about the game. Fantasy baseball is a game in which players manage imaginary baseball teams based on the real-life performance of baseball players, and compete against one another using those players' statistics to score points. [2]

Before the start of the baseball season, a date is set for a draft. Each team is allocated $270 and must draft a team of 24 players. There are Web sites and magazines that publish valuations based on the statistics of each player, but they are only guides. The final price of a player is determined in an auction. A player's name is called out and anyone who wants to can bid on him. I used a valuation service that looked at players' skill sets and assigned a value to each one. Being a value investor, I stopped my bid when the price went above the valuation of the player. After a few seasons of finishing in the top three, I finally won.

Most of the time the players' valuations and market prices stayed pretty much in line with one another. However, there were times that certain players whom I had valued at $20 went for $50 and other times players whom I had valued at $10 were won with $2 bids. Although everyone in the room knew the "intrinsic value" of a player, there were factors such as scarcity of relief pitchers, recent bad press about a hitter or the popularity of a player that caused the market price to become out of sync with his intrinsic value. When the market price for a player was at a steep discount to my valuation, I bought. Other times I sat on my hands and waited.

My goal was simple: get $20 worth of value for a market price of $10. Several other teams used different methods of valuation, but at the end of the day, the teams that consistently finished in the top three got more bang for their buck. Buying at a Discount

This strategy is identical to the approach that value investors use to buy businesses: buy stocks when they sell at a discount to their intrinsic value. Similar to valuing players in fantasy baseball, there are several approaches to determining intrinsic value. Professor Bruce C. N. Greenwald identified three approaches to value investing: classic, mixed and contemporary. [3] While the approaches are different, they all share the common principles laid out by Benjamin Graham in 1934 and again in 1949: view stocks as pieces of a business, ignore stock market fluctuations and buy only when a margin of safety exists.

The Classic Approach

Benjamin Graham had much success employing a strategy he called Net Current Asset Value (NCAV), or bargain issues. In calculating NCAV, Graham considered only current assets (i.e., cash, cash equivalents, accounts receivable, inventories). However, from this value he still subtracted total liabilities. The result would then be divided by the number of shares outstanding to give the NCAV per share. This value would be considered by Graham to be a fair value for the stock. You might think he would buy at this price, but no. In most cases, Graham only bought stocks that were trading under two-thirds, or 66 percent, of their NCAV.[4]

TransWorld Entertainment Corp. (TWMC) is an example of an NCAV issue. From the latest balance sheet (8/07), we take the current assets ($539.7 million) and subtract the total liabilities ($334.6 million), which gives us an NCAV of $205 million. Then, take 66 percent of the $205 million NCAV, which equals $135.3 million, and divide it by the total shares outstanding, which is 31 million shares, to get a 66 percent NCAV of $4.37 per share. As of October 17, TWMC was trading at $4.58 and would be purchased if the stock price traded at or below $4.37

Graham did not care what the company did, nor did he speak to management or visit them. He used a purely quantitative approach to select his stocks and a widely diversified portfolio, knowing that only a small percentage of his holdings were going to be winners. Most years his firm held more than 100 different issues. Graham and his staff examined financial statements by hand-searching for stocks trading below their NCAV. What took Graham and his team weeks to find can now be found in seconds by running a computer screen.

Although today there are no more than a dozen or so companies that would qualify as bargain issues, Graham's approach of just looking at the numbers is still used by many value investors. Their approach is to hold a diversified portfolio of stocks that they determine are selling below the liquidation value of the business. As long as the stock is cheap, it has a home in their portfolios.

When Graham retired and closed his shop, Walter Schloss, who worked as an analyst for Graham, opened his own fund. He started his fund in January 1956 and over the next 45 years outperformed the S&P 500 by close to 4 percent per year. His approach was similar: research the financial statements and buy the stock cheap.

The Mixed Approach

The modern-day version of Graham's net-net approach is private market value (PMV) as practiced by Mario Gabelli of GAMCO Investors, Inc. Gabelli defines PMV as "the value an informed industrialist would pay to purchase assets with similar characteristics. "While Mr. Market prices companies based on popularity, an industrial buyer is concerned with the business and its ability to generate cash. Lower stock prices due to stock market volatility are seen as opportunities. Gabelli's team comes up with a PMV based on their industry knowledge and comparisons to other companies in that industry. They then focus on companies that have improving fundamentals and they look for a catalyst-something happening in the company or industry that could create value. [5]

The buyer who is able to value a business better than Mr. Market has a clear advantage. Who better to value a cable television operator than a competitor? The cable television operator knows where the balance sheet undervalues assets, or perhaps how a minor liability recorded in the financial statement could spell doom for the company, and comes up with a price he would be willing to pay. When the stock price is trading below the PMV, Gabelli begins purchasing the stock. Many times, stocks in his portfolio are acquired by competitors. Gabelli's flagship fund, the Gabelli Asset Fund Class AAA, has returned an annualized return of 14.44 percent versus the S&P 500 index return of 11. 56 percent over a 20-year period.

The Contemporary Approach

The contemporary approach focuses more on the company than do the other two approaches discussed. This approach concentrates on really knowing the business. Many investors who follow this approach spend weeks researching a company and its competitors and become experts in that industry. This intense research leads them to have a very concentrated portfolio, many times holding no more than 20 stocks and mostly having fewer than 12. Due to their conviction and confidence, they will invest a sizable chunk of their assets into their best ideas.

In addition to Warren Buffett, Glenn Greenberg and John Shapiro of Chieftain Capital Management are good examples of investors who use this approach. After their research, they will begin buying the stock only if they are willing to put at least 5 percent of their assets into it. They usually hold between eight and 10 stocks in their portfolios and are willing to ramp up even higher if the opportunity should arise. Their latest filing shows that they have close to $4 billion invested in only nine stocks, with 40 percent in one stock alone.

Chieftain analysts focus their time and research on only "good" companies, which they define as those with stable and consistent earnings, a competitive advantage and strong financial statements. Out of 8,000 stocks on U. S. exchanges, the universe of companies that meet their strict criteria is only several hundred. They determine a value for a business in their universe by estimating the cash that the business will most likely generate over the next several years and discounting that estimate to the present (discounted cash flowanalysis). Like all value investors, they want to buy great companies at cheap prices.

Conclusion

Which approach should you take - classic, mixed or contemporary? It all depends on your temperament. When I first started out with a value investing approach, I, too, was at a crossroads. After researching each approach and then trying it out, I settled on the contemporary approach.

I liked the idea of investing in a business that was dominant in its field and led by excellent management. I also have no problem holding for the long haul and viewing my investment as if I am a silent in the business. Once I find a few great companies trading at attractive prices, all I need to do is sit back and watch the businesses grow. Selecting stocks for the Prime - Time and Special Situation portfolios is also performed along the lines of the contemporary approach. We do have the Bargain Basement portfolio, which has done very well since inception and which follows Graham's classic approach. At the end of the day, pick the approach that feels right for you. As long as you stick to the basic principles of value investing, which are to view stocks as pieces of a business, let Mr. Market serve you, not guide you, and buy with a margin of safety, a bigger account balance will be your reward.

  1. After I wrote this article, I stumbled upon a speech David Einhorn of Greenlight Capital delivered on May 23, 2006, at the IraW. Sohn Investment Research Conference. He, too, used fantasy baseball as an example of inefficient pricing. Einhorn's speech is well worth reading.
  2. http://en. wikipedia. org/wiki/Fantasy_baseball
  3. Greenwald, Bruce C. N. and Kahn, Judd. Value Investing: From Graham to Buffett and Beyond. Hoboken, N. J. , JohnWiley & Sons, 2001.
  4. http://www. grahaminvestor. com/articles/finding-undervalued-stocks
  5. http://www. gabelli. com/funds/products/405. html

About the author:

Charles Mizrahi
GuruFocus - Stock Picks and Market Insight of Gurus

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