“The beauty of value investing is its logical simplicity. It is based on two principles: What’s it worth (intrinsic value), and don’t lose money (margin of safety). These concepts were introduced by Benjamin Graham in 1934, and they are as relevant today as they were then.” -Christopher Browne
With those words, Christopher Browne led off chapter two of his 2006 book, “The Little Book of Value Investing.” He used the phrase “think like a banker” for an important reason: Benjamin Graham (his mentor) got his start in the financial industry as a credit analyst at a bank. As a result, two key principles of value investing originated in banking principles.
When asked for a loan, bankers first check how much collateral a borrower has available; in the case of a home improvement loan, that would likely be the amount of equity held by the borrower. To ensure the property is everything the borrower promised, the bank might send an appraiser to value the home.
Bankers next want to know how much income is available for paying interest on the loan. They expect the borrower’s income to be proportionate to the amount of the loan; in other words, can the borrower afford to service this debt?
When Graham turned to investing, he used the same principles in doing his analyses. A bank appraiser analyzes a home to establish its value, and a value analyst does the same for stocks. It’s from this principle that Graham arrived at the idea of “intrinsic value,” or in Browne’s words, “It is the price that would be paid if a company were sold by a knowledgeable owner to a knowledgeable buyer in an arm’s-length negotiated transaction.”
Although investors might not give intrinsic value much attention, it is important for two reasons:
- Potential buyers of stocks will be able to tell if it is a bargain, in terms of what a knowledgeable buyer might pay for the whole company.
- They, and owners of the stock, will know whether it is overvalued; that knowledge will be critical in avoiding losses.
To illustrate, Browne cited research by Louis Lowenstein of Columbia University. The latter investigated to find out if any professional investors had successfully ridden out the dot-com bust. He focused on the four-year period of 1999 to 2003. Lowenstein found 10 value mutual funds that not only got through the period unscathed, but posted average, annually compounded returns of 10.8%.
Among the 10 funds and their presumably hundreds of holdings, only one had a “darling of the day” stock, and that was for a brief holding period. In other words, these funds refused to buy, with one exception, overvalued stocks that were loved by too many other investors.
Browne also pointed to a Fortune magazine article from August 2000. The article was titled, “10 Stocks to Last the Decade.” The stocks were:
- Broadcom (AVGO, Financial)
- Charles Schwab (SCHW, Financial)
- Enron (now defunct)
- Genentech - now a subsidiary of Roche (ROG, Financial)
- Morgan Stanley (MS, Financial)
- Nokia (NOKIA, Financial)
- Nortel Networks (now defunct)
- Oracle (ORCL, Financial)
- Univision (delisted)
- Viacom (VIA, Financial)
A lack of fundamental analysis it seems: too many of these stocks were overvalued and Lowenstein’s research determined that they averaged a loss of 80% by the end of 2002.
How about the idea of buying a stock that may be overvalued, but is still rising quickly—a momentum stock? Browne rejected that idea, writing, “If a stock is rising, they like to buy it hoping they will know when to get out before it falls. However, this type of investing may require a knowledge that is more divine than earthbound.”
He also gave short shrift to the idea of buying stocks at more than their intrinsic value by explaining they may be subjected to “the king is wearing no clothes syndrome.” For example, after the dot-com bubble burst in 2000, many investors found themselves holding internet stocks that had no profits with which to justify their sky-high prices. Obviously, those investors found themselves much poorer from having bought those “had to own” stocks.
Browne said such situations often lead to “permanent capital loss.” When highly overvalued stocks crash, it is unlikely they will ever recover to their original (overpriced) valuation. For example, he asked, “Does the investor who bought JDS Uniphase for more than $140 per share, only to see it crash to less than $2 per share, think he will ever see $140 per share again? History says no. This is permanent capital loss. And it has happened numerous times over the years.”
In another example, he referred to the once-famous “Nifty Fifty,” a group of hot stocks in the early 1970s. They were, for a time, the “must buy” stocks, but their valuations caught up to them when the economy slumped and “The losses on those stocks were in the 70 percent-plus range and many of them were real businesses, unlike the concept stocks of the 1990s.”
How do we know if stocks are overvalued, or more to the point, how do we figure out intrinsic value? The author said there are essentially two approaches:
- By analyzing fundamentals such as return on capital.
- By using what Browne called the “appraisal method,” which is “a company-specific estimate of what the stock would be worth if the company were sold to a knowledgeable buyer in an open auction.”
The market, on the other hand, values stocks according to the emotion of the day; think of Graham’s ubiquitous Mr. Market:
“Most investors are driven by emotions that run the gamut from extreme pessimism to jubilant optimism. These emotions can drive stock prices to the extremes of overvaluation and under-valuation. The job for the smart investor is to recognize when this is happening and to take advantage of the emotional swings of the market.”
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Christopher Browne: 'Buy Stocks Like Steaks...on Sale'
- Indexing for Dummies: Boring but Rewarding
- Indexing for Dummies: Diversify With Alternative Indexes
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