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Grahamites
Grahamites
Articles (371) 

The 8 Levels of Value Investing

Advancing from a level to the next is similar to playing a game

“Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you get ahead but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day by day. At the end of the day – if you live long enough – most people get what they deserve.” – Charlie Munger (Trades, Portfolio)

As a value investor and a serious Charlie Munger (Trades, Portfolio) groupie, I often remind myself of the above quote from Munger. For me, value investing has been an amazing journey of learning, ignorance removal and gradual wise-up.

This journey has been both challenging and gratifying. In some ways it is like playing a game in which once you have accumulated enough credentials you will advance to the next level. The move from one level below to one level above takes both time and effort, but it's an integral part of the fun. In this article, I’d like to share my view of different levels of value investing based on observations, thinking and personal experiences.

Before going into the discussion, I’d like to make a few general observations:

  1. You can beat the market regardless of your level. There is no need to discriminate among different levels. What’s most important is to find the style and strategy that fits your own personality and life.
  2. No matter what level you are at, you have to understand behavioral biases.
  3. A sound investment philosophy based on “margin of safety” is required on all levels as is the willingness to work hard.

With the above points in mind, now let me move to the eight different levels of value investing in my opinion.

Level I

This level is where most value investors begin their journeys. In this level, a value investor would read most of the value investing classics such as “The Intelligent Investor” and “Common Stock and Uncommon Profits.” He acquires familiarity with the most important concepts in value investing such as margin of safety, intrinsic value, moat, etc. Most likely, he would start to “spot” value based on definitive quantitative metrics such as net net, low price-earnings (P/E), low price-book (P/B) and historically low multiples. If he can buy a basket of these cheap stocks, he would have a statistical advantage to beat the market in the long run by 1% to 2%. This level can be summarized as the “cigar butt” level. At this level, investors often fall into the so-called “value traps.”

Level II

At this level, a value investor starts to care more about the quality of the underlying business. He is likely to be attracted to high-quality businesses with a wide moat and often characterized by high return on capital. He prefers to buy a great company at a fair price than to buy a fair company at a great price.

At this level, a value investor can recite most of the famous Warren Buffett (Trades, Portfolio) and Munger quotes. He knows most of the important concepts within the value investing framework. He can discern possible wide moats without knowing why and won’t spend much time on the long-term sustainability of the moat. He is also likely to analyze one company at a time without considering the whole value chain.

Quantitatively, value investors at this level usually collect enough historical financial and valuation data and perform a good amount of quantitative analysis to come out with some sort of projections.

One common mistake investors make at this level is to miss out on real great compounders because they may appear expensive.

Level III

Once a value investor has acquired a good understanding of the value investing framework and learned some different business models and different competitive advantages, he can go deeper on both qualitative analysis and quantitative analysis. He collects as much data as possible in order to perform in-depth fundamental research.

At this level, an investor pays detailed attention to segment financials, underlying growth drivers, operating metrics, comparative analysis, etc., in addition to detailed historical annual and quarterly financial data. Essentially the investor can tie numeracy to literacy about a business on a detail level. It is at this level that an investor figures out mathematically why American Express (NYSE:AXP) could not renew the deal with Costco (NASDAQ:COST) if it has to match Visa (NYSE:V) and Citi’s (NYSE:C) offers, or why ESPN is a double-edged sword for Disney (NYSE:DIS).

At this level, an investor usually can come up with detailed numerical projections about the business for the next few years. He can express the qualitative analysis in detailed quantitative terms.

One peril of which an investor needs to be keenly aware at this level is the false security offered by the vast amount of data as well as the detailed analysis. The numbers may tell you one thing, but you may start to develop a gut feeling that the numbers might be misleading even though you don’t know why.

Level IV

Based on my observations, most investors get stuck in one of the previous three levels. Very few make it to Level IV and above.

At Level IV, an investor knows well how to play both the classic value investing game as well as the high quality game. He can increase his odds of outperformance by intentionally only playing in less efficient markets such as distressed debts, emerging markets or special situations. He is also religious about implementing the right process and designing an environment that encourages doing the right thing.

Level V

Superior thinking and superior analysis are the markers of achieving Level V.

Here are 10 signs that an investor has achieved Level V:

  1. He knows the difference between knowing the name of something and knowing something.
  2. He understands circle of competency and knows his circle of competency.
  3. He achieves ecolacy by going an extra step to ask the questions so what and then what.
  4. He can quickly filter out irrelevant data and focus on the most important, relevant and knowable data.
  5. He knows the history and the culture of the business well, and he studies the past extreme successes and failures in the industry in which the business operates.
  6. He knows the businesses within a company’s ecosystem as well as the company.
  7. He sees risks others don’t see, and he sees risks before most people see them.
  8. He asks questions about the businesses that may not have definitive answers but are important to think about.
  9. He can tell whether management is lying or not.
  10. He has a super long term investment horizon and can often tell where we are in different cycles.

At this level, an investor will rely less on precise numbers produced by detailed models. He knows being roughly right is much better than being precisely wrong. This leads to minimum use of detailed financial models and the habit of focusing on big picture numbers and deep simplicity.

Level VI

At this level, an investor has a holistic view of the business. He can incorporate macroeconomics into microeconomic analysis. Let me use an analogy to make this point: At this level, a business can be thought of as a tree. Most people see the tree as it is. However, an investor on this level can not only see the tree, he can also see the forest in which the tree grows, the park in which the forest resides and what the park, the forest and the tree will mostly look like in 10 years.

Another way to put this is the following quote from the book "101 things I Learned From Architecture School" – “when designing a stair, window, column, roof, lobby, elevator core or any other aspect of a building, always consider how its design can express and reinforce the essential idea of the building.”

At this level, an investor also sees the interactions and connections among different industries and different countries – most things are linked one way or another.

I think Li Lu at Himalaya is perfect example of Level V and Level VI.

Level VII

At this level, an investor takes investing up a notch by mastering what has worked in one market and transferring that knowledge and experiences to a less developed market. He is also actively engaged in the cultivation of the business in which he invests by providing capital and bringing together different parties that may all benefit from a win- win situation.

Tom Russo (Trades, Portfolio) and Zhang Lei from Hillhouse Capital Management are the very few investors at this level. The Blue Moon example perfectly illustrates this level of investing:

Blue Moon is in a traditional liquid laundry detergent business in China. Formidable and established players such as Procter & Gamble (NYSE:PG) and Unilever (NYSE:UN)(NYSE:UL) both play in this field and have great established brand equity already. Not only did Zhang Lei provided capital to Blue Moon, he also arranged for Blue Moon’s executives to meet with executives from China’s ecommerce giant JD.com (NASDAQ:JD) so Blue Moon’s executives could learn about ecommerce from JD while JD’s executives could learn more about merchandising from Blue Moon. Zhang Lei didn’t care about the capital spending needed to build the business, which burdens short-term financials.

This is not a zero-sum game but a win-win situation in which Hillhouse, Blue Moon and JD can all benefit from each other’s success. Subsequently, Blue Moon redesigned its detergent packs so that they could fit into JD’s distribution networks. Zhang Lei also applied his knowledge in the social media world and pushed for an aggressive social media strategy. Blue Moon now is the largest liquid detergent brand in China.

Level VIII

I can only think of Buffett and Munger at this level. Not only do Buffett and Munger possess all the capabilities needed in the previous seven levels, they also have many competitive advantages that are unique to Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), to name a few:

  1. People from all over the world bring special deals only to Berkshire Hathaway. Companies like Goldman Sachs (NYSE:GS) and GE (NYSE:GE) only turn to Berkshire in stressful times for capital and grant Berkshire extremely favorable terms.
  2. Almost every business Berkshire bought widens its moat.
  3. Buffett and Munger are perfect partners for each other and arguably only for each other.
  4. Berkshire has maximum flexibility in terms of asset class and security class. They can invest in common stocks, preferred stocks, convertible bonds, equity puts, derivatives and all types of securities in all types of businesses.
  5. Negative borrowing cost and constant flow in of permanent capital.

Let me end with another Mungerism with which we are all familiar:

Investing is not supposed to be easy. Anyone who finds it easy is stupid.

Disclosure: Long JD.com and Berkshire Hathaway.

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About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 5.0/5 (24 votes)

Voters:

Comments

jtdaniel
Jtdaniel premium member - 3 years ago

Hi Grahamites,

Just letting you know how much I enjoyed your article. Your first point may have been the most salient - "You can beat the market regardless of your level". This is contingent on the investor abiding within that level and then maintaining a reasonable amount of self-control in volatile markets.

I self-rated at Level II, which I think could also include the ability to engage in basic takeover arbitrage. Missing out on compounders is a risk at every value investing level, but as you note may be more common at Level II. I have missed a lot of them, because.a great business trading at 40X EPS is probably never going to be my first choice. Now when Microsoft fell to 10X EPS I received it warmly. I can also buy Exxon when others are fearful and identify good arbitrage plays.

From my experience, some keys to succeeding at Level II include the ability/willingness to (1) slowly build a portfolio of a few leading companies that can be bought at bargain prices, (2) buy with the intention to hold for decades, (3) reinvest dividends and/or try to average down, (4) keep a significant amount of cash available for unforeseen opportunities, and (5) consider adding an arbitrage component to the portfolio. Best, dj

fung9815
Fung9815 - 3 years ago    Report SPAM

Great article as always, enjoyed it so much!

I guess we all started off a theoritical/textbook value investors (level 1-3). Like you said, many stuck at level 3. I believe that in order to move upward, we need to be more philosophical -- think more about how things work, how people behave, and the story behind the numbers.

rherion7
Rherion7 - 3 years ago    Report SPAM

Thank you for the great article. Something I would add besides evaluating a particular investment and the particular subsection of the market that the investment resides in, etc., is risk management and knowing when, and when not, to back up the truck. As importance as all of the levels of value investing from above is seeing and capitalizing heavily on the no brainers on the few occasions that they present themselves, as Munger and Buffett testify this is responsible for a large measure of their success (20 investment punchcard).

Grahamites
Grahamites - 3 years ago    Report SPAM

dj - Thanks for the nice words and thanks for commenting. Just based on your observations, I think you are way more than level II, especially philosophically. I totally agree that early in the value investing journey, it's very easy for value investors to miss out the future multi-baggers because the static valuation multiple is high. I have thought Master Card and Priceline were so expensive back in 2011 or 2012 when both were trading not even 40x earnings but more like 25. It is hard to come up with convictions, for the right reason, that a fast grower like those two can grow at a faster than average speed for a long time but once you do get the conviction, the mistake of omission becomes less likely. And it takes a few more levels of analysis to do that.

But, as we both agree, you can still beat the market handsomely even without those multibaggers. Your four points keys sound like a great market beating framework.

Grahamites
Grahamites - 3 years ago    Report SPAM

Fung9815 - Thanks for the nice words and thanks for commenting. You are absolutely right that in order to advance to higher level, we need to be more philosophical -- think more about how things work, how people behave, and the story behind the numbers. Great thinking.

Grahamites
Grahamites - 3 years ago    Report SPAM

Rherion - Thanks for the nice words and thoughtful comments. I agree totally that temperament is also key in beating the market. Very few people can stick to the 20 punchcard philosophy, very much easier said than done. And if one possesses the temperament of only punching 20 times at those big no-brainers, he doesn't need to do too much on the analysis level. I know a doctor who does just that with great track records.

And great points on this:"Something I would add besides evaluating a particular investment and the particular subsection of the market that the investment resides in, etc., is risk management and knowing when, and when not, to back up the truck. "

batbeer2
Batbeer2 premium member - 3 years ago

>> And if one possesses the temperament of only punching 20 times at those big no-brainers, he doesn't need to do too much on the analysis level.

Yes!

I think the investor who spends 10% of his time tracking a universe of say.... 150 companies is much better off than an investor spending 100% of his time sifting through hundreds of thousands of stocks every week. Of course with such a limited universe you'll probably not be trading much.

Another way to put it is that it requires a well-developped ego to believe you can figure out which of those thousands of cheap companies is qualitatively OK or, more importantly, filter out those that are not.

Reversing the proces and looking at what you understand and then figuring out if/when it's cheap:

  1. Is safer.
  2. Requires less time (or alternatively leaves you with time to do superior research).
  3. Does nothing for your ego; which might explain why most investors can't do it.

Yes, a lot of research indicates that statistically cheap stocks outperform. I'd argue that this is precisely because too many men want to believe their analytical skills can be and should be applied universally.

Just some thoughts.

Jean-Francois Nobert
Jean-Francois Nobert premium member - 3 years ago

outstanding article as usual, but this one might be the best i ever read on Gurufocus

vgm
Vgm - 3 years ago    Report SPAM
Thanks for the outstanding article, Grahamites. And thanks to others for insightful comments too.

I wonder if I might throw in another angle. It won't fit as one of your levels, but is more of an alternative mindset to investing. Some might call it heretical.

It consists in developing a sufficient understanding of investing with the goal of identifying a person or persons with whom to entrust our money. My first ever stock purchase, which was around the time of the dotcom crash, was 3 Berkshire A shares at about $60k per share. In retrospect it was an inspired decision. I made only two mistakes: not putting all my money in BRK, and then not holding 'for ever'.

Buffett is the most obvious example, but John Malone, Prem Watsa (Trades, Portfolio) and Bruce Flatt would be others whose publicly-traded company stock(s) would have made outstanding investments over a long period of time. I identified them but didn't have the confidence to follow thru.

To me the huge advantage of this strategy is clear: the people I mentioned are far far better than I could ever hope to be - they are able to analyze, anticipate, decide, and move based on knowledge and experience I could never hope to have. Investing alongside them would allow me to sleep well, knowing the best minds and practitioners on the planet were looking after my financial needs.

Investing is a tough business, as we probably all found out the hard way. There are many ways to fail. Why not simply travel on the same vehicles as those superstars mentioned above? And who will be the next generation?

Thanks again for a brilliant article.

Thomas Macpherson
Thomas Macpherson premium member - 3 years ago

Great article as usual Grahamites. My limited processing power forces me to focus on Levels 1&2. Everything else seems to escape me no matter the amount of reading or costly mistakes. Thanks again. - Tom

snowballbuilder
Snowballbuilder - 3 years ago    Report SPAM

Interesting article grahamites

I ve really enjoyed reading

PS if JTD and Tom put theirself at level 2 .... i m probably in the underground !! ;))

Best Snow

Grahamites
Grahamites - 3 years ago    Report SPAM

Jean-Francois Nobert: Thanks for the super nice words!

Grahamites
Grahamites - 3 years ago    Report SPAM

Vgm - Thanks for your nice comments. You have a great point and a great strategy. Idendifying great capital compounders and just let them manage your money basically at no charge and they have every incentive to do it well. Very smart.

I would say this can be part of the investment analysis. You are identifying someone who is at level V and above in your assessment of the management team, which probabaly falls into level III of the company specific analysis. I admire what you have done with BRK.A during the dotcom years. Impressive!

Grahamites
Grahamites - 3 years ago    Report SPAM

Tom - Thanks for the nice words. You are being humble. Nintai's investment results speak for the high level you are at:)

Grahamites
Grahamites - 3 years ago    Report SPAM

Snow - Glad you liked the article. Thanks for the comments.

Grahamites
Grahamites - 3 years ago    Report SPAM

Batbeer - Well thought out and well put:)

Tradezero
Tradezero - 3 years ago    Report SPAM

Value investing requires a systematic approach, as this article neatly reveals.

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