Benjamin Graham is the godfather of value investing. Over many decades, his strategy of buying the market’s cheapest stocks achieved outstanding results.
Recently however, value investing has taken on a new form. Most people who call themselves value investors today do not use Graham’s relatively straightforward deep-value strategy. Instead, they rely on a combination of complicated valuation metrics to arrive at an estimate of intrinsic value.
The problem with this approach is valuation models can easily be adjusted to produce the most favorable outcomes. Using a discount cash flow model, for example, is highly inaccurate because a simple 50 basis point adjustment in the discount rate used can increase the estimate of intrinsic value by a significant amount. Also, discount cash flow analysis requires some level of forecasting, which humans are notoriously terrible at. Graham never included such complicated forward-looking valuation metrics in his analysis because he wanted to avoid losing money. The best way to do this is to invest based on what you can see, not what you may believe will happen in five or 10 years. As Aesop said thousands of years ago, “A bird in the hand is worth two in the bush.” And as Warren Buffett (Trades, Portfolio) later explained:
“First, how certain are you this company will grow, or even has birds in the bush? Second, how long will it take for the birds to leave the bush? And lastly, your bird in the hand is long-term U.S. bonds [in our case here in Singapore, it could be long-term Singapore government bonds]. So, how much better yielding is this opportunity?”
Graham’s strategy was built on figures, company financials, that are easy to value. He placed little value on intangible factors such as management, brand and reputation, instead preferring to value a company based on what he could see on the balance sheet. This approach is virtually unheard of today as Buffett has popularized the method of valuing a company based on intangible assets, which give it a "moat."
Replicating Graham
There is one case study conducted by Graham and published in a collection of notes from his lectures when he was a professor at Columbia University that really details his investment strategy and provides an example of how investors can replicate the strategy today.
The case study is a comparison between two companies. The first company is the Taylorcraft Company, with a market capitalization of $3 million and working capital of $103,000. It also had stock and surplus of $2.3 million, but $1.15 million of this was what Graham called an “arbitrary plant markup.” The second company is called Curtiss-Wright (CW, Financial):
“Taylorcraft and Curtiss-Wright apparently were selling about the same price, but that doesn't mean very much...the Curtiss-Wright Company has built up its working capital from a figure perhaps of $12-million to $130-million, approximately. It turns out that this company is selling in the market for considerably less than two-thirds of its working capital."
"The Curtiss-Wright Company happens to be the largest airplane producer in the field, and the Taylorcraft Company probably is one of the smallest. There are sometimes advantages in small size and disadvantages in large size; but it is hard to believe that a small company in a financially weak position can be worth a great deal more than its tangible investment, when the largest companies in the same field are selling at very large discounts from their working capital. During the period in which Taylorcraft was marking up its fixed assets by means of this appraisal figure, the large companies like United Aircraft and Curtiss-Wright marked down their plants to practically nothing, although the number of square feet which they owned was tremendous.”
As with any turnaround situation, there was no guarantee Curtiss-Wright’s outlook would improve, but the discount to working capital gave a huge margin of safety, which more than made up for the lack of earnings certainty going forward.
Disclosure: The author owns no stock mentioned.
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