Modern Value Investing: Adding to the Value Investing Toolbox

Higher stocks prices aren't always a value investor's best friend, and other lessons

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Robert Abbott
Jan 14, 2019
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In chapter four of Sven Carlin’s book, “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment,” the author observed that almost a century had passed since Benjamin Graham laid out the foundational principles of value investing.

In his book, published in 2018, Carlin wrote that while Graham’s principles still stand, there are investing concepts that have emerged with the potential to improve returns and reduce risk:

  • Taxes
  • Stock price movements
  • Optimism
  • The theory of reflexivity
  • Corporate governance
  • Dividends and buybacks
  • Wall Street

Sometimes, it is in your best interests to pay taxes

According to Carlin, investors should not be afraid to pay taxes. He creates a theoretical scenario in which you buy a stock at $100 because it is a bargain. A year later, the stock is up to $200 and your profit would be $80 after paying a capital gains tax of $20.

Having risen to $200, the stock is likely no longer a bargain, and its price could drop again. In addition, there may be an opportunity cost; if you hold the first stock just to avoid the tax of $20, then you may miss out on an opportunity to make $50 or $80 on another mispriced stock.

As Carlin wrote, “It is extremely important to be knowledgeable about the taxation system related to investments in the country you live.”

Stock price movements

Stock prices do not always stay attached to the underlying business reality. As an example, Carlin cited the case of Pfizer (

PFE, Financial), which sells pharmaceuticals and thus has relatively stable revenue and earnings, despite what the economy is doing.

However, the price of its shares crashed, along most of the rest of the market, in 2008 to 2009. “In a stock market panic, most investors just sell everything, no matter the stability of the business or its correlation to economic trends.”

As might be expected, Pfizer’s stock price returned to pre-crisis levels because it had stable earnings throughout the period. And, as Carlin wrote, “The market constantly offers excellent investment opportunities to those who can see the difference between the market’s erratic behavior and business fundamentals.”


The author made a point of noting that being an optimist is not about rooting for a stock price to go up — it’s about believing the market will ultimately provide decent returns thanks to compounding and other factors.

One of those other factors is business cycles. People believe stocks will go up and down, but when an eventual bear market hits, many (Carlin said “the large majority” and is probably right) investors believe the end is near.

For value investors, these corrections and recessions are not bad news, they are opportunities to buy desirable stocks at bargain prices. This window is often shorter than expected, because stimuli begin to affect the market: stimuli such as central banks loosening interest rates and injecting new capital into economies. In Carlin’s words, “However, it is important to know that recessions are always minor pauses on the amazing growth trend that is the economy.”

To illustrate, he offered this chart from the Federal Reserve Bank of St. Louis, showing the growth of U.S. GDP, with corrections and recessions in gray:


As he put it after showing this chart, “Recessions are minor blips on the long-term trend of growth and development that is a common attribute of the human race.”

The Theory of Reflexivity

This idea, developed by guru investor

George Soros (Trades, Portfolio), explains how irrational financial markets can have an effect, a reflexive effect, on the fundamentals of a company, or even on the market itself. Carlin argued that value investors must be very aware of this effect.

For example, a company may be attacked by short-sellers (who want to drive down the stock price), setting up a market panic and leading creditors to pull their credit lines. This, in turn, may affect the fundamentals. In Carlin’s eyes, this explains many cases of irrational behavior, margin of safety failures and value investing losses.

More specifically, he used the case of Tesla (

TSLA, Financial), from 2012 to 2017. The following chart shows how the company’s book value kept growing, despite the growth in negative, cumulative earnings per share:


What was happening here? While Tesla did not have one single profitable quarter between 2010 and 2017, it did increase it book value per share 10-fold by raising new capital. Carlin called this a positive reflexivity effect.

Corporate governance

Settling for mediocre returns is, in Carlin’s words, a plague on the corporate environment. It is not recognized by the market but can have significant consequences for investors who do not adjust their portfolios.

What he was complaining about is an inclination among shareholders to look at just the bottom line and the competition; if the bottom line is positive and similar to the competition’s, then it is assumed the company is doing well. But no one is asking whether it might have done much better.

As Carlin pointed out, most stocks are owned by index funds and pension funds, all of which own small stakes, meaning corporate managers do not have tight controls. So, as long as they do reasonably well, they will have no problems with shareholders, even if there is misalignment between management and shareholders.

He noted the aggregate earnings of the S&P 500 companies did not grow between 2007 and 2017, despite historically low interest rates and international economic growth. And, that is the nominal assessment. There is also a survivorship issue: Companies with lower earnings were removed from the index, while companies with growing earnings were added to it.

Stock prices, dividends and buybacks

Here’s a challenge to value investors from the author: Are higher stock prices a good thing? Carlin argues this is only true if you are a seller. As a value investor, you should see yourself as an “accumulator of stocks.”

Further, as an individual, an investor in index funds or as a pension fund participant, higher prices are a problem. Carlin wrote, “As the S&P 500 is just going up and up while earnings remain flat, most investors are just paying more for the same thing. Think of your pension fund, a higher stock price isn’t at all positive for you because new contributions mean you own a smaller part of whatever the fund is buying.”

Yet, managers try to keep pushing up share prices by paying higher dividends and buying back their own shares. Making matters worse is the news that companies have taken on debt for buybacks and dividends. According to Carlin’s data for 2007 to 2017, S&P 500 firms spent $7.16 trillion on them, while total earnings were only $6.8 trillion. And what if the companies are buying back their shares for more than their intrinsic book value?

Clearly, Carlin believed that investors should build wealth through compounding and internal growth, rather than through capital gains.

Wall Street and its fees

Finally, Carlin pointed an accusing finger at fees and Wall Street’s self-interests. This, he wrote, is one of the reasons average investors earn significantly lower returns than the market. He cited a 2017 report from JPMorgan that the average investor earned average annual returns of 2.3% between 1997 and 2017, while the market returned an average of 7.5%.

The good news is that fees came down quite substantially in the past several decades, thanks to new and intense competition, particularly from online and do-it-yourself services.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed and do not expect to buy any in the next 72 hours.

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