What is a value investor? Are there any rules or guidelines that set them apart from other investors?
Yes, in a broad sense there are informal guidelines that distinguish value investors: They buy (or try to buy) stocks that are selling for less than their intrinsic value, to give themselves a margin of safety.
Yes, too, in the sense that they focus on a company’s fundamentals: earnings, cash flow, and so on — and not on investor psychology (as technical investors do with their charts).
But, within those broad guidelines, there are as many approaches as there are investors, it seems. Which perhaps is why the authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors" titled chapter 12, “Variations on a Theme: Value Investing Styles.”
In this chapter, authors Stephen Horan, Robert R. Johnson and Thomas Robinson profiled nine prominent value investors, saying, “This is not meant to be an exhaustive list, but rather a representative sample of some of the most acclaimed value investors. The intention is not to describe each style in great detail, but instead to provide a flavor of each approach and show how they relate to, and differ from, one another.”
Benjamin Graham
Appropriately, they began with Benjamin Graham, notint that he has been called the “father of value investing.” However, they think that term is too restrictive; instead, they argue, he might be better described as the founder of a profession: financial analysis.
“Graham is credited with applying the scientific method and quantitative study to the investment process, which led to the creation of the field we now know as financial analysis. Prior to Graham’s contributions, stock market participants were referred to as speculators and not investors. Bonds were seen as the purview of true investors, while stock market activity was viewed as speculation.”
Graham’s illustrious career included managing investment funds for Graham-Newman Corp. and teaching at Columbia University. His work influenced following generations of value investing gurus, including Bill Ruane, John Bogle, John Neff, Seth Klarman (Trades, Portfolio), Wally Weitz and Warren Buffett (Trades, Portfolio). Several of those names also worked at Graham-Newman.
In addition, he wrote two seminal books, “Security Analysis” (with David Dodd) and “The Intelligent Investor.” "Security Analysis" has been called the “bible of investing,” and Buffett once described "The Intelligent Investor" as “by far the best book on investing ever written.”
What was it about Graham’s investing and investing style that made him so prominent and influential? Two key principles: first, that investors should own common stocks because they provide protection against inflation. Second, that combining the dividend yield on common stocks and increases in market value (capital gains) meant stocks would outperform bonds in the long term.
Graham also gave investors the concept of “margin of safety,” now an essential part of the foundation for value investors. He called it the secret of sound investing. Margin of safety refers to the difference between the intrinsic value of an asset and its market price. If you can buy a stock at a discount (market price) to its intrinsic value, as determined by your financial analysis, then you have a margin of safety.
That margin might also be called a margin for error, because it allowed Graham and subsequent value investors to accommodate mistakes made in calculating the intrinsic value or bad luck with the market.
Earlier in the chapter, the authors noted that Graham applied the scientific method to investment analysis. He did that by testing common stocks against seven criteria, at least for stocks in the portfolio of a defensive investor:
- Adequate size of business: He wanted to see a minimum of $100 million in annual sales (in 1973 dollars) for an industrial company, and at least $50 million in total assets for a public utility (industrials and publicly traded utilities were among the most commonly traded sectors in Graham’s day).
- Strong financial condition: To determine this, he checked the current ratio (current assets divided by current liabilities). He wanted only industrial companies that had a current ratio of at least 2, and he stipulated that long-term debt should not be greater than the net current assets (current assets minus current liabilities). On the public utilities side, he would not buy stocks that had debt of more than twice the stockholders’ equity.
- Earnings stability: The company had to show positive earnings for each of the preceding 10 years.
- Dividend record: There were no breaks in dividend payments for at least 20 years.
- Earnings growth: Over the past 10 years, per-share earnings had to have grown by at least a third (he used three-year averages at the beginning and end).
- Moderate ratio of price-earnings: The price of the stock should not be greater than 15 times average earnings during the three previous years.
- Moderate ratio of price-assets: Graham would not pay more than one and a half times the most recently reported book value. However, if the multiplier of earnings was less than 15, he could justify a higher multiplier of assets. His rule of thumb was that the product of the multiplier times the ratio of price to book should not be more than 22.5.
Conclusion
Graham was both a successful trader and an intellectual leader. The authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors" wrote, “Graham’s contributions to investing in general, and value investing in particular, cannot be overstated.”
Those contributions — most notably that investors should invest in stocks to protect themselves against inflation, that dividends and capital gains should outperform bonds and that a margin of safety was essential — were passed on to the following generation. And thanks to the success of that generation, Graham’s legacy likely will last for many more generations.
Read more here:
Strategic Value Investing: Relative Valuation
Strategic Value Investing: Residual Income Models
Strategic Value Investing: Deep-Value Stocks
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