Ben Graham said: “Investment is most intelligent when it is most businesslike.” These are the nine most important words ever written about investing.

–Warren Buffett

If you were asked to name the most successful investors of the past century, the following names would probably be on your short list: Ben Graham, Warren Buffett, Seth Klarman,  John Templeton, Joel Greenblatt, and Peter Lynch. All these people share something in common — they practice value investing.

What is value investing?

What Value Investing is Not

First, let me emphasize what it is not. It does not involve trading where one believes in the ability to predict a stock’s short-term price movements. Yet it also does not involve index investing where one believes in the efficient market hypothesis and the inability to beat the market. It is not throwing caution to the winds and gambling your entire net worth on a “can’t miss” investment.  It is not buying an exciting “story stock” in a high-growth industry. And it certainly is not chart reading and buying a stock simply because its price is going up. Rather, value investing could be considered the exact opposite of all of these things.

Value Investor Checklist

Perhaps the best description of value investing ever written is in Seth Klarman’s 1991 investing classic “Margin of Safety.”  I’d recommend that you read it in hardcover, but unfortunately it is out of print and costs between $775 and $2,197 on Amazon.com, depending on how many dog-ears and scribbles you are willing to put up with. So you’ll just have to trust me that he describes value investing as follows:

• The process of fundamental analysis, whereby stocks are regarded as fractional ownership of the underlying businesses that they represent.

• The confident belief that one can determine the value underlying a stock, but the humility to realize that human error and bad luck can cause such a determination to be inaccurate.

• The risk-averseness to require a significant margin of safety whereby one has the discipline to only buy when the price of the stock is trading at a considerable discount from the calculated fair value.

• The belief that the market is inefficient and that stock prices often diverge markedly from fair value because of the short-term “fear and greed” swings of most market participants.

• The emotional strength to stand apart from the crowd and challenge conventional wisdom, while having the patience of Job to suffer periods of severe underperformance during prolonged periods of market overvaluation. 

• Supreme confidence that over the long term, economic reality wins out and stock prices move towards underlying value.

Put another way, value investing is businesslike. It distinguishes between a stock’s price and its underlying value. Value investors view stocks as fractional shares of real businesses that have relatively constant values, compared to their manic-depressive ever-changing daily market prices. In addition, such investors approach a potential stock purchase in a thoughtful, analytical, and quantifiable way, just like a business would approach a potential corporate acquisition.  The goal is not excitement, but making a profit.

Boring is Beautiful

Peter Lynch’s investment criteria are the antithesis of exciting. He has written that his perfect stock would have the following characteristics:

(1)   A name that is dull or, even better, ridiculous (e.g., Masco Screw Products or Pep Boys — Manny, Moe & Jack).

(2)   Does something that makes people shrug, retch, or turn away in disgust (e.g., it’s rumored to be involved with toxic waste and/or the Mafia).

To sum up, the objective of a value investor is to buy $1 worth of value for a price of 75 cents or even less and then wait for price and value to inevitably converge. What type of business that value can be extracted from is irrelevant, but it’s more likely to be found in boring and/or unpleasant businesses that most investors avoid (which causes the undervaluation). It’s really a very simple concept, but extremely difficult for most people to put into practice.

Human Emotions and the Growth Trap

I have seen no trend toward value investing in the 35 years I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult.

—Warren Buffett

Traditional value investing strategies have worked for years, and everyone’s known about them. They continue to work because it’s hard for people to do, for two main reasons. First, the companies that show up on the screens can be scary and not doing so well, so people find them difficult to buy. Second, there can be one-, two- or three-year periods when a strategy like this doesn’t work. Most people aren’t capable of sticking it out through that.

—Joel Greenblatt

If the stock market were efficient, value investing couldn’t outperform the stock indices. No investing methodology could. But history has proved that the market is not efficient and value investors take advantage of this inefficiency.

What causes this inefficiency? — human emotions.  Investors overreact to good news, bidding stocks up until they trade far above their intrinsic value, and overreact to bad news (or not as good news), dumping stocks until they trade far below their intrinsic value. Wharton Professor of Finance Jeremy Siegel characterizes this phenomenon as the “growth trap,” which he discusses in his 2005 book The Future for Investors: 

The growth trap seduces investors into overpaying for the very firms and industries that drive innovation and spearhead economic expansion. This relentless pursuit of growth — through buying hot stocks, seeking exciting new technologies, or investing in fast-growing countries — dooms investors to poor returns. In fact, history shows that many of the best-performing investments are instead found in shrinking industries and in slower-growing countries.

It’s an Expectations Game

As Siegel demonstrates, the long-term return of a stock does not depend upon a company’s growth rate but rather upon the differential between the actual growth rate and investor expectations of future growth. High growth companies get most investors so excited that they bid up the stock price to a level that overestimates future growth, whereas lower growth companies don’t excite most investors, leading to investor neglect and prices that underestimate future growth.

Siegel provides the example of IBM and Standard Oil of New Jersey (now Exxon Mobil) between 1950 and 2003.  Over this time period, IBM’s revenue and earnings per share grew more than three percentage points per year above those of Exxon Mobil’s, yet Exxon Mobil proved to be the superior stock investment, returning more than half a percentage point per year more than IBM.  How can this be?

Your Purchase Price is Critical

The answer is price.  Investors were willing to pay a much higher price for IBM’s earnings than for Standard Oil’s. As it turns out, too high of a price. Why would an investor pay a higher price for one company’s earnings than another? — expectations of future growth.  If one company is expected to grow earnings faster as another, an investor should be willing to pay more for current earnings, which are just a snapshot, because the earnings will be larger in the future. But over the time period studied, IBM sported an average P/E ratio of 26.76, more than twice Standard Oil’s average P/E of 12.97. To justify such a huge price premium, IBM’s earnings would need to have grown somewhere between 75-100% faster than Standard Oil’s – but it turned out they grew only 46% faster. Couple this with the fact that Standard Oil had a dividend yield more than twice that of IBM (thus allowing for substantially more dividend reinvestment, an important component of long-term returns), and slower-growing Standard Oil became the superior investment, hands down:

1950-2003	IBM	Standard Oil	Advantage
Earnings Per Share Growth	10.94%	7.47%	IBM
Dividend Yield %	2.18%	5.19%	Standard Oil
Average P/E	26.76	12.97	Standard Oil

 

Siegel’s conclusion is that valuation matters:

“The price investors paid for IBM stock was just too high. Even though the computer giant trumped Standard Oil on growth, Standard Oil trumped IBM on valuation, and valuation determines investor returns.”

Don’t Overpay for Country Exposure, Either

While the above example is anecdotal and involves only two stocks, Siegel discovered that the “growth trap” is a universal concept that applies not only to individual stocks, but to industry sectors and countries as well. For example, since 1957 the financial sector has experienced the fastest earnings growth, yet has underperformed the original S&P 500 index, whereas the energy sector has had slow growth but has outperformed the index.  Similarly, during the 1990s, China was the fastest growing economy in the world, yet was the worst performing stock market.

Difference Between the Value Investing Process and Value Stocks Generally

Keep in mind that great value investors do even better than value stocks in general. Take Warren Buffett, for example. His investment vehicle, Berkshire Hathaway, has generated compounded annual gains of 19.7% for 47 years and has underperformed the S&P 500 in only nine of those years.

Value investing is a process based on discovering a limited number of stocks trading at prices significantly below their long-term intrinsic values and then holding them long term. Intrinsic value is usually derived from a discounted cash flow analysis, which is based on analyzing the entire life cycle of a company.

In contrast, the definition of value stocks used in these academic studies is based on a very simplistic financial snapshot of current value ratios (e.g., low price to trailing 12-month earnings or low price to accounting book value). 

The amazing thing is that even a mindless index approach based on such a simplistic definition of value stocks outperforms the general market.

Be the Tortoise, Not the Hare

Value investing works, but requires a long-term perspective. It takes advantage of the inefficient pricing caused by human nature, which focuses on short-term greed and fear, and which is unlikely to change anytime soon. If you don’t mind analytical work, are a contrarian by nature, grasp the difference between price and value, and have the emotional fortitude to be patient and withstand short-term bouts of underperformance, I would recommend that you give value investing a try.

Just like in Aesop’s fables, the investing tortoise really does beat the hare.