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:

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.

Around the Roadrunner Portfolios

Buckle (NYSE: BKE) had performed well despite the general retail-spending weakness that had obliterated the stocks of several other mall-based specialty retailers (e.g., Aeropostale (ARO), Abercrombie & Fitch (ANF), and American Eagle (AEO)), but the company’s sales finally succumbed to the deteriorating macroeconomic forces in September. Same-store sales for September were down 4.5%, which was worse than the consensus analyst estimate of a 1.2% gain.

Buckle management does not provide commentary on its monthly sales figures, but I believe the problem is not company-specific as much as macroeconomic. The U.S. consumer is simply cutting back purchases. According to ShopperTrak, U.S. store traffic was down 5.9% year-over-year for the week ending October 5^th, marking the 13^th weekly decline in the last 16 weeks. Furthermore, according to Gallup, economic confidence plunged during the first week of October by the largest amount since the Lehman Brothers bankruptcy in September 2008. Uncertainty surrounding the length of the U.S. government shutdown, higher-than-expected Obamacare insurance premiums, and the possibility of a U.S. debt default if the debt ceiling is not raised by October 17^th are all weighing heavily on the psyche of U.S. consumers.

The good news is that many of these issues may be short-term in nature and consumer confidence and spending could rebound quickly. Store buyers (including from the Buckle) were recently seen shopping for spring 2014 merchandise at a Los-Angeles trade show, where buyer traffic was characterized as “busy.”

Ascendiant Capital Markets also speculated that Buckle may be suffering from a short-term rotation by consumers away from “embellished” denim clothes, which is Buckle’s specialty, but denim should come back into consumer favor in 2014.

Given the September sales miss, it is possible that Buckle may not pay a special dividend in 2013 as it has in recent past years. One could argue that the huge $4.50 special paid in December 2012 was meant to cover both 2012 and 2013 because it was double the average special dividend paid since 2008 and could have been an attempt to avoid the dividend tax-rate increase in 2013.  

The stock has fallen 19% from its August high of $57.68 and is now back under my $47 buy-below price. Consequently, if you missed the earlier opportunity to buy into Buckle, the next few months may be a low-risk time to initiate a position in this long-term moneymaker.

Diamond Hill Investment Group (Nasdaq: DHIL) released its third-quarter mutual-fund guide and investment results year-to-date for its seven equity mutual funds and one fixed-income fund have been pretty good. The immediately-completed third quarter was less impressive, but high management fees (page 11) keep pouring in nonetheless. Most of the funds’ 10-year returns outperform on a gross basis (before fees), but returns on a net basis (after fees) are only average. Even utilizing a Buffett-Graham value philosophy, it’s hard to beat the market!

Virtually all of the equity funds suffered underperformance against their respective benchmarks over the past 3 and 5-year trailing time periods, but have much better relative returns on a 10-year and one-year basis. The Large Cap Fund is one of the better equity performers, which is good since it possesses more than half of the firm’s total mutual-fund assets. The company’s assets under management continue to climb and at $11.04 billion are up 17.1% year-to-date.

The stock has been one of Roadrunner’s best performers, up more than 59% since being recommended on January 24^th.  Given the increase in assets under management and the decent investment returns on its portfolios, I am raising the buy-below price on Diamond Hill Investment Group from $74 to $89.

SolarWinds (NYSE: SWI) has acquired another business and the market responded by pushing the stock down to another 52-week low. On October 7^th, SolarWinds announced the acquisition of privately-held Confio – the maker of database performance management software – for $103 million in cash. Confio grew revenues 50% in 2012 and its products are used by 40% of Fortune 50 enterprises. SolarWinds big buy comes on the heels of the company’s acquisition of remote monitoring and management (RMM) software expert N-able Technologies for $120 million in cash back in May. I’m glad that the company paid cash for both of these acquisitions (thanks in part to a new $125 million credit line at a 1.4% interest rate) rather than stock because it means shareholders’ ownership stakes were not diluted. Even after both acquisitions, SolarWinds’ balance sheet is still strong with $133 million in cash.

According to SolarWinds CEO Kevin Thompson, the Confio acquisition is the “last meaningful piece of the puzzle” in the company’s strategic initiative to become a one-stop shop for all of an IT manager’s software needs. Sounds good, so why do investors continue to punish the company’s share price for making these acquisitions? The reason may be that investors view the acquisitions as evidence that the company’s core business is slowing down and the only way SolarWinds can continue growing is to buy the growth of other businesses. Furthermore, integrating multiple acquisitions is rarely a smooth process and often takes longer than expected, sometimes diverting management’s attention from the competitive marketplace. According to JP Morgan, these fears are misplaced and SolarWinds is merely experiencing the healthy growing pains of a young business:

We believe that much of the company’s recent performance issues have had to do with the macro backdrop and some execution issues which equate to growing pains. We do not believe that growing pains are a bad thing and if the company is able to reaccelerate organic growth, investors will likely express renewed confidence. We note that the execution by SolarWinds’ management team has been impressive up until recently.

Furthermore, both N-able and Confio have seasoned and fully-functional management teams that SolarWinds has decided to leave alone through the end of the year, so no integration will occur until 2014 at the earliest. In the conference call explaining the acquisition, I found SolarWinds’ management quite convincing in their rationale for the deal. CEO Thompson stated:

The addition of Confio’s Ignite database performance management solution to the SolarWinds family is the last major component needed to round out our systems management product portfolio. We believe we are now able to solve virtually all of the major problems faced on a daily basis by system administrators.

Unlike N-able Technologies, which markets to third-party managed services providers (MSP), Confio markets directly to IT managers similar to SolarWinds’ traditional business. Consequently, because Confio’s sales model is, as CEO Thompson puts it, “very similar to what we do,” any integration in 2014 should prove to be easy. Certainly much easier than an integration of N-able will be, because N-able really constitutes a new line of business for SolarWinds.

Analysts on the conference call asked CEO Thompson about the company’s execution problems during 2013 and whether it indicated recognition that SolarWinds’ business opportunity of selling software directly to IT managers was less than originally expected. Thompson’s answer exuded confidence that the business opportunity remains as huge as ever:

We absolutely believe in the strategy that we have created. We believe in the business, and the business model that we’ve worked so hard to build over the last really seven years as I’ve been here. We’ve got confidence in the size of the market opportunity in front of us. We’ve got confidence in our ability to cause this business to grow. And while we definitely started the year a little slower than what we had anticipating having, in no way has that shaken our confidence in what we created or in the size of the opportunity in front of us.

We think the timeframe for our opportunity is now. We don’t see any reason that we shouldn’t continue to be aggressive. We are about building a $1 billion software company and beyond. And the fact that we had six months that wasn’t as great as we like to have it be, it doesn’t in any way change what we’re trying to create. So, we got confidence in what we’re doing.

The other issue Thompson addressed impressively was the company’s growth rate and the importance of matching growth to costs. Despite the slowdown in SolarWinds’ license revenue, SolarWinds remains a very profitable and high-growth company! Returns on invested capital (ROIC) have been above 23% each year since the company went public in 2009. I appreciate Thompson’s focus on profitable growth and not just growth for growth’s sake. In other words, a company should not maximize growth but rather maximize shareholder value, which often occurs at less-than-maximum growth:  

We’re still growing 25% faster than the average public software company. We’re not growing much slower than our high-growth peers, which are growing 10 points or 12 points faster than us. They’re spending 50% more than we are to create that extra growth. They’re spending 4 percentage points of revenue for every 1 percentage point of growth that they are growing faster than we are. So, the way I look at it, I’ve got a better business than companies growing faster right now. So, why should we be afraid to continue to make the moves we need to make and to build the technology company we’re trying to build?

The decision to incur $40 million in debt to partially pay for the Confio acquisition is also an indication of Thompson’s smart use of capital. While $40 million constitutes less than one fiscal quarter’s worth of corporate cash flow and Thompson could have easily paid for the acquisition totally with the company’s cash on hand, it’s better to borrow at the obscenely-low interest rate of 1.4% — which is virtually free money. Why reduce business flexibility by crimping your cash balance, when virtually-free money is available to acquire valuable technologies? Leave the cash balance alone because it is needed for share buybacks and other value-producing corporate purposes.

Bottom line: Although SolarWinds no longer qualifies as a momentum stock, and its EV-to-EBITDA ratio of 16.7 still is too high to qualify it as a value stock, it is definitely a high-quality growth stock that should generate annual earnings and revenue growth of 20%-plus for years to come and outperform the overall market – especially at its current depressed price. In fact, SolarWinds is one of my favorite buys in the entire Roadrunner universe right now. Two very-smart hedge fund managers – Steven Mandel and Lee Ainslie — have been picking up SolarWinds shares recently at prices in the $37.66 to $45.82 range.

Western Refining (NYSE: WNR) jumped almost 8% over a two-day period (Oct. 10-11) on news that the Environmental Protection Agency (EPA) is considering a significant 16% reduction in the amount of renewable fuels (e.g., corn-based ethanol and bio-diesel) that must be blended into fuel during 2014. Specifically, the EPA may cut the mandate from 18.15 billion gallons of renewable fuels to only 15.21 billion gallons.

Such a reduction would benefit refiners because procuring and blending renewable fuels into gasoline is costly and reduces refiner profit margins. Furthermore, a combination of falling gasoline demand and increased renewable-fuel blending would force refiners to blend more than 10% ethanol into gasoline. Without a downward adjustment, the 2014 renewable-fuels mandate could force production of 15% ethanol gasoline, which is undesired by many customers because too much ethanol can damage vehicle engines and inhibit the proper operation of emission-control systems.

In other good news, the much-anticipated debut of Western Refining Logistics (NYSE: WNRL), the company’s master limited partnership focused on pipelines and storage, occurred on Thursday October 10^th. The MLP units were issued at $22 (above the expected range of $19 to $21) and jumped a healthy 9.5% on their first day of trading. The IPO raised more than $302 million with a portion being used to pay back parent Western Refining for certain expenses. The MLP structure is tax-advantaged and consequently raises the value of Western’s pipeline assets. After the IPO, parent Western Refining continues to own more than 65% of WNRL which is expected to pay an annual cash distribution of $1.15 per unit.