Friday, June 8, 2012

Value Investing: An Identity Crisis?

Any post about value investing always evokes strong responses, but I thought I would start this one by turning the focus inwards. So, here are a few questions for you :
1. Would you classify yourself as a "value investor"?
a. Yes
b. No

2. If yes, what makes you a value investor?
a. I try to estimate the value of a stock before I invest in it
b. I only buy stocks that trade at attractive multiples (low PE, low PBV etc.)
c. I do my homework, looking at the fundamentals, before I invest
d. I don't know. I just am.

3. Finally, do you think that value investors collectively do better than other investors in the market?
a. Yes
b. No
c. Not Sure
If yes, what is the source of their advantage? If not, why do you think they fail?

  • On the first question, I would not be surprised if the preponderance of visitor to this site classify themselves as value investors. After all, value investing has become so broadly defined that everyone seems to be in this camp, and when everyone is a value investor, no one is a value investor. For value investing to work as an investment philosophy, it needs foils, preferably in the form of investors who know little about fundamentals and care about them even less. Paraphrasing Warren Buffett, if investing is a game of poker and value investors are the card counters, you need suckers at the table who will supply the winnings.
  • On the second question,  as value investing has expanded well beyond the Ben Graham school of strict (and passive) value investing to include different and seemingly contradictory strands of investing, there is less consensus about what comprises a good "value” stock. In a recent paper on value investing (which, in turn, is closely modeled on a chapter in my book on investment philosophies), I presented my take on these issues.
  • On the third question, it does seem to be taken for granted, at least in the value investing community, that value investors are not only more virtuous than other, more fickle investors (growth investors, momentum investors) but that their "hard work" pays off in the form of higher returns, at least over long periods. It would be vindication of the "ant and the grasshopper" fable, if it were true, but is it?
What is the key characteristic that separates value investors from the rest of the world? In my view of the world, and I understand that yours might be different, the key to understanding value investing comes from breaking down a business into assets in place and growth assets.

It is this mechanism that I used to my posts on estimating how much you are paying for growth and how much that growth is worth. If you are a value investor, you make your investment judgments, based upon the value of assets in place and consider growth assets to be speculative and inherently an unreliable basis for investing. Put bluntly, if you are a value investor, you want to buy a business only if it trades at less than the value of the assets in place and view growth, if it happens, as icing on the cake.

It is how you find investments that sell for less than the value of assets in place that provides a framework to understanding the different strands of value investing, and there are three ways you can go about this mission:
a. Passive value investing: The oldest strand of value investing traces its lineage back to Ben Graham and his use of screens to find cheap stocks. Reviewing those screens, which combine market and accounting data, from Graham's book on security analysis, you are looking at stocks that trade at low multiples of earnings, pay a high proportion of these earnings as dividends and have a high proportion of assets that can be liquidated for close to their book value. In the years since, investors have added other screens (good management, stable earnings, strong competitive advantages etc.) that are all designed to reduce the potential for downside on the investment.
b. Contrarian value investing: In contrarian value investing, you adopt a different tack. You look for companies whose stock prices have collapsed for one reason on another. In its least sophisticated variant, you just buy the biggest losers (at least in terms of stock price), on the assumption that markets generally over react and that the portfolio of these losers will bounce back over time. In its more refined forms, you add other criteria to the mix. Thus, you may buy stocks that have gone down but only if they have a strong brand name and/or little debt.
c. Activist value investing: In activist value investing, you focus on poorly performing companies and look at the value of its assets in place, with better management in place. You then try to change the way the company is run by either acquiring control of the firm or putting pressure on existing management. Activist investing requires far more resources than either passive or contrarian value investing.

The skills and strengths you need to succeed in each of these value investing approaches is different and it is not clear than an investor who succeeds using one strand of value investing will be comfortable with the others. In the next three posts, I will focus on each of these strands of value investing. In the last post, I will examine the most contentious issue of all, which is whether value investors collectively generate value from their efforts or whether this too is "fool's gold".  


Eric Wu said...

From Buffett himself (source is 1992 Berkshire annual letter):

Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid?

Aswath Damodaran said...

Fair enough. If your definition of value investing is that any stock that trades at less than its fair value (whether it is Nokia or Facebook) is a "value" stock, it is a much broader definition of value investing. I don't disagree with you on your view of the world, which is close to mine, but neither of us would really be viewed as soul mates in a value investing conference.

Jim S. said...

I view the “margin of safety” as the most important concept in value investing. Value investors utilize conservative appraisals of business value, attempting to limit losses in cases in which their estimates prove incorrect. I also suspect that this is the source of any outperformance. It seems possible for value investors to avoid some of the losses experienced by other types of investors, while enjoying similar (or better) potential upside. But I don't think it's easy.

UK Rookie said...

Interesting post. And I do consider myself to be a value investor.

I have noted how fashionable 'contrarian' value investing has become. (Spot the oxymoron?)

I also agreed with Buffett when he said something like "Value Investing is a redundant term, if you're not investing for value, you're not investing". I can't remember the exact quote off the top of my head.

Like Eric Wu has just said, growth is a key component of any company valuation.

So I have been looking at solid, healthy, scalable businesses in the past couple of years, even if they don't look all that cheap. For example, companies like Unilever and Diageo in the UK (Diageo is a little on the expensive side at the moment, although I'm not planning to sell my stock just yet).

This is in part an attempt to be truly contrarian. And also because most 'value' stocks seem to carry a fair degree of risk at the moment.


Unknown said...

There are 2 components of "value investing", together trying to discover miss priced stocks:
1. "Looking in the mirror" component" where a part of the future price appreciation is given by low P/B, P/S, P/E, P/CF, dividend spread (to 10y t-bonds)
2. "looking forward" component: where the future price appreciation will be given by a higher future growth than what markets currently anticipate.

Mirror component are easy. Growth forecast is difficult - some might argue impossible.

Dave J said...

Professor, I consider you to be a thorough and insightful person but it looks like you read only the "intelligent investor" and not "security analysis" since the paragraph you wrote about passive investing is filled with misconception about graham.
- he did account for quality of management and stability of earnings .those are not new.
- he did not look only for high dividends. in fact he devised a couple of formulas for determining value. one of them was for companies with low ROC and it gave a more significant weight to dividends than the formulas for companies with high ROC.
- he did account for the value of growth and in his footnotes he directed readers to Phil fishers book for further reading on growth, competitive advantages etc.
- Graham was a supporter of shareholder activism and an activist investor himself.

Jago said...

Personally, I reject the traditional academic separation of value and growth stocks. Growth is a component of value.

I also reject that there is any other kind of investing besides value investing to begin with. Other types would be what, "hope investing"? There is tons of various types of speculation, but that's not investing.

Aswath Damodaran said...

The separation between value and growth is not an academic construct but a practitioner one. Portfolio managers put themselves into value and growth camps and most value investing conferences either pay lip service to growth or treat it as worth nothing. In fact, value investing icons like Buffett talk about growth but I challenge you to name the last great growth company that Buffett invested in, while it was still a growth company.

Jim S. said...

A couple examples of Buffett's recent "growth" investments from the 2011 BRK letter:

"Vic Mancinelli again set a record at CTB, our agricultural equipment operation. We purchased CTB in 2002 for $139 million. It has subsequently distributed $180 million to Berkshire, last year earned $124 million pre-tax and has $109 million in cash."

"TTI, our electric components distributor, increased its sales to a record $2.1 billion, up 12.4% from 2010. Earnings also hit a record, up 127% from 2007, the year in which we purchased the business."

Anonymous said...

We should go back to Graham who said: an investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.
Any thing other than that is speculation. Guys like him and Buffett did not spend their time on models to value a business which is only a futile attempt. As no one has a crystal ball, it is not possible to predict the futue. What is possible is to make a reasonable assessment as to what the business is like, how it has functioned in the past in both optimistic and depressed conditions, how the management has acted, and the like.
It is virtually impossible to precisely value a business. So valuing a growth company which is a young, start-up business is ruled out, unless one wants to purely speculate, which is ok. There is no harm in keeping some funds for (an intelligent)speculation. It lets you have some fun and games; supplies the kick.
There is no such thing as growth investing. It is either investing or it is not.
If someone wants to get only market return, there are index funds which will do a super job at that beating virtually a large majority of mutual funds. This return may not be the required return of the investor; but at least it is the market return under the given conditions.
If he wanted to do any better, he should rather engage himself in identifying mispricing of the markets which happens only now and then (since market is efficient generally) and wait for the opportunity. It could a long wait, never mind.

Anonymous said...

Notwithstanding Buffett's accusations of fuzzy thinking, there is a distinction between value investors and others:

1. value investors try to get something for free: Graham Net-Net types buy the working capital and get the remaining assets for free; others pay for the assets and expect to get the franchise for free; and still others pay for the franchise and expect to get the growth for free.

This idea of a free option on the value of the fixed assets, the franchise, or future growth is what margin of safety means to them and what disciplines their buying decisions.

The difference is not the amount of the discount to intrinsic value, but what kind of discount it is. Qualitatively speaking, paying half price for Amazon's future growth is not the same as not paying anything for Coca Cola's growth.

And, in large measure, value investing is made possible by "beta arbitrage". There can be a wide divergence between WACC driven by equity beta and the true cost of holding that stock over the medium to long-term. Occasionally, this divergence between measured risk and actual risk creates a "value investing" situation.


Aswath Damodaran said...

I think the examples you offer are revealing in themselves. First, for a company with tens of billions of dollars in investments, it is interesting that the "growth" investments that you cite are tiny. Second, neither CTB nor TTI would make anyone's list of great growth companies in any time period. They are companies in niche portions of mature businesses that were able to deliver solid revenue growth and profits; in other words, they fit nicely into the value investing story.

Jim S. said...

Fair point on the size of these companies, but I think it's reasonable to think of them as revenue/EPS "growth" firms rather than cyclically depressed "value" companies. This highlights the relevance of your original question on the definition of value investing.

I think a fair criticism of Buffett as a "growth" investor could be achieved by looking at companies that fit criteria along the following lines:

1 - Growth company: revenue/EPS/FCF growth >10-15% over the past 5-10 years
2 - Big enough to move the needle for BRK: EBT > $50m at the beginning of the period
3 - Little risk of technological obsolescence: perhaps just rule out certain industries?
4 - Satisfactory returns to investors: stock price appreciation >10% annually

If it turns out BRK missed a lot of these, I think it would be fair to criticize Buffett's acumen as a "growth" investor, but only under my own arbitrary definition of "growth".

Sakya Duvvuru said...

Professor, a book on Buffet's growth investing:

anahin said...

Ben Graham was Warren Buffett's professor and mentor, and the original proponent of Value Investing.
Buffett calls Graham his second greatest influence after his own father, and even named his son after Graham.

The Benjamin Graham stock screener ( gives a complete Graham analysis, for all 4000 stocks listed on the NYSE and NASDAQ.

Maddie said...

Hello Sir!

I would want to know if valuation techniques used by Social VCs such as Acumen Fund any different from conventional techniques?

Doug said...

I think that you are overthinking the term "value investing." A value investor looks to buy shares in a company for less than its estimated "intrinsic value," usually with a substantial "margin of safety.

Low P/E, P/B, "vulture", "fallen angels," etc. are all just shortcuts to the concept. In fact, I would go as far to say that these methods are "quantitative investing that overweights value factors" than "value investing."

Aswath Damodaran said...

You are probably right. I was not trying to suggest that Graham was just a screener, but his legacy has become that, whether he would have wanted it or not. I think he was well ahead of his time in recognizing the value of growth but his investments skewed towards mature firms and his activism was limited by what activists could accomplish in his time period (which was very little, since they did not the capacity to get their message heard)

Anonymous said...

Hi Aswath,

I saw this on WSO.

Does your framework for "value investing" take into account investing across the capital structure, e.g. distressed debt, convertibles or preferred stock, or is is solely focused on stock investing, i.e. listed companies, which is a rather limited part of finance in my opinion.

I'm referring to the kind of investing illustrated in books like Margin of Saftey by Seth Klarman. This could be passive or active in terms of management / board involvement.

To answer your questions...

1. Would you classify yourself as a "value investor"?
b. No.... (levered beta all the way, well maybe 75% of the way)

2. If yes, what makes you a value investor?
To the extent that I am, a combination of a (security valuation, debt & equity) & c (fundamental corporate/asset value)

3. Do you think value investors do better collectively?
b. No... The collective is the average as randomness and psychology dominate insight, individual brilliance / structural advantages and luck.

Why they fail (i.e. are average) see 3 above.


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Anonymous said...

"The separation between value and growth is not an academic construct but a practitioner one"

Value investors have a totally different concept of "growth" than growth investors. CRM is a growth stock. No value investor would ever touch it. Apple is a growth stock...Buffett won't touch it because he can't be sure its earnings are sustainable.


The motto of a value investor should be buy when everybody else is panic selling and sell when theirs a buying panic. When markets go to extremes this can create tremendous buying opportunities and tremendous bargains for investors. Take the case of closed end high yield bond funds in the 2008 and 2009 financial panic. The yields on these funds were over twenty percent yes you heard it right twenty percent. And the reason was simply because everyone was expecting a worldwide depression to ensue but when they all finally realized that was not in the cards these funds sky rocketed.

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Anonymous said...

Trying to categorize simultaneously the behavior the market prices AND the perception/behaviors of investors is superfluous. At the end of the day both are nothing else than natural phenomena which can be captured only that far in categories. Same value the POTENTIAL GROWTH and they compare with it and perceive themselves as VALUE investors. Some others value the PRESENT and PAST financial performance of a company and they take that as a benchmark. And some others try a combination of both. So it is a matter of the BENCHMARK rather that creates a perception. Smoke and mirrors ...