- Value Investing as taught by its founder was an elaborate framework that included checks for Quality and Growth.
- Value Traps are the result of incorrect Value Investing. It's a capital mistake to invest based on quantitative valuations alone.
- Warren Buffett, Benjamin Graham and Seth Klarman all say that one can never become wealthy by risking one's money.
What does the word "Value" actually mean? When you say something is of value to you, does it only imply easily available? Or inexpensive?
Doesn't "Value" actually denote something of significant worth?
Benjamin Graham - once known as The Dean of Wall Street - was a scholar and financial analyst who mentored legendary investors such as Warren Buffett, William J. Ruane, Irving Kahn and Walter J. Schloss.
Warren Buffett wrote a detailed article explaining how Graham's record of creating exceptional investors (such as Buffett himself) is unquestionable, and how Graham's principles are everlasting. The article is called The Superinvestors of Graham-and-Doddsville [PDF].
But most Graham analyses today only follow the quantitative part of Graham's recommendations (NCAV, Graham Number, etc.) without the supporting qualitative criteria, thus leading to the misconception that Graham only recommended inexpensive stocks.
Such misinterpretations - along with today's mass marketing of low cost products as "value" purchases - has resulted in Graham's timeless methods being mistaken for bargain hunting, and in Graham himself now being known as "the father of value investing".
Benjamin Graham actually did recommend paying more for quality and growth. His only prerequisite was that there be the Margin of Safety between Price and Value.
While the popular interpretation of the Margin of Safety today is to buy stocks with low P/E and P/B ratios, a true Graham Margin of Safety is both qualitative and quantitative.
In fact, when we look at Graham's actual stock selection rules, we see that most of the rules were concerned with the qualitative assessment of a stock.
Net Current Asset Value (or NCAV/Net-Net)
Two common valuation methods attributed to Graham today are NCAV and the Benjamin Graham Formula.
While NCAV analyses today have the saving grace of being at least partially correct, the Benjamin Graham Formula is misunderstood to the point of actually being dangerous.
The NCAV valuation method was indeed developed and recommended by Benjamin Graham. But Graham also recommended in The Intelligent Investor that an NCAV stock have a positive EPS figure to be eligible for investment.
The positive EPS requirement is the qualitative check for NCAV stocks; and is — if you think about it — a very logical rule. There's really not much point buying a stock for its Current Assets (cash equivalents), if the company's losing money.
NCAV stocks were also the last of Graham's recommended stock categories. Graham specified 8 rules for Defensive quality stocks and 7 rules for Enterprising quality stock, most of which were checks for quality and growth.
It's a capital mistake to invest based on quantitative valuations alone, often leading to what are referred to as a value traps. But such problems are not the result of following Graham, but rather the result of following Graham incompletely.
The Benjamin Graham Formula
This is always some variation of the below equation:
V = EPS x (8.5 + 2g), or Value = Current (Normal) Earnings x (8.5 plus twice the expected annual growth rate)
Benjamin Graham actually gave several warnings about this formula and only mentioned it briefly to demonstrate why projections of growth are never reliable. But due to an omission in recent editions of The Intelligent Investor, this formula is often mistakenly used today instead of Graham's actual (and more thorough) methods for stock analysis.
Understanding The Benjamin Graham Formula Correctly discusses the issue in detail.
What Graham Taught
Perhaps two of Graham's most important principles from The Intelligent Investor are:
"to distill the secret of sound investment into three words, we venture the motto - Margin of Safety."
and
"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
In fact, when we study the methods of most successful investors, we see similar principles expressed and applied in different ways by all of them. Graham's is probably just the best documented, and most recommended.
Buffett too says "Rule #1: Never lose money. Rule #2: Never forget rule #1."
Seth Klarman says "Loss avoidance must be the cornerstone of your investment philosophy."
Almost everyone knows the principle of the Margin of Safety, in one form or another. But only a select few apply it successfully.
The application is actually best explained in Graham's definition of investment given above, i.e., never risk your principal amount. This is the central theme of what Graham, Buffett and Klarman are all saying - one can never invest successfully by risking one's money.
Graham repeatedly emphasized this counterproductive nature of risk in investment. Again, from The Intelligent Investor:
"there has developed the general notion that the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run. Our view is different. The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bring to bear on his task."
Another common thread we see between Graham, Buffett and Klarman is their emphasis about the unpredictability of stock markets over the short-term.
In fact, George Soros' theory of reflexivity is a direct refutation of Efficient Market Hypothesis (EMH); a theory that Buffett too refuted in The Superinvestors of Graham-and-Doddsville.
The theory of reflexivity states that our view of the world is inherently flawed. But those who have a marginally clearer view of reality tend to make slightly better decisions and over time, the slightly better decisions can snowball into significant differences in gains.
Graham's Actual Methods
Warren Buffett describes Graham's book - The Intelligent Investor - as "by far the best book about investing ever written" (in its preface).
Graham's first recommended strategy - for casual investors - was to invest in Index stocks. For more serious investors, Graham recommended three different categories of stocks - Defensive, Enterprising and NCAV - and 17 qualitative and quantitative rules for identifying them. For advanced investors, Graham described various "special situations".
The first requires almost no analysis, and is easily accomplished today with a good S&P500 Index fund. The last requires more than the average level of experience, intuition and talent. Such stocks are not amenable to impartial algorithmic analysis, and require a case-specific approach.
But Defensive, Enterprising and NCAV stocks can be reliably detected by today's data-mining software, and offer a great avenue for accurate automated analysis and profitable investment.
Application of Graham's Methods Today
Before talking about actual application, perhaps a note on diversification should perhaps first be included. The principle on which diversification (and dollar cost averaging) works is that a given investment results in more units acquired for undervalued stocks, and vice versa.
So betting heavily on a few promising stocks goes against Graham's very definition of sound investment. Even for Defensive quality stocks - his safest category of stocks - Benjamin Graham did not recommend having less than 10 stocks in one's portfolio; no matter how undervalued a stock may appear.
GrahamValue provides two web-based Graham screeners:
1. A free Classic Graham screener that lets you screen 5000+ NYSE and NASDAQ stocks by a strict 17-point Benjamin Graham Value Investing assessment.
2. An Advanced Graham screener (more customizable) that lets you screen the same 5000+ stocks by customized combinations of the Graham Number and Graham's 15 other Value Investing rules.
Growth Stock Strategy
Graham wrote that a Growth Stock strategy did not necessarily yield better results than any general investment strategy.
"The implication here is that no outstanding rewards came from diversified investment in growth companies as compared with that in common stocks generally. There is no reason at all for thinking that the average intelligent investor, even with much devoted effort, can derive better results over the years from the purchase of growth stocks than the investment companies specializing in this area. Surely these organizations have more brains and better research facilities at their disposal than you do. Consequently we should advise against the usual type of growth-stock commitment for the enterprising investor."
Benjamin Graham, Chapter 7 - Portfolio Policy for the Enterprising Investor: The Positive Side; The Intelligent Investor
Buffett and Graham have both spoken about the unreliability of financial projections on various occasions. Graham developed a Value Investing framework that comprises of seventeen qualitative and quantitative rules, two of which are exclusively concerned with growth.
Unfortunately, most Value Investing today has been reduced to oversimplified bargain hunting that involves checking for one or two quantitative criteria at the most.
Emerging Markets
Vanguard has a paper titled Investing in emerging markets: Evaluating the allure of rapid economic growth, the stated intent of which is to "caution long-term investors against making asset allocation decisions solely on the basis of expected economic growth".
Of particular relevance here is the section titled "Growth stocks: A potentially useful analogy for the allure of emerging markets".
Emerging Markets and Growth Stocks do present opportunities of significant value for the Enterprising investor. The general idea is not to ignore such opportunities entirely, but to be prudent and cautious about them.
Warren Buffett
Letter to Shareholders (1992)
Here's a note on Value and Growth from Warren Buffett's 1992 letter to shareholders:
"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... 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?"
Warren Buffett, Berkshire Hathaway: Letter to Shareholders (1992).
Shareholders Meeting (2000)
At the 2000 Berkshire Hathaway Annual Shareholders Meeting, Buffett says yet again that there is no distinction between growth and value.
"But there is no distinction in our minds between growth and value. Every business we look at as being a value proposition. The potential for growth and the likelihood of good economics being attached to that growth are part of the equation in evaluation.
But they’re all value decisions. A company that pays no dividends growing a hundred percent a year, you know, is losing money. Now, that’s a value decision. You have to decide how much value you’re going to get.
Actually, it’s very simple. The first investment primer, when would you guess it was written?
The first investment primer that I know of, and it was pretty good advice, was delivered in about 600 B.C. by Aesop. And Aesop, you’ll remember, said, “A bird in the hand is worth two in the bush.”
Now incidentally, Aesop did not know it was 600 BC. He was smart, but he wasn’t that smart."
Warren Buffett, Berkshire Hathaway Annual Shareholders Meeting (2000).