But what is Value Investing?

This is obviously a beginning investor question. But weekends are for beginning value investors, since that is probably when they have time to investigate their investing strategies. In layman’s terms, Value Investing is about buying something for less than it is worth, whether its socks or stocks. Investors who use this form of analysis are called Value Investors. Famed value investors are Warren Buffet who began his career as a value investor and Sir John Templeton, Seth Klarman and Joel Greenblatt. But the Godfather of Value is Benjamin Graham.

Origins of Value Investing

Because of their 1934 book, Security Analysis , Benjamin Graham and David Dodd are regarded as the pioneers of value investing. This book provided the investment community with a concept of value investing, although it did not gain that moniker until later. The value duo chastised the investment community for being too short sighted. Oh, and obsessing about earnings. Some things in investing don’t change much. The real importance of Security Analysis is that it provided a set of criteria, what would later become the value investing criteria for individual stock selection.

Ultimately Graham says, “But in applying analysis to the field of securities we encounter the serious obstacle that investment is by nature not an exact science.” No kidding. That is why he developed the concept of a margin of safety. Investing, even value investing, is not precise so you need to have a buffer.

Graham’s 1949 book, The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)  , was widely acclaimed with Warren Buffett cementing its reputation by commenting that it was,” by far the best book on investing ever written.”

How to value a Value Investment

So, how does one know if a stock is undervalued or not? As with most things in life, keep it simple. Value Investing is at heart a contrarian investing philosophy. We look for the out of favor, the unpopular and the beaten down to discover what is a bargain. Numerous directions can result in a value investing strategy. Here is one example.

The search begins by analyzing a company’s financial statements. From the balance sheet, calculate the book value, simply, total assets-total liabilities. Dividing book value by the number of shares outstanding on the balance sheet date, you arrive with a book value per share figure. Comparing the current stock price and book value per share gives an investor a good start in determining if the stock is undervalued or not. . I have written previously about a low price to book value investing strategy. Compare this ratio to the companies industry or the market as a whole.

Complications can arise. Intangible assets such as brand names, patents and trademarks come into play and can affect calculations, which is why  price to Tangible book is often used instead of the traditional price to book value.

Should I become a Value Investor?

It’s natural for a beginner to ask, “How do value investor’s performance fare against the market?” The weird part is that there is so much research showing that value investing is superior to “growth” or  technical investing that  you would think everyone would be a value investor. Fortunately, for you and I that is not true.

A good illustration is Warren Buffett’s article in 1984 titled, The SuperInvestors of Graham-and-Doddsville. Buffett challenged the ‘efficient market” theory and compared the performance of Graham and Dodd’s value investors against the market. He argued that if a large proportion of the winners belong to a particular group who practice value investing, their success is due to a winning strategy, not by chance as efficient market theorists assert.

In summary, value investing could be called by common sense investing, in a world where common sense is rare. . Look around chroma investing, it is free. There are not many better value investments than free.

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Buffett Quotes

“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful. ”

“Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.”

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down. ”

“The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer. ”

Conclusions

I know I have been quoting Warren Buffett, but another analogy, that comes from Ben Graham may be more in order and that is of Mr. Market. Mr. Market is panicked right now and he is starting to hand out bargains. Because he is panicked doesn’t mean we need to be. My equity portfolios are down like everyone else’s, but I have had nearly a third in cash in my IRA in cash and 80% in cash in the two investing accounts for Chroma Investing: the Small Investor Portfolio and 80-20 Investing Portfolio.

Take another look at your watchlist and you may see investing opportunities that did not exist a few weeks ago. That is what I am doing.

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Montier quotes Keynes in his opening, “central principle of investment is to go contrary to general opinion, on the grounds that, if everyone is agreed about its merits, the investment is inevitably too dear and therefore unattractive.” Tail  risk is a nebulous concept that must be defined. He settles on the notion of “systemic illiquidity.”

Montier defines three general types of tail risk protection.

1. Cash- He states that it, “is perhaps the oldest, easiest, and most underrated source of tail risk protection.”

2. Options/Contingent claims- the example of this he gives is credit default swaps on mortgage backed securities, when the times were good and few people thought they needed them.

3. Strategies that are negatively correlated with tail risk- for systemic illquidity long volatility strategies are negatively correlated.

He sums up this section by stating that tail risk protection requires timing and substantial levels of investment to work.

At that point Montier turns to a value investing approach to guarding against tail risk. He states that “is the only risk-averse way of investing that I know of. It comes with ready-made framework for assessing (tail) risk.” He has defined risk as the permanment impairment of capital, that can be broken down in three ways.

1. Valuation Risk- this is the risk of paying too much for an investment, buying something that is overvalued. He re-emphasizes the value of cash as a tail risk protection. It is better to “better to hold cash and deal with the limited real erosion of capital caused by inflation, rather than hold overvalued assets and run the risk of the permanent impairment of capital.” Montier argues that Bernanke would prefer we hold overvalued assets. Buffett has said, “holding cash is uncomfortable, but not as uncomfortable as doing something stupid.”

2. Fundamental Risk- when we ponder Fundamental risk it helps us define exactly which fat tail risks we are really worried about. Graham said the “danger of a loss of quality and earnings power through economic changes or deterioration in management,” is what fundamental risk is. Again Montier highlights the value of cash as a hedge. It is good against deflation and better than bonds against inflation.  He suggests that most “Financial implosions” are the result not of Black Swans, but of “predictable surprises.” This is a term coined by Michael Watkins and Max Bazeman. predictable surprises have three characteristics. 1)at least some people are award of the problem, 2) the problem gets worse over time and 3) eventually the problem explodes into a crisis.

3. Financial Risk- this is risk of leverage and crowded trades. You can easily avoid leverage and being a contrarian, Montier says,  reduces the risk of being in an over crowded trade.

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We all have some advantages over other investors. Are you a good at analyzing financial records? Are you patient? Do you have intimate knowledge of the biotech industry? You get the idea. These are all advantages that one person could have over another investor.

Before we turn to Klarman’s next point, let me point out some great investor’s “edges.”

-Monish Pabrai has reminded me that checklists aren’t just good for surgeons and airline pilots. I am still developing a comprehensive checklist.

-Warren Buffett- Mental discipline. “Be greedy when other are fearful,” is easy to say, much harder to live when you are uncertain. Think March 2009 when most investor’s were soiling themselves.

-Joel Greenblatt- Probably has two edges. Mechanical Investing ( such as Magic Formula Investing) probably has some merit. Figuring out which criteria are currently important is your edge. He also reminds us about the importance of special situations, especially spin-offs and the oddities involved in mergers (although not Merger Arbitrage).

-Benjamin Graham- cigar butt stocks. Despite the ongoing positive investing results from Net Net stocks, some people can not invest in such “Ugly” companies. That has often been my edge. Apparently, I like warts when I invest.

-Seth Klarman- Complexity. He is a master investor because he and his team analyze the difficult to analyze and discover where the market has mis-priced something, usually significantly. If you can master the detail and complexity you are in good company. Everyone thinks they can do this, I am not one of them.

-George Soros – reminds us that investors behavior affects other investors decisions in ways that affect price. That brings us to Klarman’s next point in his 2010 letter.

“There is a second element in designing a sound investment approach: you must consider the competitive landscape and the behavior of other market participants.” So, it is not enough for you to have an edge to be a successful investor, according to Klarman, you must see how others are behaving in the markets. Not everyone  will be like us, value investors, some will be speculators, others Technical Traders. The point is if you aren’t clear what the rest of the people investing against you are doing, you can be hurt by them. Klarman uses a football analogy. If your opposition is defending against the run: Pass. Even if you have great running back. This may seem obvious. But as humans we tend to be seduced by the herd, the trend, the momentum. Whatever you want to call it. Value Investors are ultimately contrarians with a refined attitude. We need to remember, if too many people are afraid of something, it is worth a look. And if everyone you know loves something, tread with caution.

“When observing your competitors, your focus should be on their approach and process, not their results.” This could have been said by James Montier. Klarman says we shouldn’t replicate other investors portfolios, but “looking for opportunities where they are not.” Is it in housing debt or Greek equities. Talk about fearful places to look. There are opportunities in investing that you have to search out. Here a few investment ideas that Klarman alludes to, and you ignore Klarman at your own peril.

-Bond prices don’t just fall when they fall below BBB- High grade bond funds are often forced to sell in that situation- possible buying opportunity.

-A mortgage security will be downgraded when it can’t return par to bondholders. This will cause a rash of selling. Forced sellers are at a disadvantage to you. Know your edge.

-When a stock suspends dividend, some  funds must sell. Look at the fundamentals. Perhaps their is opportunity.

-Does the value of a stock change when it is deleted from an index? To index funds, that stock must be sold, even though the value may not change. Obvious. Yes. Opportunity, if you don’t have to sell. Also yes.

-Finally a significant drop in a stock price can be enough to make investors bolt for the door. Momentum and Technical traders can lose their edge here. Don’t assume the market knows better.

If Klarman is pointing out anything, it is the inefficiencies that can benefit someone with an investing edge that the seller of that investment doesn’t have.

If you liked this post, please go the share button, and share it with your friends. Or comment.

If you want to read a long excerpt of the 2010 Klarman letter I have referred, to which only briefly touches on the them I have discussed, please follow the link to My Investing Notebook. The letter is worth reading in its entirety.

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First, that despite all logic to the contrary, if you had followed Warren Buffett’s investments in public companies from 1980 to 2006, once the trades were announced you still would have had real, significant returns. Approximately 6% returns (pg.13) The authors postulate that there was overconfidence by other traders as the root cause.

Second, more interesting to me is that Mr. Buy and Hold forever’s average holding time of an investment during this time was only one year (pg.10) with only 20% of the stocks being held more than two years. While nearly a third (30%) were sold in less than six months. This seems a case of do as I say and not as I do. I have often said that if you want to make money like Buffet you need to invest like Buffett did in the days of his investment partnerships. These funds were more like hedge funds and were more Graham oriented in style than Buffett has become. They also involved more buying and selling. I know this is not fashionable for value investors, but it worked for Buffett when his returns were often 50% a year. A small investor’s competitive advantage over large investors is that he or she can put money in less liquid investments without moving the needle very much.

Third, Buffett does run a relatively concentrated or focused portfolio. His average holdings in the 1980′s was 22, 12 in the 1990′s and 33 beyo0nd 2000 (pg.11)

Fourth, the study says that, “it appears that Buffett avoids firms with high asset growth that under-perform the market and invests in large firms with low book-to-market ratios and large accounting accruals, characteristics generally associated with low returns.”

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The first account I set up was the  Small Investor Portfolio. I started it with $2000. I will add $200/month to the account. It is meant to replicate what a beginning value investor or a value investor with a small amount of capital might be able to do on his own.  You can see the three stocks I have purchased for this portfolio already by looking at IFON, DUCK and ORXE.

This fund will be  primarily an asset valued portfolio relying heavily on Net Net stocks and other asset valuation strategies in the vein of Benjamin Graham. The stocks should have at least a 33% discount to Net Current Asset Value or some other Margin of Safety from intrinsic value.   I will create a spreadsheet to track the financial information that I glean from a companies financial statements. I will also read the latest 10k and 10Q’s looking for trouble or problems. Finally, I will do a little scuttlebutt research to see if I can see if there is a sig alert (for non Los Angelinos, that is when one or more lanes get shut down on a freeway) for the company. The Small Investor Portfolio will rely  heavily on analysis both quantitative and qualitative. I will take my cue mostly from asset valuation focused investors like Ben Graham and not from future earnings oriented investors like Warren Buffett. I will not be doing any Discounted Cash Flow analysis or looking for Owner’s Earnings growth. The strategy will be to identify these cigar butt, stocks that are discounted from their Intrinsic value and purchase them with a Margin of Safety. Unlike some other value investors I will include ADR (foreign stocks listed on an American exchange) and Penny stocks that trade on the Pink sheets or over the counter. The stocks should have a positive net income. The exceptions will be companies with positive operating income, with one time charges offs or discontinued operations. The other exception to positive Net Income will be biotech or pharma stocks with huge upside potential.  I will hold the stocks until I have reached the stocks intrinsic value or the circumstances surrounding the company change significantly enough to warrant a reevaluation of the company. If my estimation of the company’s value changes significantly in a negative manner, then I will sell the stock. In some cases I will utilize some special situation stocks in the manner outlined by Joel Greenblatt in his book You Can be a Stock Market Genius. I will explore these situations as they come up. And although ORXE was a NCAV stock, I consider it a special situation stock. With only $2000 to start, the small investor portfolio will be a Focused portfolio containing initially no more than 4 stocks. As the account grows with profits or the monthly capital additions I will expand this to at most 8 positions, and begin to increase the dollar amounts as the account grows. If the opportunity is there I will try to remain 80% invested at all times, retaining 20% in cash for new opportunities that come up, particularly if the market declines. If the Net Net and special situations dry up, I will stay in cash or reevaluate the investment strategy. This will be a long only portfolio. I will avoid financial stocks because I do not know how to evaluate their assets in a meaningful way.

The concept for the 80-20 investing portfolio is simple. Set up a few simple established value investing principles, make them stringent and then buy every stock that passes the criteria. So while the value investing criteria may be similar to the Small Investor Porfolio the strategy is not.  Some of these criteria  are concepts I have not yet covered in this blog, but I will post about them in the ensuing weeks. The criteria will include a combination of the following:

1. Price to Book ratio in the bottom 20% of stocks screened.

2. a Piotroski F score of 7 or better.

3. The annual growth in total assets should be in the lowest 20% of companies screened (currently negative double digit asset growth).

4. A passing score on the appropriate Altman Z score.That means above 3.o for Manufacturing companies and 2.6 for other companies.

5. Net Current Asset value equal to or greater than market cap.

6. Ratio of current P/E to 7-10 year P/E is less than 1.

7. Price to Sales ratio  less than 1.

There is no margin of safety per se. I think that by combing the different criteria that have been tested over the long term and then adding criteria that should minimize the down risk suck as Altman Z score, I am hoping that I have built in a margin of safety into the criteria itself.

In the future I will introduce a system for Hedging downside risk by using LEAPs or long term Asset Protected securities. This is the flip side to long positions. More about this in a future post. Thus this will be a long and short (although only using options) portfolio.

The strategy is buy as many of these positions as you can.  If I run out of cash, I will only replace a position in the portfolio with a better position. Since intrinsic value will be more difficult to calculate, I will hold the stock until the stock appreciates 50% and sell. If it declines or fails to meet my sell price I will sell at two years.

All the analysis has gone into the set-up. I will not be doing heavy analysis for this portfolio. In fact, apart from verifying that the company passes the criterias, I will do NO analysis. I will make sure that a company passes all the quantitative criteria and that is it. This will be a mechanical trading system in a similar to the magic formula investing strategy. Because I am expecting that more stocks will need to be purchased for this system to function, I have established the 80-20 Account with $5000. I will add $300/month to this account.

You might ask why I am not combining both criteria. It is simple. I am experimenting. There is some research that suggests that we are our own worst enemies in investing, that emotion, and poor decision processes will hinder our investment performance. I want to test these theories in a real and concrete way.  With 80-20 Investing I want to remove ego and emotion and see if it is possible to make money in a more simple way. Some of the Net Net companies don’t pass the risk thresholds I have set. But I am not sure that means that they are statistically worse investments. I am attempting to discover for myself what really works.

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I have meant to post on  James Montier’s concept of investing risk ever since I first read Montiers writings. He gets risk in a way that the uber-smart quants sometimes fail at. He recognizes that risk is not an equation or number, it is a concept.  Much of this post refers to his Clear and Present Danger; The Trinity of Risk, but I will refer to other of his writings as well. You really should read Montier directly.

For anyone who follows in the Graham school of investing, or this blog, you know that first and foremost is preservation of capital. Montier begins in this tradition,  “Graham saw risk as the Permanent loss of capital.” Amen. We as investor’s often spend way too much time chasing the return and not examining the downside. That is the risk.

Montier divides investing risk into what he calls the trinity.

The first aspect of this trinity is valuation risk. Simply stated the risk that you will screw up the valuation of a company and over pay for the stock. Montier says, “buying expensive stocks leaves you vulnerable to disappointment.”This is classic value investing. Don’t overpay. There are lots of metrics to keep things cheap.

Montier suggests that we should return to works of Graham and make sure we are not buying a stock with a P/E greater than 16. He quotes Graham, “We would suggest that about 16 times is as high a price as can be paid in an investment purchase of a common stock? Although this rule is of necessity arbitrary in its nature, it is not entirely so. Investment presupposes demonstrable value, and the typical common stock’s value can be demonstrated only by means of an established, i.e. an average, earnings power. But it is difficult to see how average earnings of less than 6% upon the market price could ever be considered as vindicating that price.”

The second aspect of the trinity is business/earnings risk.

Again Montier defines the term by quoting Graham, “Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.” When a company suffers an earnings drop, or an outright loss the price of the stock can drop substantially.

The trick in assessing Earnings risk, is to figure out whether or not an earnings set back is temporary or permanent. If you get this wrong you will end up with a value trap instead of a good deal. Again Montier has a metric. Instead of just looking at Price Earnings alone, he suggests that you look at the ratio of P/E to the ten year average P/E. To minimize earnings risk this ratio should be less than two, perhaps considerably.

The third of three is Balance Sheet/Financial Risk. Montier again uses Graham to define, “The purpose of balance-sheet analysis is to detect? the presence of financial weakness that may detract from the investment merit of an issue.” According to Montier most investors are smitten with earnings and only look at balance sheet risk when something goes awry. Obviously, with the emphasis on NCAV stocks on this, we often start with balance sheet risk.

Montier uses a metric that readers of this blog will recognize, the Altman Z score. Interestingly, he uses the standard manufacturing equation in his evalution, but I will tweak Montier, if I may, and refer to the non-manfuacturing Z-score.

T1- Working Capital/Total Assets

T2- Retained Earnings/ Total Assets

T3- Earnings before Interest and Taxes (EBIT)/ Total Assets

T4- Market Value of Equity/Book Value of Total Liabilities

T5- Sales/Total Assets

The revised Altman Z score is Z= 6.56T1+3.26T2+6.72T3+1.05T4

The score should be above 2.6 for non-manufacturing, non financial companies to minimize balance sheet risk. If it is below 1.8 watch out. For manufacturing companies refer to the original Altman Z score.

Now you can put all this together. But ultimately, Montier sums up best when he argues  “that risk is really a notion or a concept not a number. Indeed the use of pseudoscience in risk management has long been a rant of “(his).

Look at a range of factors that make up investment risk and take appropriate action.

What do you think comprises investment risk. Am I missing anything?

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It is a term that Benjamin Graham and David Dodd coined in their seminal book, Security Analysis. First Graham began with the idea of intrinsic value. Or how much a company is worth (in opposition to how much it costs). If the price of a companies’ share  is lower than the intrinsic value of that share then the difference is a margin of safety. Graham argued for a minimum margin of safety of 33%. More is better, but harder to find. The purpose is to protect an investor in case some part of your analysis in determining the intrinsic value is incorrect, or  to help protect if the market or luck turns against you.

In a recent example VOXX, my NCAV value was $9.82/share. By my reckoning this would be VOXX’s intrinsic value. The price when I bought VOXX was $6.60/share. This gave me a Margin of Safety of about right under 33%. Any questions? Please post in the comments or email me chroma@chromainvesting.com

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But what is back testing? It is a process where one takes an idea like investing in low price to book stocks. You formulate a method, for example, that you will buy only price to book stocks in the lowest quintile (20%) on the last trading day of the month and rebalance your porfolio quarterly. Then you test this idea in past period of time. These are usually tested over longer periods. In my post last month about Ben Graham’s Stock Selection Criteria, Oppenheimer back tests the strategy from 1974-1981. In the post on Buying Low Price to Book stocks, Ibbotson back tested from 1967-1984.

I have used these and other academic studies to form the basis of an investment strategy that underpines this website. In fact, it was some of this same back tested research that sparked the idea of 80/20 investing, which I am still developing. But I am not an academic, I am a small time investor. And like many of you, I am really only interested in real returns. So I am keenly aware of some of  the practical limitations of back testing. When I began my research on Graham, years ago, I was puzzled by something. Graham had developed a set of investing criteria. And someone set up a fund that set out to capitalize on this method. The studies show that it should have worked. But it didn’t. The fund had to disband a few years later. Why? What was the disconnect?

So what is the Problem with Back Testing? It turns out there are several Problems for the practical investor.

1) Friction- Friction are the Brokerage Commissions, taxes and bid-ask spread issues that Damodaran referred to. Broker commissions and taxes you can calculate, but because many of the value investing approaches studied deal with small cap stocks that are often illiquid, the difference between the bid for a stock, the amount an investor is offering to buy the stock at, and the ask price, that is the price the seller of that stocks is asking for, can often be quite large, sometimes 10% or more. This cannot be easily calculated in an academic study.

2) Buying on an arbirtrary time frame- For academic research you must attempt measure results over a given time , with specific criteria, but the best deals will not always occur on the end of the month, or once a year.  Rebalancing at mechancial intervals, may also limit your profits, by telling you exit a position too early or too late.

3) Survivor bias- Taleb speaks about this as  a general problem with the investing community in general, and economists in particular. Is the back testing incorporating the number of companies that fit the strategy but failed or when bankrupt?

4) Portfolio limits- If you have a limited investing portfolio such as $5,000, you cannot know going into a year knowing how many opportunities you will have. With such a small portfolio you cannot possibly invest in every opportunity that arises. But that is the very assumption you supposed accept. If 40 opportunities arise, you buy all forty, and if five arise then buy only five. In what proportions? Do you leave everything else in cash?

Are their any solutions to these problems? Some. But not neccessarily solutions that you will be happy with.

1) Friction- There are several ways of dealing with the friction issues. Some I have written about before. For brokerage commissions, select a good discount broker or one that doesn’t charge fees for maintaining a certain balance. Tradeking, my primary broker, charges just $4.95 a trade. Taxes can be controlled by  investing in tax advantaged accounts like ROTH or traditional IRA’s. But bid-ask spreads are a little trickier.  My favorite strategy is to sell on good news. I have noticed that the volume on thinly traded stocks tends to go up when there is good news and investors are trying to buy the equity. Since value investing is also a contrarian strategy, good news is often a catalyst for a price rise and a good opportunity to exit a position. Another tactic is simply patience. Set up flags when a stocks price reaches a certain price. Then put in a limit order. And wait.

2) Buy when opportunities present themselves. Don’t be afraid of cash. It is a better alternative than losing money. I think Graham’s idea of holding for a 50% gain or two years is a good starting place for parameters to frame your investment horizon. But you shouldn’t completely exit a position just because you have reached a 50% gain, if your analysis suggests  a larger upside. Perhaps, in that instance you take a portion of your profits off the table. Two years should be the outside to hold an investment that is not performing. Maybe. If you discover a much better investing opportunity, two years could be too long.

3) Surviving Survivor bias. Look for tools to minimize the chances of a company failing. The most important thing is preservation of capital or as Buffett says, “Rule number #1 is don’t lose money. Rule #2 is don’t forget Rule #1. ” These tools may include the Altman Z score, the Piotroski F score and other more simple financial metrics such as the acid test.

4) Portfolio- Decide how many companies you are willing to invest in. Invest in great investment opportunties when they arise. Keep a Focused Investment strategy. It is possible that if you chose to invest in 8 companies, that after a price drop, one of the companies you have already invested in is the best value, and you should add to your position.

This does not mean a simple approach to investing cannot work. But I am more suspicious of mechanical investing that I was before.

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