Value Stocks: In the 1930s, Benjamin Graham and David Dodd, finance professors at Columbia University, laid out what many consider the bible for value investing. The best-known disciple of this approach is Warren Buffett although as I mentioned earlier Buffet really defies categorization. Buffett called the Intelligent Investor, Graham’s seminal work, “By far the best book on investing ever written.”
In a simplistic sense, the value investor looks to buy a $1 worth of earnings at something considerably less. Graham called this discount to intrinsic worth the “margin of safety”. Warren Buffett calls them “the three most important words in all of investing.” For Buffet, this margin of safety is at least 40%. The value investor seeks companies that are incorrectly valued (undervalued) by the market and therefore have the potential to increase in share price when the market eventually corrects its error in valuation.
This begets the real dilemma and the single most important question an investor will ever encounter. How do you know how much something is worth? Do you value a company by its discounted cash flow, its price to earnings ratio, its book value, or finally what someone would be willing to pay for it? If the answer was straightforward there would be little price fluctuation in the market. There would also not be much opportunity for the value investor, as people would generally agree on what something was worth. You might argue that this is exactly the case. The quoted price of a stock at any time reflects generally what a company’s shares are worth. The value investor doesn’t believe that. Graham created “Mr. Market” as a personification of this collective inherent mispricing as seen in the day-to-day price fluctuation of stocks. It’s not always the case but sometimes ‘Mr. Market’ makes mistakes or gets too emotional and bargains are there for the picking. Buffett is fond of quoting, “price is what you pay and value you is what you get.” There is a clear difference in the value investor’s mind.
Price Earnings Ratio: The stock price divided by the earnings per share. A good way to visualize that is if a company was not growing and trading at a P.E. of twenty, it would take this company twenty years of earnings to pay for one share. Some people measure the growth rate relative to the P.E and come up with a ratio known as the PEG ratio, annual earnings growth rate divided by P.E. Some people prefer to use the price/earnings ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG means that the stock is more undervalued. Both of these approaches have fundamental problems. Earnings can be misleading and often the quality of the earnings is not clearly understood. For example an abnormally low tax rate, the issuance of stock options, and the improper amortization of research and development are just a few things that can distort the price to earnings ratio. That’s why many value investors think that cash flow is a better measure of a company’s worth.
Cash Flow: assumptions about growth and reinvestment and depreciation, off balance sheet, liabilities, commitments. Both the P.E model and the Cash flow model rely heavily on assumptions about future growth. How reliable is your crystal ball? It’s hard enough making forecasts for the next year, how on earth can your predict the business prospects 10 years out with enough accuracy to even put a number on it. Few companies have that kind of consistency and when they do, they are rarely considered value stocks. For many of these reasons, value investors want to know what a company can be broken up for and sold, liquidated, etc.
Book Value: The book value represents the company’s common stock equity as it appears on a balance sheet, equal to total assets minus liabilities. Often times though a company has goodwill characterized as an asset and it may or may not have the stated value or in some cases any value at all. That’s why some investors believe net tangible assets are a better measure of a company’s liquidation value. There can also be off balance sheet liabilities and commitments that can overstate book value. For example Electronic Arts, the largest video game software developer has a pristine balance sheet with lots of cash and no debt. But further reading into the 10k reveals that the company has made billions of dollars of commitments to third party game developers for future products with no guarantee of any success.
- Pros: Buying something at a perceived discount can provide a level of safety from the perils of paying too much for a stock. Often times a patient investor can wait out the mispricing and recoup or even profit from his investment. The person who paid too much may never be able to get all of his capital back. There is a common misconception that a good company is a good stock. In reality buying at significant discount can produce far greater and quicker returns than the best growth stock investments. Value investors don’t often fall victim to manias and fads. The expected volatility is moderate.
- Cons: Value stocks can often be fundamentally troubled companies. Years of under investing in the business can make a company appear more attractive than it really is. To stay viable as a business, the company may need to spend more on capital investments thereby diminishing the expected cash flow. It’s difficult to accurately value a stock or company for many reasons not the least of which is accurately projecting the sustainability of future cash flow. Companies with poor business prospects can trade for less than their intrinsic value for a long time as the news flow is poor and investors are unlikely to bid up the price. An investor may have to wait until someone buys out the company to see price appreciation. Mistakes in value investing can also be costly as the value investor is more likely to continue to buy on the way down as the discount to intrinsic value grows. Capital loss can be greatly compounded by adding to your position rather than cutting your losses.