Benjamin Graham is commonly credited as establishing the discipline of security analysis and being the father of Value Investing. He promoted investment as a rational activity, an approach which requires the investor to return to the financial statements in order to avoid huge mistakes and misjudgments. In his seminal book Security Analysis, published in 1935, Benjamin Graham started sharing his approach and ideas with both professionals and casual investors. He drew a line in the sand between investment and speculation. He defined an investment operation as one which, upon thorough analysis, promises safety of principal and a satisfactory return. Any operations not meeting these requirements are speculative. With the publication of Security Analysis the concept of the Value Investor was born, i.e. someone who seeks to purchase a stock at a bargain price – buying a RAND for fifty cents or put differently buy cheap (or rather good value) and sell dear. One can infer from this that there are times during the market cycle when value investors will have fewer opportunities and times when they will have more opportunities in the market. In short, value investors have more buying opportunities in bear markets than bull markets.

   Toward the latter stages of bull markets value investors find it very hard to find cheap stocks, whereas there are many businesses falling into this classification toward the end of a bear market. Another interesting phenomenon is that it is almost always toward the end of bull markets that investors (or the markets in general) stop paying attention to fundamentals like book value, cash flow, interest, and various other fundamental ratios to value common stock. These are the greedy times as Buffett calls them (and when he is fearful of the markets). Two examples in recent memory springs to mind: the Dot-Com bubble of 2000 and the American Sub-Prime Housing bubble of 2007. In both cases greed and herding resulted in fundamentals being discarded for the more attractive, and at the time more lucrative, new economy thinking. During both these periods it looked as if value investors were an endangered species. This is because proponents of the New Economy hypothesis always argue that some of the fundamental truths of economic reality had been repealed and that value investors’ days are numbered and are being left behind. Value investors’ opinion will be that the market levels are in the tulip mania (see post below) territory, whereas new economy proponents will argue that the good times are here to stay and that markets will keep on rising. Value investors are very patient and therefore not deterred from their approach. They know that the most important thing when employing a decipline is consistent implementation. Therefore, they quietly await the ever looming bear market that will present the perfect time for them to find great buys (i.e. good valuations) at low prices.

   Graham’s original ideas still remain relevant today. Graham’s best known student, or disciple as he likes to refer to himself, is value investor Warren Buffett, whose track record and global fame speaks for itself. Buffett, who had studied different investment theories since the age of 11, says he was struck by the compelling logic of Graham’s approach when he first encountered it. Buffett is by no means the only Graham success story in the world, many other have equally impressive track records, e.g. all the super investors from Graham and Doddsville. Some people refer to Buffett’s approach to value investing as growth-at-a-reasonable-price investing, rather than pure value investing. Buffett's approach is value investing but combined with elements of growth investing, even though Benjamin Graham himself was not a great supporter of valuing and considering potential business growth. In short a growth-at-a-reasonable-price investor buys high quality growth companies when they are experiencing temporary difficulties and have therefore lost favour in the market and thus have an artificially suppressed market price (i.e. buy a RAND for 50 cents).

   Since Security Analysis, and later the Intelligent Investor, many other investment approaches have emerged. During the 1950 and 1960 the very popular modern investment theory, based on rigorous mathematical and statistical analysis and on what’s know as the efficient market hypothesis, emerged. Other investment approaches that emerged include growth investment, momentum investment, technical investment, to name but a few main ones. In the last decade or two behavioural finance emerged. Its been built on psychological research that advocates the idea that investors act based on emotions and other factors, e.g. herding behaviour, the tendency or biases to give more significance to the most recent news, good or bad, etc. Behavioural finance challenges the fact that people are unemotional and always act 100% rational, a premise of the efficient market hypothesis. This finding about excessive reaction confirms a long held Value Investing belief that over the long run, the performance of both businesses and their share prices will revert to the mean. At the core of most investment approaches lies the skill, or art, of business valuation, i.e. the technique by which the real or intrinsic value of a business is estimated. Value Investors want to buy stocks whose true value (per share) is much more that the market price (per share) of the stock, because Value Investors believe that over time the market price will reflect the intrinsic value of the business, i.e. it will revert to the mean as mention above.

   There are many approaches to valuing businesses. There is general agreement that John Burr Williams’ approach,  published as The Theory of Investment Value in 1938, of summing the estimated cash flows a business will produce over its life, and discounting it back to its present value, will yield the value of the business. This is called the discounted cash flow (DCF) approach, present value (PV) approach, or a newer approach called adjusted present value (APV). Then there is the route of multiples, i.e. …. Newer theories, based on option pricing theory, called Real Option Pricing (or Real Options), value businesses like quants value options (for more on Black-Scholes pricing models see Fischer Black and Myron Scholes' 1973 paper The Pricing of Options and Corporate Liabilities). Graham’s approach started with what the business is worth today, rather than to rely only on assumptions about events and conditions far into the future. Therefore, value investors prefer to value a business first by examining the assets of the business, then to look at the earnings power of the business, and if the business shows signs of competitive advantage they value the growth potential of the business via cash flow forecast and DCF analysis.

   Graham’s skepticism of cash flow forecast and valuing growth potential is simply because he believed that in most cases the growth is not worth much. In most competitive environments all the value of the growth will be used to buy additional capital required to enable the growth. Therefore, Graham’s approach only values growth that produces returns in excess of the cost of the additional capital, i.e. a type of economic growth which generally only businesses generating excessive profits achieve. One of Warren Buffett’s well publicized criteria to picking winning investments is that the business, underlying the investment, should have a sustainable competitive advantage, this is because he is looking for the growth stocks at value prices. Businesses with a sustainable competitive advantage are in some way protected, by various forms of barriers to entry (or what Buffett calls a business moat), from competitors entering their market and driving down their excess profits. Therefore, value investors interested in the growth value of a business will pay careful attention to the strategic positioning of the business. Again ahead of its time was that this assessment of the strategic position of a business, now commonplace among the most sophisticated investors, was inherent from the start in Graham’s approach. Next we consider the basic tenets of value investing as well as valuation in a little more detail.

Be Extraordinary!
Myles

What are some great sources of investment opportunity? Source include stock market correction or panic like a bull-to-bear market switch, industry recession, business calamity, war, or structural changes? The perfect buying situation is when a stock market correction or panic is coupled with an industry recession or an individual business calamity or structural changes or war.

   Recessions signal the start of great buying opportunities, for the value investor with spare cash available. Recovery time from a recession is generally anything between one to four years and during this time there are excellent buying opportunities. During recessions the manic-depressive Mr. Market goes into panic mode and out of fear offers to sell great companies often at single digit PEs. The true value investor understands that during a recession period everyone gets hurt, but the strong survive while the weak are removed from the economic landscape. Sticking to intrinsic value calculations and focusing on business fundamentals, while ignoring manic price fluctuations, allows the value investor to pick up fantastic businesses at bargain sale prices.

   Recessions are so important to the value investor we will discuss it further. George Soros, the famous macro investor, observed business boom-bust cycle markets so often during his career he formulated a graphical model of it and constructed his own market theory he called reflexivity. In his market theory he does not specify the cause of such boom-bust cycles, but he speculates that they always have a political element. Government economic intervention as the cause of business cycles has been extensively written about by various authors, including those from the Austrian School of economics. They write that an extra market force (in the case the central bank of a country) can initiate an artificial, or unsustainable, economic boom. They further write that a money-induced boom contains the seeds of its own destruction, i.e. the market upturn, must by the logic of market forces set in motion, be followed by a downturn.

   When markets, or the economy as a whole, are not performing optimally politicians can interpret this situation as a threat to their elected positions. If they do, they will often take corrective action to rectify the situation before it becomes a political issue during election time. One of the popular methods of stimulating economic activity is to increase the money supply. This expansion of the money supply leads to lower interest rates. In turn lower interest rates generally lead to an overconsumption in the market as well as lower discount rates (i.e. lower cost of debt thus lower weighted cost of capital). These lower discount rates in turn lead to increased business valuation calculations, or valuation inflation, and increased malinvestment to the valuation inflation.

   Over-consumption and lower cost of debt leads to increased revenues, allows businesses to expand, and leads to greater profits. This process can very easily lead to a speculative bubble, i.e. from price increases due to valuation increases, to increased investor enthusiasm, to increased demand, and hence further price increases. When a bubble starts forming, substitutes for business fundamentals start to justify the politically motivated economic boom. Therefore, as fundamental data no longer justifies the boom, market participants replace fundamental analysis with fundamental substitute analysis that will support the boom. These substitutes are always consistent with the perceived new economic conditions driving the boom (e.g. stocks are values at multiples of revenue, not earnings, and growth is funded by selling stock, not executing sound business plans). This leads to a situation where a substantial gap between market behaviour, or speculation, and fundamentals forms and widens.

   This ever widening gap however cannot continue indefinite and at some point the market has to correct, it has to abandon the substitutes and re-establish fundamentals. This does not happen however before the last marginal investors in the market buy in. As the old saying goes: what the wise man does in the beginning, the fool does in the end. This final marginal buying further fuels the gap and is the boom’s final push. At this point the politicians have to cool down the market bubble in order to avoid a market crash. Interest rates are raised to reduce consumption and increase discount rates, which causes valuations to decline and malinvestment to halt.

   Now the actual fundamentals start to decline as a result of lack of buying and together with rising interest rates the fundamental substitute’s starts to deteriorate. This deterioration starts the investment liquidation cycle and marginal short selling. This market behaviour feeds off itself resulting in mass selling. This triggers investors to take a so called flight to quality that involves liquidating perceived risky investments in favour of government securities or precious metals to preserve the balance of their portfolios. This process typically continues until the true fundamentals decline below pre-bubble levels. As Warren Buffett says: a pin lies and wait for every bubble, and when the two eventually meet, a new wave of investors learn some very old lessons.

   At this point malinvestments are liquidated and recovery of the market can begin. Fundamentals and market conditions reconcile again and economic growth can again begin. There is however the chance of recession or depression, based on the severity of the crash. Therefore, often this phase is met with a new wave of government intervention in order to shorten the duration of the correction cycle and fuel economic growth.

   The second of our ideal buying opportunities is linked to business calamity. Sometimes great companies make mistakes which cause them to lose money. This creates concern in the market and their share price reflects this by declining sharply. This in turn represents a great contrarian buying opportunity. The value investor has to determine whether this is a passing calamity or irreversible damage. A company with an identifiable competitive advantage almost always has the financial durability to survive calamity. Deciding whether the calamity is correctable is important. Even more important is whether the calamity affect’s the competitive advantage of the company, in which case the investor should not consider investing. Often just one division of a company suffers a calamity, but affects the entire company. If the investor believes that management can fix the calamity or that the other divisions, with the competitive advantage, can save the company then the investor should consider investing if the price is right.

   The final opportunities arise with structural changes and world events like war. Structural changes in a company, like mergers, restructuring, and reorganizations, can often affect earnings negatively and thus negatively affect the share price thereby creating buying opportunities. War, or the threat thereof, will send stock prices tumbling. The uncertainty and great potential for disaster will send fear through the entire market triggering a mass sell-off and a hoarding of cash and safe commodities like gold. This in turn disrupts the entire economy and creates great buying opportunities for the value investor who can determine which companies will recover from the ones that won’t.


Be extraordinary!
Myles Rennie

Benjamin Graham's favorite allegory was that of Mr. Market. He said that Mr. Market turns up every day at our door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but often it is ridiculous. We are free to either agree with his quoted price and trade with him, or to ignore him completely. Mr. Market doesn't mind this, and will be back tomorrow to quote another price. The point is that we are better off not being concerned with Mr. Market’s often irrational behavior except when we can benefit from it.

   If Benjamin Graham is right, if market prices are frequently nonsensical, then we would be foolish to use price as a sole indicator of performance. Although this is true, the majority of the investment industry is focused only on price. If prices go up, most investors assume something good is happening, and if prices go down they assume something bad is happening. I prefer not to base my actions on the ups and downs of market prices.

   This problem is compounded by the foolish habit of evaluating price performance over very short time periods. Not only do most investors depend on the wrong thing, i.e. price, they also look at it too often. I believe this price based, short term mentality is a flawed way of thinking. I don’t check stock quotes every day and I don’t buy and sell at the snap of a finger.

   I do not want to participate in the senseless short term game of chasing performance, measured totally by price. There is considerable pressure on portfolio managers to generate short term performance numbers. These numbers attract a lot of attention and are praised by financial reporters. This fixation on short term price performance attracts a lot of new deposits into the top performing funds. I do not believe that focusing on short term performance is sustainable. Shareholder wealth in businesses is created over time and therefore I expect my investments in great businesses to follow this trend. I believe that any other approach all but guarantees underperformance. Warren Buffett states that we have to drop our insistence on price as the only measuring stick, and we have to break ourselves of the counterproductive habit of making short term judgements.

   My approach opens itself up to short term underperformance. Shahan showed that investors focusing on short term performance will inevitably achieve it, but at the expense of long term results. I accept that in order to achieve long term results I have to be indifferent to short term performance. Examining portfolios managed by Buffett, Munger, Ruane, Simpson and Keynes shows that on average their portfolios underperformed the S&P500 26% of the time during the lifetime of the fund. Munger and Ruane’s portfolios respectively underperformed the market 36% and 37% of the time, with Carlie Munger trailing the market by 37 percentage points at one time. These superinvestors all experienced trailing performance at one time or another, some having to endure years of trailing the market.

   I therefore know I could be trailing the market for some periods of time. If I know that price is not a good measure of performance I have to define an alternative. Here I follow Warren Buffett’s lead. Just like Buffett I believe that my economic fate will be determined by the economic fate of the businesses I own. I believe that shareholder value and operating results are the correct measures of performance. I let the economics of the business dictate whether I am increasing or decreasing the value of my holdings. I believe, like Buffett, that the market will at times ignore business success, but eventually confirm it.

   In conclusion, I believe there is a strong correlation between the operating earnings of a company and its future share price, given the appropriate time horizon. In other words, the longer the time period, the stronger the correlation. Warren Buffett says that a strong business will eventually command a strong price. He does caution that the translation of earnings into share price is both uneven and unpredictable. Benjamin Graham gave the same advice saying that in the short run the market is a voting machine but in the long run it is a weighing machine.

   My investment horizon is measured in years and I am in no hurry to affirm what I already know is true. What is important to me is that the intrinsic value of my investments is increasing at a satisfactory rate.

Be extraordinary!
Myles Rennie

Both value investing and focus investing aim to keep portfolio turnover very low. The turnover ratio describes the amount of activity in a portfolio. For example, if a portfolio manager sells and re-buys all the stocks in the portfolio once a year, or half the portfolio twice, the turnover ratio is 100 percent. Sell and re-buy everything twice a year, and you have 200 percent turnover.
   My investment philosophy includes a simple principle: once a stock has been properly selected and has proven itself, it is only occasionally that there is any reason for selling it at all. Therefore, I prefer a low turnover approach to investing. This approach has two additional benefits:
  1.      It works to reduce transaction costs
  2.      It increases after-tax returns

   On the average mutual funds generate between 100 percent and 200 percent turnover ratios per year. Studies have shown that funds with low turnover ratios outperform funds with high turnover ratios by as much as 14 percent over a 10 year period. The bottom line is every time you trade it costs money, i.e. add brokerage costs, which works to lower your net returns.

   Another important economic advantage of low turnover funds is the postponing of capital gains tax. The more you turn the more you increase your tax liability. Every time a stock is sold, and a capital gain is realized, the capital gains tax is incurred. Therefore, not only does any new stock purchased have to outperform the stock it replaced, it has the anchor of outperforming the capital gains tax associated with the stock it replaced as well. Few investors realize this, but taxes are often the biggest expense that they face.

   When a stock appreciates in price and is not sold the increase in value is unrealized gain. No capital gains tax is owed until the stock is sold. I prefer to leave the gain in place, allowing my investments to compound more forcefully. Warren Buffett calls this “an interest-free loan from the Treasury.” Interestingly, but counter intuitive, is that the greatest tax damage to a portfolio occurs at the outset of turnover and then diminishes as turnover increases. A study by Jeffrey-Arnott showed that, at a 25 percent turnover ratio, the portfolio incurs 80 percent of the taxes that would be generated by a portfolio turnover ratio of 100 percent. Therefore, I am mindful of my turnover ratio even though it’s in the low range. My target turnover ratio is somewhere between zero and 20 percent. 

Be extraordinary!
Myles Rennie

There are good reasons to exit an investment position. The best reason to liquidate a position is when someone wants to buy a home, pay school fees, etc. These personal reasons to sell stocks are all reasonable and not considered here. Liquidation of an investment position, as far as I am concerned, is only motivated by a single objective – to obtain the greatest total RAND benefit from the investment capital available.

   I believe there are three reasons for the sale of a common stock. These reasons are purely financial and never personal. The first reason is obvious. This is when a mistake has been made in the original investment and it becomes increasingly clear that the factual information, i.e. simplicity of the business, durability of competitive advantage, quality of management, and good economic position, of the investment is, by a significant margin, less favorable than originally believed. Managing these situations requires self-control and the acknowledgement of your mistake.

   The second reason to sell a stock is when, over time, the underlying company changes and no longer qualifies in regards to my investment criteria set out in valuation of a common stock to about the same degree it qualified at the time of purchase. For this reason it is important for me to keep close contact, and up to date, on all the activities of all my investments all the time.

   The final reason to sell a stock seldom arises and will be acted upon only when I am very sure of my facts. I don’t time the market, I price the market. Therefore, in order to exchange one position for another the new position should present similar or better business simplicity characteristics, an equal durable competitive advantage, and similar quality of management as the existing investment. It further has to present better price to intrinsic value economics, as well as better growth prospects, than the current investment. Only if these factors are all applicable and in favour of the new investment, including the effect of capital gains tax on the investment returns, will one position be sold to enter a new position.

   Good investment opportunities are rare and there is always the risk that the new opportunity has been misjudged. Therefore, before selling a good holding in order to get a still better one, the greatest care will be taken in trying to evaluate all elements of the situation. In closing, my investment philosophy includes a simple principle. This is that once a stock has been properly selected and has proven itself, it is only occasionally that there is any reason for selling it at all.

Be extraordinary!
Myles Rennie

My investment philosophy starts with a very simple statement “I invest, I don’t speculate”. The difference can be considered subjective, but I see a clear distinction between investment and speculation. Firstly, an investment approach relies on a well understood, analytic philosophy designed to deliver superior investment returns over time. Speculation on the other hand relies on spotting trends, taking chances, and does not consider capital protection. My investment approach looks to find businesses that are easy to understand, have a durable competitive advantage, have high quality management with a lot of integrity and energy, and finally sells at a price that is below its intrinsic value. From this it is clear that my investments returns are not based on chance, it is based on a fundamental analysis of both the balance sheet and the earnings power of the underlying asset. I look toward these valuations to justify the price I pay for owning a share of the asset.

   I do not look at share prices every day or every week. I invest based on business fundamentals. The business fundamentals of a solid business do not change on a daily or weekly basis. Therefore, if I considered a company good enough to invest in yesterday, I am pretty confident that company will still be good enough today and tomorrow. Most people however look to the market to guide them when making investment decisions. When I, on the other hand, consider investments I ignore the market completely because I believe the market to be manic depressive, behave irrationally, and be driven by the human emotions of fear and greed. Therefore, I choose not to use the market to instruct or guide me, I choose to use the market to serve me. I prefer to take advantage of the ups and downs of the market, to my advantage, rather than the market taking advantage of me.

   My investment approach is a combination of value investing and focus investing.

Be extraordinary!
Myles Rennie