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proponents of the New Economy hypothesis always argue that some of the fundamental truths of economic reality had been repealed and that value investors’ days are numbered and are being left behind.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

George Santayana said that those who do not learn from history are doomed to repeat it. The history of stock markets are fascinating and provides valuable lessons to the modern day investor. This post is a very, very brief overview of stock markets, their origins, and the early days.

The first financial instruments traded in the world were debt. The ancient Mesopotamian society created interest-bearing loans. In the Roman Republic, long before the existence of the Roman Empire, there were societates publicanorum, organizations of contractors or leaseholders who performed temple-building and other services for the government. Participants in such organizations had partes (i.e. parts) or shares. Tradable bonds as a commonly used type of security were a more recent innovation, spearheaded by the Italian city-states of the late medieval and early Renaissance periods.

   War instigated the development and maturity of bonds as we know it today. Sometimes bonds were issued and sold to voluntary buyers and sometimes they were more like forced loans from the citizenry. Initially regarded with suspicion, it came to be seen as a valuable investment that could be bought and sold. The bond market had begun.

   By the late 1500s, British merchants were experimenting with joint-stock companies intended to operate on an ongoing basis. Unofficial stock markets existed across Europe through the 1600s and brokers would meet at coffee houses to trade stocks and bonds. In 1602 the Dutch East India Company (Verenigde Oostindische Compagnie, or VOC) was formed and Amsterdam became the first official stock exchange. The VOC established the exchange and issued corporate VOC shares. Control of the company was held tightly by its directors, with ordinary shareholders not having much influence on management or even access to the company's accounting statements. However, the returns offered to early shareholders were lucrative, an average dividend of 16 percent per year from 1602 to 1650. Reinvesting the dividend back in shares would have earned an early investor 16 percent compound annually.

   By the early 1700s there were fully operational stock exchanges in other parts of the world. Stock exchanges became an important way for companies to raise capital for investment, while also offering both investors and speculators the opportunity to share in company profits and benefit from the fluctuations of stock prices. New techniques and instruments quickly proliferated for securities as well as commodities, including options, repos and margin trading. Sophistication and opportunity quickly grew in the markets.

   Since inception stock markets have attracted both investors and speculators. The first author known to have published a book on stock markets and investing was Joseph de la Vegain in 1688. His book Confusion of Confusions explained the workings of stock markets, he warned about the potential excesses, he described stock trading, he highlighted the unpredictability of market shifts, and he explained the importance of patience in investment. Since the early days people were trying to formula strategies to better investing...and speculation.

   The first speculative stock market bubble was Tulip Mania during the Dutch Golden Age. It lasted 4 months with its peak in February 1637, when a single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman. Many people lost everything in the mad rush to make money. The British journalist Charles Mackay’s wrote the book Extraordinary Popular Delusions and the Madness of Crowds in 1841 to describe the bubble and the behaviour of speculators witnessed at the time. The behaviour he describes is still common today. The second big bubble occurred a few decades later. At the center of it were the South Sea Company, set up in 1711 to conduct English trade with South America, and the Mississippi Company, focused on commerce with France's Louisiana colony. Investors (... and speculators) snapped up shares in both, and whatever else was available. In 1720, at the height of the mania, there was even an offering of a company for carrying out an undertaking of great advantage, but nobody to know what it is. By the end of that same year, share prices were collapsing, as it became clear that expectations of imminent wealth from the Americas were overblown. In London, Parliament even passed the Bubble Act, to stop people issuing shares to unsuspecting investors (... and speculators).

   Since those early days different approaches to investment and speculation have been formulated. Many people proposed approaches which, on paper, would yield grand returns. However, the markets were dominated by speculation, insider information, and other practices which could at best be described as unethical and borderline criminal. Then, in the early 20th century, Benjamin Graham changed all that, which I will write about in my next post.

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