SCOTT FRANCIS – 14 OCTOBER 2013
Summary: The term value investing has been around since the 1930s, and generally involves buying securities that appear under-priced. But there are active and passive approaches to value investing, with one being more of an art and the other a science.
Key take-out: The art of value investment usually requires a contrarian approach, looking to buy companies at a time when they are out of favour.
It usually does not take a new investor long to come across the concept of ‘value investing’.
As an investment approach that offers the enticement of above-average returns, it is immediately of interest.
Some of the greatest investment writers and practitioners were and are, Benjamin Graham (considered one of the fathers of value investing), David Dodd, Warren Buffett and, in Australia, Peter Hall and Kerr Neilson.
As ‘value investing’ has evolved, there have been two camps that have grown – those who take an ‘active’ approach to value investment, and those who take a ‘passive’ approach to capturing these returns. The active approach – almost always accompanied by the slogan of ‘buying companies at less than their intrinsic value’ is more the ‘art’ of value investing, whereas the passive exposure to value companies to earn above average returns has more of the ‘science’ of investing behind its approach.
The art of value investing
The art of value investing is to identify a ‘mispriced’ company, and hold it until the true value of the company is realised. I put it in the category of being an art, as it is clearly not a skill that many investment managers have, and it requires a level of analytic and emotional skill to find and hold such an investment.
Of course, it is not exclusively an art. Investment analysis behind this approach often includes things like looking at the price earnings ratio of a company, the dividend yield, perhaps the history of how earnings have grown over time or how well shareholder funds have been used by the company (return on equity). Many value managers, over time, have also been wary of companies with too much debt.
It often involves an analysis of the company and its prospects over time, as well as the quality of management.
The art of value investment usually requires a contrarian approach – the ability to look at a company and thinking about buying it at a time when it is well and truly out of favour (think about Telstra when it was trading around $2.50) or when there is significant fear in the market (think about when the ASX 200 was trading around 3,200 points four years ago).
Much of the focus around this style of value investing is not getting caught up in investment trends. A great example of this was Warren Buffett’s refusal to get caught up in the ‘dot com’ bubble because he could not understand how these companies had ‘barriers to entry’ high enough to keep competitors out and justify the large sums of money that they were valued at. He was criticised as being out of touch, however the ‘dot com’ crash that followed proved him far more astute than those who hitched their wagon to that trend.
As a final characteristic, value investors of this kind are necessarily patient. They are buying ‘mispriced’ companies, or companies trading below what they have valued them at, and usually accept that it may take a long period of time before the price and value of the company merge.
So, for those who engage in the art of value investment, the general characteristics of their practice are:
- Analysis of the fundamentals (cash flow, debt, dividends) of the companies that they own;
- Having a positive opinion of the quality of management;
- Avoidance of investment trends;
- Being prepared to take a contrarian approach to out-of-favour companies (or when the whole market is out of favour);
- Being a long-term investor
As I read books and articles from the 1930s to 1970s, I can’t help but think the investment world is a very different place now to when it was then. Reading about the trades of value investors, there are many times they were able to buy companies at well below the value of their assets, or even at prices well below the value of the cash held in a company. These were extraordinary opportunities that rarely exist today.
In 1976 Ben Graham gave an interview to the Financial Analysis Journal where, somewhat extraordinarily, he said:
‘I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.’
This brings us to the second of the value investing strategies, the ‘science’ of value investing.
The science of value investing
While not the start of the research in this area, to US-based academics, Eugene Fama and Kenneth French, did the research that led to the ‘Fama and French 3 Factor Model’ of investment.
It proposed that there were three sources of returns from markets:
- The average market return (index return);
- A premium for investors that could be earned from holding small companies;
- A premium for investors that could be earned from holding value companies.
In looking at value companies, they proposed that these companies were not carefully selected companies, but rather a section of the market with value characteristics – they used the 30% of companies in the market that had the lowest price-to-book ratios.
In this way they formed a ‘passive’ value portfolio. The suggestion is that this value part of the market does not outperform because of careful investment selection; rather, this is a riskier part of the market that has fallen in price. For example, during the Global Financial Crisis, bank shares fell sharply in price. Buying them as they fell in price was a wonderful investment, which has subsequently provided above average returns. However, there were risks around doing this at the time.
Fama and French have an association with the investment company Dimensional which, in part, looks to form value portfolios on the basis of price-to-book ratios of companies.
However, this is not the only passive value approach. Other value signals such as price earnings ratios and dividend yield are used by passive investment companies to form portfolios. For example, Vanguard has the Australian High Yield Australian Share Fund, which has returned (to the end of August this year) 15.7% pa for three years and 7.0% pa for five years compared to the average market return of 9.9% (three years ) and 4.6% (five years).
Of course, while this example shows a positive return, investing in value companies is certainly not without risk, and periods of poor performance must be expected.
I consider this approach to value investing to be more of the ‘science’, as it is less about finding undervalued companies, and more about applying the published investment research that companies with value characteristics offer potentially higher rates of return.
There are many people who suggest that value investing offers a higher-than-average rate of return – and I have split the camps into two differing ideas.
Of course, the camps are not without overlap. Those who follow what I have described as the art of value investing include a lot of security analysis. The overlap might be the quote from Graham, who questions the returns from value investing as a security analysis activity.
The great thing is that, as independent investors, we don’t have to tie our philosophy to one approach or the other. The majority of my investments are in index style funds, that include passive funds with value characteristics. However I still enjoy looking at individual investments and sneaking a few thousand dollars’ worth of an idea into my portfolio now and then – just on the hope I might have picked up a gem that (surprisingly) everyone else has overlooked.
Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.