Value Investing: Proven Market-Beating Performance (Part 2 of Series)

ValueIn this Part 2 of my series on Value Investing (see Part 1 on Warren Buffett here), I’m going to dive deeper into the art and science of what makes this paramount investment style and philosophy wonderful.  Throughout my professional career in the investment business and the rigorous personal study and attainment of the Chartered Financial Analyst designation, I have concluded that

there is no clearer, more surefire way to build long-term wealth than through the practice of deep value investing.

But as I have discussed throughout multiple blog posts thus far, to be successful in the business of value investing requires – yep, you guessed it – enormous patience.

As Warren Buffett plainly stated: “Success in investing doesn’t correlate with I.Q. once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”   As you’ll read, a value investor must control his or her emotions – emotions tend to cloud judgment and make us react to short-term, let’s call them “fickle” situations.

But before we get into the meat and potatoes here, I want to acknowledge Christopher H. Browne’s The Little Book of Value Investing which has helped inspire me to share this wonderful investment philosophy.  Timeless concepts of value investing are discussed here, but many more can be found in the book.  I highly recommend it to all interested in learning the value investing art.

(Christopher Browne was a key part of the Tweedy, Browne Company, the longest running value investing firm on Wall Street until his death in 2009.)

Ok, let’s get started…

Some Basics for Ya

The roots of value investing can be traced back to the 1930s to a man named Benjamin Graham, a writer, professor, and money manager whose work in the field led him to publish two pivotal works on value investing – Security Analysis and The Intelligent Investor.  For many including Warren Buffett, The Intelligent Investor is considered to be the Bible of Value Investing, and lays the groundwork for all value practitioners to this day (and probably forever!).

Value investing was one of the first investment philosophies to construct a scientific and mathematical framework around stock picking. This revolutionary yet logical concept challenged the stock speculation mania that had dominated the financial world through the Roaring ’20s and into the Great Depression.

So who are value investors?

Value investors buy stocks whose market or trading price is significantly less than the intrinsic value of the underlying business.

And what do I mean by intrinsic value?  As you might have guessed, there are a plethora of ways to determine intrinsic value. Benjamin Graham looked at a stock’s book value (as shown on the company’s balance sheet) and at it’s Price to Earnings ratio (ratio of price divided by the company’s annual earnings, or P/E ratio) in order to determine intrinsic value. I’ll get into deeper details in subsequent posts with mathematical examples, but for now, let me explain an example for simplicity.

As you are aware from every day life, sometimes things we want to own go on sale.  For example, we walk into an electronics store and discover that a particular plasma TV we’ve been wanting has recently been market down 30% due to a special promotion or an inventory overstock.  Does that mean the TV is suddenly worth less and will produce a poorer image or sound quality than when it was fully priced?  Will the TV have a shorter lifespan than it had when the price was higher?  Would purchasing that TV at a later date after we saw the price begin to increase make it more desirable to us? Of course the answer to these questions is NO!  That TV is the same TV regardless of price.  We’d want to buy that TV as cheaply as we could because no matter the price, we’re still getting the same TV! Benjamin Graham would have referred to this steep discount as a margin of safety.

Yet for some reason, the average investor thinks about stock purchase differently.

Generally speaking, he or she prefers to buy a stock after the price has gone up, because rising prices give us false confidence that the fun will continue….but that’s simply illogical short-sided!

Value investing, on the other hand, requires reason and sound judgment.   A value investor approaches stock buying just like the electronics store customer – he stands ready and waiting for great stocks to “go on sale.” Since most participants in the stock market are focused on the short-term, “bad news” about a company (e.g. a quarterly earnings miss, change in management, production slowdown, etc.) impels these impatient investors to sell the stock and drive the price downward.

However, as long as the underlying fundamental earnings or cash flow ability of the company has not been structurally altered, the market has simply slapped a “sale” sign on the same great stock it’s always been and always will be.

These “sales” provide value investors the opportunity to buy wonderful companies at discounted prices.  The value investor is later rewarded as the market comes to its senses and recognizes what he already knew about the long-term value of the stock.

Sidenote: The time required for the market to come to its senses can vary significantly from case to case, so the value investor must exercise the utmost patience (there’s that word again!) – not easy to do!

But does it work?

Yep…in fact there’s a ton of evidence to support that value investing produces outsized returns relative to general stock market index performance over the long term. But don’t take my word for it. Let’s look at an excerpt from Christopher H. Browne in The Little Book of Value Investing as he discusses the Morningstar research platform’s rankings as they pertain to mutual fund investment styles:

What Morningstar statistics show is that no matter what size company the fund invests in, the value funds earn the best returns over the long run. This turns out to be true not just not just among funds investing in U.S. companies, but funds that invest in companies all over the globe.

As mentioned in a 1984 speech on the fiftieth anniversary of the publication of Security Analysis, Warren Buffett explored the performance of some of the most successful documented investors of all time. These seven “super investors” as he called them were all practitioners of the value investment philosophy, and all had generated superior performance versus the general stock market and versus more growth (I call it “glamour”) oriented strategies.

A final word on temperament…

A value investor must be a contrarian of the highest degree.  When economic times are most uncertain and fear is widespread (think late 2008 through early 2009 when the world feared financial meltdown), value investors are putting investment capital to work in stocks who have been “thrown out with the bathwater.”

On the other hand, when stocks are soaring, when the economy is humming along without a seeming hitch, and when investor euphoria is widespread (think about the height of technology bubble in ’99-’01), value investors find no deals or “sales” to be had.  As the famous value investing adage goes: Be greedy when others are fearful, and be fearful when others greedy.

Stay tuned for Parts 3 where I discuss the tools and methods needed to uncover value.

As always, please let me know if you have questions on Value Investing or any other long term wealth subject.

And make sure to sign up to receive up to date blog posts which also allows you to download my free eBook describing the 15 Ways to Achieve Financial Freedom.


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