Value investing

Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham & David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis. Although value investing has taken many forms since its inception, it generally involves buying securities whose shares appear underpriced by some form(s) of fundamental analysis.^[1] As examples, such securities may be stock in public companies that trade at discounts to book value or tangible book value, have high dividend yields, have low price-to-earning multiples or have low price-to-book ratios.

Notable proponents of value investing, including Berkshire Hathaway chairman Warren Buffett, have argued that the essence of value investing is buying stocks at less than their intrinsic value.^[2] The discount of the market price to the intrinsic value is what Benjamin Graham called the "margin of safety". The intrinsic value is the discounted value of all future distributions.

However, the future distributions and the appropriate discount rate can only be assumptions. Warren Buffett has taken the value investing concept even further as his thinking has evolved to where for the last 25 years or so his focus has been on "finding an outstanding company at a sensible price" rather than generic companies at a bargain price. This concept is important as you are actually buying into a business.

History

Benjamin Graham

Benjamin Graham

Value investing was established by Benjamin Graham and David Dodd, both professors at Columbia Business School and teachers of many famous investors. In Graham's book The Intelligent Investor, he advocated the important concept of margin of safety — first introduced in Security Analysis, a 1934 book he coauthored with David Dodd — which calls for a cautious approach to investing. In terms of picking stocks, he recommended defensive investment in stocks trading below their tangible book value as a safeguard to adverse future developments often encountered in the stock market.

[edit] Further evolution

However, the concept of value (as well as "book value") has evolved significantly since the 1970s. Book value is most useful in industries where most assets are tangible. Intangible assets such as patents, software, brands, or goodwill are difficult to quantify, and may not survive the break-up of a company. When an industry is going through fast technological advancements, the value of its assets is not easily estimated. Sometimes, the production power of an asset can be significantly reduced due to competitive disruptive innovation and therefore its value can suffer permanent impairment. One good example of decreasing asset value is a personal computer. An example of where book value does not mean much is the service and retail sectors. One modern model of calculating value is the discounted cash flow model (DCF). The value of an asset is the sum of its future cash flows, discounted back to the present.

Value Investing Performance

Performance, value strategies

Value investing has proven to be a successful investment strategy. There are several ways to evaluate its success. One way is to examine the performance of simple value strategies, such as buying low PE ratio stocks, low price-to-cash-flow ratio stocks, or low price-to-book ratio stocks. Numerous academics have published studies investigating the effects of buying value stocks. These studies have consistently found that value stocks outperform growth stocks and the market as a whole.^[3][4][5]

Performance, value investors

Another way to examine the performance of value investing strategies is to examine the investing performance of well-known value investors. Simply examining the performance of the best known value investors would not be instructive, because investors do not become well known unless they are successful. This introduces a selection bias. A better way to investigate the performance of a group of value investors was suggested by Warren Buffett, in his May 17, 1984 speech that was published as The Superinvestors of Graham-and-Doddsville. In this speech, Buffett examined the performance of those investors who worked at Graham-Newman Corporation and were thus most influenced by Benjamin Graham. Buffett's conclusion is identical to that of the academic research on simple value investing strategies--value investing is, on average, successful in the long run.

During about a 25-year period (1965-90), published research and articles in leading journals of the value ilk were few. Warren Buffett once commented, "You couldn't advance in a finance department in this country unless you thought that the world was flat."

Well Known Value Investors

Benjamin Graham is regarded by many to be the father of value investing. Along with David Dodd, he wrote Security Analysis, first published in 1934. The most lasting contribution of this book to the field of security analysis was to emphasize the quantifiable aspects of security analysis (such as the evaluations of earnings and book value) while minimizing the importance of more qualitative factors such as the quality of a company's management. Graham later wrote The Intelligent Investor, a book that brought value investing to individual investors. Aside from Buffett, many of Graham's other students, such as William J. Ruane, Irving Kahn and Charles Brandes have gone on to become successful investors in their own right.

Graham's most famous student, however, was Warren Buffett, who ran successful investing partnerships before closing them in 1969 to focus on running Berkshire Hathaway. Charlie Munger joined Buffett at Berkshire Hathaway in the 1970s and has since worked as Vice Chairman of the company. Buffett has credited Munger with encouraging him to focus on long-term sustainable growth rather than on simply the valuation of current cash flows or assets

Another famous value investor is John Templeton. He first achieved investing success by buying shares of a number of companies in the aftermath of the stock market crash of 1929.

Martin J. Whitman is another well-regarded value investor. His approach is called safe-and-cheap, which was hitherto referred to as financial-integrity approach. Martin Whitman focuses on acquiring common shares of companies with extremely strong financial position at a price reflecting meaningful discount to the estimated NAV of the company concerned. Martin Whitman believes it is ill-advised for investors to pay much attention to the trend of macro-factors (like employment, movement of interest rate, GDP, etc.) not so much because they are not important as because attempts to predict their movement are almost always futile. Martin Whitman's letters to shareholders of his Third Avenue Value Fund (TAVF) are considered valuable resources "for investors to pirate good ideas" by another famous investor Joel Greenblatt in his book on special-situation investment "You Can Be a Stock Market Genius" (ISBN 0-684-84007-3, pp 247)

Joel Greenblatt achieved annual returns at the hedge fund Gotham Capital of over 50% per year for 10 years from 1985 to 1995 before closing the fund and returning his investors' money. He is known for investing in special situations such as spin-offs, mergers, and divestitures.

Investment specific technological progress

Introduction

To model how something is produced, think of a box that in one end takes in inputs such as labor (employees) and capital (equipment, buildings, etc.) and in another end spits out the final good (see Figure 1). With this picture in mind now one can ask, how does technological progress affect production? One way of thinking is that technological progress affects specific inputs (arrows going in) such as equipment and buildings. To realize the benefits of such technological change for production these inputs must be purchased. So for example, the advent of the microchip (an important technological improvement in computers) will affect the production of Ford cars only if Ford Motor Co.'s assembly plants (the red box) invest in computers with microchips (instead of computers with punch cards) and use them (they are one of the arrows going in the box) in the production of Mustangs (the arrow coming out). As the name suggests, this is investment-specific technological progress---it requires investing in new machines or buildings which contain or embody the latest technology. Notice that the term investment can be very general: not only must a firm buy the new technology to reap its benefits, but it also must invest in training its workers and managers to be able to use this new technology (Greenwood & Jovanovic 2001) .

Importance

Identifying investment-specific technological progress is important, because knowing what type of technological progress is operating in an economy will determine how someone (should) want his or her tax dollars to be spent and how he or she may want to invest his or her savings (Gort et al 1999). If "investment-specific" technological change is the main source of progress, then one would want his or her dollars spent on helping firms buy new equipment and renovate their plants, because these investments will improve production and hence what you consume. Furthermore, one may want to help pay for current employee training in using new technologies (to keep them up to date) or subsidize the education of new employees (who will enter the job market knowing how to use the new technology). So, the type of technological progress will also matter for unemployment and education issues. Finally, if technological progress is "investment-specific" you may want to direct your money towards the research and development (R & D) of new technologies (like quantum computers or alternative energy sources) (Krusell 1998).

More generally, why is any type of technological progress important? Technological change has made our lives easier. Because of technological progress, people can work less, make more money and enjoy more leisure time (Greenwood & Vandenbroucke 2006). Women have been able to break away from the traditional "housewife" role, join the labor-force in greater numbers (Greenwood et al 2005) and become less economically dependent on men (Greenwood & Guner 2004). Finally, technological progress has been shown to affect the fall in child labor starting around 1900 (Greenwood & Seshadri 2005). Figure 2 illustrates this last point: as of 1900 child labor's share of the paid labor force began to fall.

Figure 2

A Simple Example: the microwave oven

An example of investment-specific technological progress is the microwave oven. The idea of the microwave came to be by accident: in 1946 an engineer noticed that a candy bar in his pocket had melted while working on something completely unrelated to cooking (Gallawa 2005). The development of this good, from melting the candy bar to the home appliance we know today, took time and the investment of resources to make a microwave small and cheap. The first microwave oven cost between 2000 and 3000 dollars and was housed in refrigerator-sized cabinets (Gallawa 2005)! Today, almost any college student can enjoy a 3-minute microwaveable meal in the smallest dorm room. But a microwave's uses do not stop at the dorm room. Many industries have found microwave heating advantageous: it has been used to dry cork, ceramics, paper, leather, and so on (Gallawa 2005). However, for either college students or firms to reap the benefits of quick warming, they must first "invest" in a microwave oven (that "embodies" the technological advance). To realize the benefits of investment-specific technological progress you must first invest in a technology that embodies it.

How do you measure investment-specific technological progress?

While measuring technological progress is not easy, economists have found indirect ways of estimating it. If "'investment-specific'" technological progress makes producing goods easier, then we should expect the price of these goods (relative to the price of other goods) to decrease. In particular, "investment-specific" technological change has affected the prices of two inputs into the production process: equipment and structures. We think of equipment as machines (like computers) and structures as buildings. If there is technological progress in the production (or creation) of these goods, then we should expect the price of them to fall or the value of them to rise relative to older versions of the same good.

Figure 3 (the pink line) shows how the price of new producer durables (such as equipment) in the US relative to the price of new consumer nondurables (like clothing) has consistently declined over the past fifty years (Gort et al 1999). By relative price of producer durables we mean dividing the price that firms pay (for inputs of production) by the price that a regular consumer pays (for things like jeans). We use relative prices so we can say how many units of equipment can be bought instead (or in terms) of buying one unit of consumer goods. Figure 3 (the pink line) says that over time, firms have been able to buy more and more units of equipment instead of one unit of consumption, especially when we take into account that the quality of equipment being acquired has increased (a computer today is much faster than a computer five years ago and we should take that into account when comparing their prices). If we do not take into account quality (which is wrong) it looks like the price of equipment has not decreased as much (see the black line in Figure 3).

Figure 3

Measuring the price of structures is more complicated than measuring the price of equipment, but economists have again been able to get an idea of how much progress there has been in structures (such as buildings). One approach is that if newer buildings were constructed or designed using newer technologies then they should be worth more than older buildings (because they embody the new technology (Gort et al 1999). In particular, they should rent for more. As Figure 4 shows, this is true. Renting a square foot in a new building is much more expensive than renting a square foot in a building forty years old. So it must be the case that you are paying for a nicer, more functional and maybe even safer building.

Figure 4

Based on Figures 3 and 4 we can conclude that investment-specific technological change is operating in the US. Estimates suggest that the rate of technological progress in equipment and structures is about 3.2% and 1%, respectively (Gort et al 1999) (Greenwood et al 1997).

Conclusion

In the second section it was mentioned that "investment-specific" technological change is important since it will affect production (both in quality and size). An important question then is, just how much "bang for your buck" do you get with "investment-specific" technological change? The answer is quite astounding; economists have found that 37% of growth in US output (production) is due to technological progress in equipment and 15% is due to technological progress in structures (Gort et al 1999) (Greenwood et al 1997). All in all, more than half (37% + 15% = 52%) of the growth of the US economy is due to "investment-specific" technological change (Gort et al 1999) (Greenwood et al 1997).

Investment

Types of investments

The term "investment" is used differently in economics and in finance. Economists refer to a real investment (such as a machine or a house), while financial economists refer to a financial asset, such as money that is put into a bank or the market, which may then be used to buy a real asset.

Business Management

The investment decision (also known as capital budgeting) is one of the fundamental decisions of business management: managers determine the assets that the business enterprise obtains. These assets may be physical (such as buildings or machinery), intangible (such as patents, software, goodwill), or financial (see below). The manager must assess whether the net present value of the investment to the enterprise is positive; the net present value is calculated using the enterprise's marginal cost of capital.

A business might invest with the goal of making profit. These are marketable securities or passive investment. It might also invest with the goal of controlling or influencing the operation of the second company, the investee. These are called intercorporate, long-term and strategic investments. Hence, a company can have none, some or total control over the investee's strategic, operating, investing and financing decisions. One can control a company by owning over 50% ownership, or have the ability to elect a majority of the Board of Directors.

Economics

In economics, investment is the production per unit time of goods which are not consumed but are to be used for future production. Examples include tangibles (such as building a railroad or factory) and intangibles (such as a year of schooling or on-the-job training). In measures of national income and output, gross investment I is also a component of Gross domestic product (GDP), given in the formula GDP = C + I + G + NX, where C is consumption, G is government spending, and NX is net exports. Thus investment is everything that remains of production after consumption, government spending, and exports are subtracted.

I is divided into non-residential investment (such as factories) and residential investment (new houses). Net investment deducts depreciation from gross investment. It is the value of the net increase in the capital stock per year.

Investment, as production over a period of time ("per year"), is not capital. The time dimension of investment makes it a flow. By contrast, capital is a stock, that is, an accumulation measurable at a point in time (say December 31st).

Investment is often modeled as a function of Income and Interest rates, given by the relation I = f(Y, r). An increase in income encourages higher investment, whereas a higher interest rate may discourage investment as it becomes more costly to borrow money. Even if a firm chooses to use its own funds in an investment, the interest rate represents an opportunity cost of investing those funds rather than loaning them out for interest.

Finance

In finance, investment=cost of capital, like buying securities or other monetary or paper (financial) assets in the money markets or capital markets, or in fairly liquid real assets, such as gold, real estate, or collectibles. Valuation is the method for assessing whether a potential investment is worth its price. Returns on investments will follow the risk-return spectrum.

Types of financial investments include shares, other equity investment, and bonds (including bonds denominated in foreign currencies). These financial assets are then expected to provide income or positive future cash flows, and may increase or decrease in value giving the investor capital gains or losses.

Trades in contingent claims or derivative securities do not necessarily have future positive expected cash flows, and so are not considered assets, or strictly speaking, securities or investments. Nevertheless, since their cash flows are closely related to (or derived from) those of specific securities, they are often studied as or treated as investments.

Investments are often made indirectly through intermediaries, such as banks, mutual funds, pension funds, insurance companies, collective investment schemes, and investment clubs. Though their legal and procedural details differ, an intermediary generally makes an investment using money from many individuals, each of whom receives a claim on the intermediary.

Personal finance

Within personal finance, money used to purchase shares, put in a collective investment scheme or used to buy any asset where there is an element of capital risk is deemed an investment. Saving within personal finance refers to money put aside, normally on a regular basis. This distinction is important, as investment risk can cause a capital loss when an investment is realized, unlike saving(s) where the more limited risk is cash devaluing due to inflation.

In many instances the terms saving and investment are used interchangeably, which confuses this distinction. For example many deposit accounts are labeled as investment accounts by banks for marketing purposes. Whether an asset is a saving(s) or an investment depends on where the money is invested: if it is cash then it is savings, if its value can fluctuate then it is investment.

Real estate

In real estate, investment is money used to purchase property for the sole purpose of holding or leasing for income and where there is an element of capital risk. Unlike other economic or financial investment, real estate is purchased. The seller is also called a Vendor and normally the purchaser is called a Buyer.

Residential real estate

The most common form of real estate investment as it includes the property purchased as other people's houses. In many cases the Buyer does not have the full purchase price for a property and must engage a lender such as a Bank, Finance company or Private Lender. Herein the lender is the investor as only the lender stands to gain returns from it. Different countries have their individual normal lending levels, but usually they will fall into the range of 70-90% of the purchase price. Against other types of real estate, residential real estate is the least risky.

Commercial real estate

Commercial real estate is the owning of a small building or large warehouse a company rents from so that it can conduct its business. Due to the higher risk of Commercial real estate, lending rates of banks and other lenders are lower and often fall in the range of 50-70%.