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The value of ‘value’ and Benjamin Graham’s three core beliefs

It’s no secret that ‘value’ based investment strategies have generally underperformed market returns throughout the current bull-market, with this underperformance being particularly acute over the past three years. However, the underperformance of value as a style has not been driven by a failure of value investing to deliver what it sets out to achieve. Rather, in many ways, it has been a function of what value investing sets out to avoid.

The ideas behind value investing today are much broader than those originally envisaged by Benjamin Graham, the academic credited with its birth. Graham’s work heavily influenced some of the world’s most famous investors, notably Warren Buffett and Charlie Munger, who have expanded on his ideas and applied his approach to a much wider universe of investing strategies.

Nonetheless, the three core tenets of Graham’s work have remained unchanged in the 85 years since he first published them.

1. The future is unknowable

That the future is unknowable might sound trite but consider the authority that most analysts summon when setting out their forecasts. Much of the published investment research today suggests that economic forecasting enjoys a level of precision normally reserved for hard sciences like physics. Friedrich Hayek, a Nobel Prize-winning economist, referred to this as the ‘Pretence of Knowledge’. Hayek described the task of economics as being:

“to demonstrate to men how little they really know about what they imagine they can design.”

In the real-world, both economists and market forecasters have dismal records of predicting things like recessions or major turning points in the share market. In an $80 trillion global economy driven by eight billion individual actors, divining such things is beyond the tools at our disposal.

2. Find a margin of safety

Without prediction, we are confronted with two choices. First, we can fall back on the ideas behind the Efficient Market Hypothesis (EMH). This proposes that investors are rational economic actors, and that all new market information is instantly reflected in security prices. We will earn the return of the ‘market’ and live with the ‘risks’ that this entails. If you invested your retirement savings in February 2009, bully for you. If you instead invested them in February 2008, well, that just reflects the risks that come with investing in the ‘market’.

An alternative approach is an investment strategy where some form of a margin of safety exists. A buffer that can protect us regardless of the economic weather or the broader fortunes of the market is the second of Graham’s key value-investing principles. In many ways it is the defining feature of the investment approach. Most value-based strategies are thus anchored on two equally-important goals, generating investment returns and preserving capital.

3. All securities have an intrinsic value

Graham’s third key principle is the idea that all securities have an intrinsic value. If you can determine this intrinsic value, and then buy the asset at a discount to this price, you have created the buffer you need to protect yourself from the whims of the market.

This final concept is where many value-based strategies fail. Determining the intrinsic value of an asset can too often become a subjective exercise, as is determining a knowable intrinsic value in a world where the future is unknowable.

Regardless of its drawbacks, investors like Warren Buffett apply this method when they talk about their search for stocks with wide ‘economic moats’. Businesses can have structural competitive advantages, either through a business model or brand that cannot be readily replicated. The ‘moat’ ensures a long-term competitive advantage, and if the business is bought at the right price, excess market returns are generated over the long-run.

Beware simple screens and ‘value traps’

As with all investment approaches, value-based investing has its pitfalls. For example, many value investors screen potential investments using metrics like price to book value or price to earnings ratios. It is easy to construct a portfolio of ‘cheap’ stocks using such metrics. Whether they are companies truly trading below intrinsic value is another question.

One of the greatest economic forces of recent times has been the arrival of the ‘disrupter’. Typically, these are technology-based companies with innovative approaches to competing in established industries. A defining feature of the disrupter business model is its low capital intensity. Given this, holding a portfolio of stocks today that look cheap on a price to book value basis may in fact just mean owning a collection of companies in structural decline.

Stocks that look cheap on a price to earnings metric and cheapness relative to near-term earnings can often reflect a company with challenged longer-term prospects. Confusing ‘cheap’ with ‘intrinsic value’ is one of the key predicaments value investors must navigate.

Seeking both a return on capital, and a return of capital

Few of the drivers behind absolute market returns this cycle have demonstrated much in the way of safety for investors. Anyone doubting that markets today are mainly driven by central bank actions need only reflect on the magnitude of the share markets swings between September 2018 and March 2019. Global share markets collapsed 17% (in US dollar terms), and then rallied 19%, as the US Fed shifted from guiding to future rates hikes, to hinting at future rate cuts.

Collectively, central banks have injected US$14 trillion into capital markets since 2008 via quantitative easing. Despite these actions, the recovery since the GFC has been anaemic and characterised by low to non-existent levels of inflation. In the US, the only developed economy to experience a meaningful expansion since the crisis, growth has averaged a mere 2.3%, much lower than the 3.6% average of the past three cycles.

Against this bleak backdrop, investors have craved ‘growth’ of any kind. They have found it most noticeably in a small handful of high-growth technology stocks. Some of these companies have revolutionised entire industries while many more remain a long way from delivering on grand promises. On our analysis, eleven stocks (Microsoft, Facebook, Apple, Amazon, Netflix, Google, Twitter, Tencent, Alibaba, Baidu and Nvidia) have accounted for 21% of all global share market gains over the past five years. Indeed, four of them, Microsoft, Amazon, Apple and Facebook, are responsible for 23% of the S&P 500’s total return year-to-date.

The recent winners carry no margin of safety

From early 2000 through to the GFC in 2008, value as a style greatly outperformed growth. From 2000 to 2003 covers the dotcom crash and the ensuing broader market correction, while 2003 to 2008 were periods of solid global economic growth and normal levels of inflation.

The excitement surrounding FAANG stocks today has obvious parallels to the dotcom euphoria of 1999 and early 2000. That does not mean this basket of stocks cannot continue to propel broader markets higher for some time to come. How much longer, of course, is unknowable in the eyes of a grizzled value investor. What is clear, is that – having rallied 238% over the past five years – there seems little in the way of a margin of safety in owning them today.

 

Miles Staude of Staude Capital Limited in London is the Portfolio Manager at the Global Value Fund(ASX:GVF). This article is the opinion of the writer and does not consider the circumstances of any individual.

  •   25 July 2019
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