Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 316

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.


 

Leave a Comment:

     

RELATED ARTICLES

Why it's a frothy market but not a bubble

FANMAG: Because FAANGs are so yesterday

After 30 years of investing, I prefer to skip this party

banner

Most viewed in recent weeks

Three steps to planning your spending in retirement

What happens when a superannuation expert sets up his own retirement portfolio using decades of knowledge? He finds he can afford much more investment risk in his portfolio than conventional thinking suggests.

Finding sustainable dividend stocks on the ASX

There is a small universe of companies on the ASX which are reliable dividend payers over five years, are fairly valued and are classified as ‘negligible’ or ‘low’ on both ESG risk and carbon risk.

Among key trends in Australian banks, one factor stands out

The Big Four banks look similar but they are at fundamentally different stages as they move to simpler business models. Amid challenges from operating systems, loan growth and neobank threats, one factor stands tall.

Why mega-tech growth are the best ‘value’ stocks in the market

They are six of the greatest businesses ever and should form part of the global portfolios of all investors. The market sees risk in inflation and valuations but the companies are positioned for outstanding growth.

How inflation impacts different types of investments

A comprehensive study of the impact of inflation on returns from different assets over the past 120 years. The high returns in recent years are due to low inflation and falling rates but this ‘sweet spot’ is ending.

How to manage the run down in your income in retirement

The first of five articles on modern retirement income products that aim for an increasing pension that lasts for life and on average should not decline in real terms. They are not silver bullets but worth a look.

Latest Updates

Superannuation

Retirement income promise relies on spending capital

The Government has taken the next step towards encouraging retirees to live off their capital, and from 1 July 2022 will require super funds - even SMSFs - to address retirement income and protect longevity risk.

Superannuation

How retirees might find a retirement solution in future

Superannuation funds need to establish a framework that offers retirees a retirement income solution that lasts a lifetime. It will challenge trustees to find a way to engage that their members understand and trust.

Investment strategies

Dividend investors, your turn is coming

Dividend payments from listed companies, depended on by many in retirement, have lagged the rebound in share prices over the past year. Better times are ahead but sources of dividends will differ from previous years.

Investment strategies

Four tips to catch the next 10-bagger in early-stage growth

Small cap investors face less mature companies with zero profit that need significant capital for growth. Without years of financial data to rely on, investors must employ creative ways to value companies.

Investment strategies

Investing in Japan: ready for an Olympic revival?

All eyes are on Japan and the opportunity to win for competing athletes. After disappointing investors for many years, Japan is also in focus for its value, diversification and the safe haven status of its currency.

Fixed interest

Five lessons for bond investors from the Virgin collapse

The collapse of Virgin Australia not only hit shareholders, but their bond investors received between 9 and 13 cents in the $1. A widely-diversified portfolio can tolerate losses better than a concentrated one.

Investment strategies

The 60:40 portfolio ... if no longer appropriate, then what is?

The traditional 60/40 portfolio might deliver only 1.5% above inflation in future without diversification benefits. Knowing an asset’s attributes rather than arbitrary definitions is better for investors.

Retirement

Two factors that can transform retirement investing

Retirees want better returns but they have limited appetite to dial up their risk exposure in order to achieve it. Financial advice and protection strategies in portfolios can enhance investment outcomes.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.