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Value Investing: An Identity Crisis?
 

Aswath Damodaran's picture
(Gorilla, 579
 
Points)
 on 6/13/12 at 1:00pm
invest.jpg

Any post about value investing always evokes strong responses, but I thought I would start this one by turning the focus inwards. So, here are a few questions for you :

1. Would you classify yourself as a "value investor"?

a. Yes
b. No

2. If yes, what makes you a value investor?

a. I try to estimate the value of a stock before I invest in it
b. I only buy stocks that trade at attractive multiples (low PE, low PBV etc.)
c. I do my homework, looking at the fundamentals, before I invest
d. I don't know. I just am.

3. Finally, do you think that value investors collectively do better than other investors in the market?

a. Yes
b. No
c. Not Sure

If yes, what is the source of their advantage? If not, why do you think they fail?

  • On the first question, I would not be surprised if the preponderance of visitor to this site classify themselves as value investors. After all, value investing has become so broadly defined that everyone seems to be in this camp, and when everyone is a value investor, no one is a value investor. For value investing to work as an investment philosophy, it needs foils, preferably in the form of investors who know little about fundamentals and care about them even less. Paraphrasing Warren Buffett, if investing is a game of poker and value investors are the card counters, you need suckers at the table who will supply the winnings.
  • On the second question,  as value investing has expanded well beyond the Ben Graham school of strict (and passive) value investing to include different and seemingly contradictory strands of investing, there is less consensus about what comprises a good "value” stock. In a recent paper on value investing (which, in turn, is closely modeled on a chapter in my book on investment philosophies), I presented my take on these issues.
  • On the third question, it does seem to be taken for granted, at least in the value investing community, that value investors are not only more virtuous than other, more fickle investors (growth investors, momentum investors) but that their "hard work" pays off in the form of higher returns, at least over long periods. It would be vindication of the "ant and the grasshopper" fable, if it were true, but is it?

What is the key characteristic that separates value investors from the rest of the world? In my view of the world, and I understand that yours might be different, the key to understanding value investing comes from breaking down a business into assets in place and growth assets.

It is this mechanism that I used to my posts on estimating how much you are paying for growth and how much that growth is worth.

If you are a value investor, you make your investment judgments, based upon the value of assets in place and consider growth assets to be speculative and inherently an unreliable basis for investing. Put bluntly, if you are a value investor, you want to buy a business only if it trades at less than the value of the assets in place and view growth, if it happens, as icing on the cake.

It is how you find investments that sell for less than the value of assets in place that provides a framework to understanding the different strands of value investing, and there are three ways you can go about this mission:

a. Passive Value Investing

The oldest strand of value investing traces its lineage back to Ben Graham and his use of screens to find cheap stocks. Reviewing those screens, which combine market and accounting data, from Graham's book on security analysis, you are looking at stocks that trade at low multiples of earnings, pay a high proportion of these earnings as dividends and have a high proportion of assets that can be liquidated for close to their book value. In the years since, investors have added other screens (good management, stable earnings, strong competitive advantages etc.) that are all designed to reduce the potential for downside on the investment.

b. Contrarian Value Investing

In contrarian value investing, you adopt a different tack. You look for companies whose stock prices have collapsed for one reason on another. In its least sophisticated variant, you just buy the biggest losers (at least in terms of stock price), on the assumption that markets generally over react and that the portfolio of these losers will bounce back over time. In its more refined forms, you add other criteria to the mix. Thus, you may buy stocks that have gone down but only if they have a strong brand name and/or little debt.

c. Activist Value Investing

In activist value investing, you focus on poorly performing companies and look at the value of its assets in place, with better management in place. You then try to change the way the company is run by either acquiring control of the firm or putting pressure on existing management. Activist investing requires far more resources than either passive or contrarian value investing.

The skills and strengths you need to succeed in each of these value investing approaches is different and it is not clear than an investor who succeeds using one strand of value investing will be comfortable with the others.

In the next three posts, I will focus on each of these strands of value investing. In the last post, I will examine the most contentious issue of all, which is whether value investors collectively generate value from their efforts or whether this too is "fool's gold".

Professor of Finance at Stern Damodaran's Blog -- See my other wso posts

Comments

zeuscannon's picture

Really looking forward to

 
Points)
 on 6/13/12 at 1:34pm

Really looking forward to this!

Relinquis's picture

Aswath Damodaran, Does your

RE
(Neanderthal, 2,186
 
Points)
 on 6/13/12 at 1:44pm

Aswath Damodaran,

Does your framework for "value investing" take into account investing across the capital structure, e.g. distressed debt, convertibles or preferred stock, or is is solely focused on stock investing, i.e. listed companies, which is a rather limited part of finance in my opinion.

I'm referring to the kind of investing illustrated in books like Margin of Saftey by Seth Klarman. This could be passive or active in terms of management / board involvement.

To answer your questions...

relinquis... Killing the GMAT this December; Over/Under set at: 725 GMATs.

In reply to Relinquis
AndyLouis's picture

Relinquis: Aswath

(Almost Human, 6,114
 
Points)
 on 6/13/12 at 1:45pm
Relinquis:

Aswath Damodaran,

Does your framework for "value investing" take into account investing across the capital structure, e.g. distressed debt, convertibles or preferred stock, or is is solely focused on stock investing, i.e. listed companies, which is a rather limited part of finance in my opinion.

I'm referring to the kind of investing illustrated in books like Margin of Saftey by Seth Klarman. This could be passive or active in terms of management / board involvement.

To answer your questions...

Hey Relinquis, this is a syndication from his blog. For specific questions you should comment on his original post at http://www.aswathdamodaran.blogspot.com.ar/2012/06...

WSO's COO (Chief Operating Orangutan) | My story | Connect with me on Linkedin.

2013 WSO Conference

Relinquis's picture

Noted. Thanks.

RE
(Neanderthal, 2,186
 
Points)
 on 6/13/12 at 1:50pm

Noted. Thanks.

relinquis... Killing the GMAT this December; Over/Under set at: 725 GMATs.

Ovechkin08's picture

Just my 2 cents, but Warren

O
(Orangutan, 322
 
Points)
 on 6/13/12 at 2:00pm

Just my 2 cents, but Warren Buffett is NOT a value investor. He is a GARP investor, a growth at a reasonable price guy. Everyone thinks Buffett is a value investor becuase he studied under Graham and Dodd but if you read his letters to the shareholders he clearly states that he gave up on what modern day value investors would consider "value investing." Buffet recalls how be bought flee-ridden dogs like second hand department stores and textile factories (Berkshire) becuase they were cheap and trading below book value. He soon discovered Charlie Munger and decided to drop that act.

Warren took from Ben the key ideas of margin of safety and Mr. Market but abandoned the cigar-but style of investing, which I think all value guys claim to believe in. What warren realised was that you could outperform the market by paying fair value for growth, hence his purchase of Coca-Cola.

The rest is legendary......

Hayek's picture

Appears to be based on this

CO
 
Points)
 on 6/13/12 at 2:49pm

Appears to be based on this paper:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id...

SRRubio123's picture

Long term buy and hold value

 
Points)
 on 6/13/12 at 4:11pm

Long term buy and hold value investing is for suckers

This aint the 1980s/90s no mo'

anon56's picture

I think you have fallen into

 
Points)
 on 6/13/12 at 4:43pm

I think you have fallen into a few traps in terms of misunderstanding, or falsely caricaturing, value investing.

Value investing is not exclusively scouring for firms trading at less than book, nor is it finding stocks trading at 7x earnings or any other ratio. Value investing is, at its heart, investing at a price that you believe, based on fundamental research, is significantly less than a company's true value. In particular you have drawn a false dichotomy between investing in value companies and growth companies, in many of Buffet's investments for instance the value comes from the cheap price you are paying for growth.

To address the issue of Buffet specifically, we need to recognise that there is not 'one' Buffet investing approach; in the beginning he attempted to pick 'cigar butts' whereas now he is, as has been mentioned, focused on buying good companies at reasonable prices. In the intermediate period he was picking up good companies at amazing prices; here I think is where he made is money.

For me, the key to value investing is having a fundamental bottom up 'worst reasonable case' valuation that you are confident in. Once this is in place, and you invest at a sufficient discount to this worst case scenario. The advantage over other types of investors comes from having sufficient confidence in your analysis that regardless of market gyrations, you buy and hold the company because you know its true 'minimum value' (or at least a rough estimate) and whatever Mr. Market tries to convince you can be ignored. Investments are only cut when the story has changed.

That being said, while value investing can doubtless be a solid investment strategy and I think has proved its self (to date at least) superior to momentum approaches, it is not necessarily a profitable strategy. Its success depends on the ability to find and correctly establish the minimum price of a company and the ability to stand behind one's convictions. Furthermore the value investments that were possible during the mid to late 20th century simply aren't available now. I just think that the spread of information is too easy and too rapid for value investing to generate the returns we have seen in the past, at least in most developed equity markets.

Spalding Get Your Foot Off the Boat's picture

Agee with Anon on everything

 
Points)
 on 6/13/12 at 5:48pm

Agee with Anon on everything except that there are scarce opportunities... for the little investor, i don't think this holds true, even in the most developed markets

anon56's picture

Also, for people looking to

 
Points)
 on 6/13/12 at 6:24pm

Also, for people looking to get an accurate introduction to value investing, this video, although a little old now, is very good:

http://www.youtube.com/watch?v=VAW3gC6AsAo

Spalding Get Your Foot Off the Boat's picture

Anon - can you tell us a

 
Points)
 on 6/13/12 at 8:02pm

Anon - can you tell us a little about your background and what you do?

I'm looking to get into a mid to small HF and focus on value, but planning on getting my MBA first. I noticed your video above is a Darden MBA clip - Darden has recently been added to my radar for MBA schools but I've not heard anything about it's placement in value investing... i'm currently targeting CBS, NYU, Booth, Wharton more heavily for this

In reply to anon56
Oreos's picture

anon56: . the ability to

ST
(Neanderthal, 2,561
 
Points)
 on 6/14/12 at 3:25am
anon56:

. the ability to stand behind one's convictions.

/ your ability to lock up capital and withstand the moans of your short sighted investors

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