Winner of CFA UK and Brandes Essay competition 2019

Wednesday 30 October 2019

Value Investing - Brandes competition winner 2019 

Author: Tomasz Bulinski, CFA 

 

The financial world has changed significantly since Benjamin Graham first published Security Analysis in 1934. Which, if any, of his ideas do you find still have relevance to the modern investor, and how do you apply them in your career?

 

My story with value investing is probably a very common one. I received a copy of “The Intelligent Investor” from my then girlfriend, now wife, as a gift for my 21st birthday, just in time to shape my plans for a future career in investments. Graham’s ideas immediately struck me as an intellectually elegant way to achieve success in the stock market. I found it very appealing that one can achieve above-average results by consistently adhering to virtues such as patience, control of one’s emotions and scepticism as to the behaviour of crowds.
  
A follower’s disillusionment

Having read “The Intelligent Investor”, a volume of other titles such as “Security Analysis” started filling my bookshelves. I was very eager to put Graham’s intellectual framework into practice. After securing my first dream job in public market investing, I did just that. However, to my disappointment, the results of simply carbon copying Graham’s teachings in the realities of the 21st century were far from perfect.
 
Thankfully, this initial disillusionment happened during my grace period as a fresh graduate. Revisiting Graham’s work paid hefty dividends in terms of the performance of my stock picks and there are several key lessons from Graham that I can swear by today.
 
In the following essay I will discuss a number of Graham’s ideas which are still relevant to the modern investor and explain how I apply them in practice in my role as an equity analyst. 

Teacher and student a century apart

Let’s begin by reflecting on the most important changes that happened to the asset management industry since Graham’s times.
 
The most important change appears to be the increase in the competitive intensity. Since 1940, the number of mutual funds in the US grew from 68 funds to almost 8,000 in 2017, implying a CAGR in excess of 6%.1  At the same time, the hedge fund industry grew from non-existent to managing an astonishing amount of USD3.2 trillion globally.2  Personal wealth created by many market participants and the relatively low barriers to entry meant that financial and human capital poured into the sector. This is particularly important considering the declining number of stocks listed on public markets. The number of US listed companies is currently hovering around 4,000 as compared to the peak of 8,090,3  which means there are now more professional eyes looking at a lower number of companies.
 
At the same time, the sector composition of stock listed companies followed the growth of consumer companies and the decline of manufacturing. With the rise of capital light business models, which base their revenue generation on intangible assets, putting most of our attention on the balance sheet makes less intellectual sense. Whilst I am not ignoring the importance of assets and liabilities in equity analysis, I believe it is fair to say that it has declined since Graham’s times.
 
Last but not least, I should also mention the rise of passive investing which currently accounts for almost 50% of US assets under management.4  The natural implication of the rise of indexes is the automatic flow of funds into the biggest companies. The large grow larger, with no regard to the underlying fundamentals. At one of his investing classes at Columbia Business School, Graham famously said that in the long run the market is like a weighing machine. What he meant by this comparison is that in the long term what matters most is the underlying value of the business. However, the “long run” can now extend to ever longer periods, due to the distortions caused by the flows into passive funds. In today’s realities, being right in the long-term is merely symbolic when your investors ask for the funds back due to a period of underperformance.
 
The comforting constant of human nature

Despite the dramatic changes in the industry, many of Graham’s ideas are positioned with the factors that are not susceptible to change, namely human nature and the ebbs and flows of the capitalistic system.
 
None of Graham’s ideas resonate so well with me as those related to the cognitive weaknesses of our minds. Graham is a remarkable observer for simply recognising that human decision making is far from perfect when faced with the stock market environment: “Evidently, the processes by which the securities market arrives at its appraisals are frequently illogical and erroneous. These processes are not automatic or mechanical, but psychological, for they go on in the minds of people who buy or sell”.5
  
However, the fact that he created a sound intellectual framework to improve our flawed decision-making, before the progress in cognitive psychology in the second half of the 20th century, makes him a truly phenomenal thinker who should be recognised far beyond the limits of the world of investments. Interestingly, the importance of psychology in the financial markets is clearly recognised by the CFA programme which makes its future charterholders much more sensitive to the psychological biases through an elaborate study of this subject for the level 3 exam. 

I would now like to discuss three phenomena from the field of behavioural finance discussed by Graham in his writings: loss aversion, recency bias and human inclination towards lotteries. 

Numbers still speak louder than emotions

 
…at least when it comes to stock picking. The key insight into behavioural finance developed by Graham is his acknowledgement of the importance of loss aversion in investors’ decision making. Whilst it might sound obvious today, as we have the knowledge of Kahneman’s and Tversky’s academic studies on this subject,6  during Graham’s times it was truly innovative.
 
Nowadays we know that people suffer from losses more profoundly than they enjoy the wins of the same magnitude. The existence of loss aversion makes it difficult for us to invest in stocks which are ugly or obscure in some way, as our brains associate them with losses. Graham has some practical advice for us on how we can cope with loss aversion. Namely, we should have faith in our factual analysis and not feel threatened by the opinions of other market players: “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right”.7
 
Graham’s guidance is equally relevant whether we look at the lowest multiple stocks in the market or the segment of high-quality companies. A miss in quarterly earnings, a temporary increase to the cost base or a rise in the competitive intensity can create ugliness even in some of the best regarded companies.
 
As an equity analyst, I follow Graham’s advice in this respect, which gives me the confidence to see an opportunity rather than a threat in such cases. The situations that cause controversy can be a very fertile hunting ground, whatever the quality of stocks.  We just have to maintain the clarity of mind and stick to our own analysis.
 
The delusive charm of the present

Another idea presented by Graham which is rooted in psychology and which holds equally true today is the importance of the analysis of the companies’ earnings power based on many years of historical earnings.
 
Don’t take a single year’s earnings seriously”,8  advises Graham. This can help us combat one of the most destructive cognitive failures, namely the recency bias: “Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favourable business conditions. The purchasers view the current good earnings as equivalent to earning power and assume that prosperity is synonymous with safety”. 9
 
I try to implement this piece of advice by focusing on the long-term financial performance of a company, in order to minimise the risk of overpaying for a stock which has recently delivered positive performance. The above comment from Graham should be an important sanity check for all the market participants today, especially at such a late stage of the market cycle.
 
Stock market lotteries selling dreams

Lotteries have been successful in every part of the world, whether they have been managed by the government or the organised crime. Our minds find the idea of a massive pay-out difficult to resist, even when the odds are stacked clearly against us. It should not come as a surprise that the lottery mechanism has been also present in stock market investing.
 
Graham makes it very clear that we should shy away from the popular companies, as their popularity leads to the margin of safety being too small for a prudent investor: “If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily”.10
  
Just as in lotteries, despite the odds working against us on a portfolio level, some investors will still desperately search for that one multi-bagger. As an equity analyst who has covered a large number of internet stocks worldwide, I find this particularly important as the advances in technology lead to the creation of a number of fast growing but unproven business models.

No safety, know pain

Whilst Graham’s ideas with regards to the psychology of the market are important, they would be of little help without a disciplined valuation approach. The consideration of the price paid for a stock is an inherent part of an investment process of any successful value investor.
 
Let’s start by clarifying the misconception that value investing is a strategy focused on bargain stocks. The reason why Graham was so concentrated on bargain stocks was merely because his career spanned the years of the Great Depression. The only way to achieve a margin of safety, in an environment where bankruptcy was a real threat, was to invest in cheap stocks that had tangible assets supporting their valuation. Hence, we need a modified approach towards the margin of safety which accommodates the relative prosperity of the times we live in. Graham admitted that it was possible to implement value investing beyond bargain stocks: “(…) the growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment - provided the calculation of the future is conservatively made and provided it shows a satisfactory margin in relation to the price paid”.11
 
I will now discuss two practical ways to achieve the margin of safety, based on Graham’s ideas, which I apply in my career.
 
The security of understating

With most of the listed companies trading substantially above their net asset values, the market must be valuing the discounted cash flows of those entities at a substantial premium to their capital employed. So how can we implement the concept of the margin of safety in such situations?
 
For those stocks whose value is driven by future cash flows rather than their assets, the margin of safety can be achieved primarily through conservatism in the earning’s estimates. Graham wrote: “It is a basic rule of prudent investment that all estimates, when they differ from past performance must err at least slightly on the side of understatement”.12
 
Whilst such conservatism might result in missing a few opportunities, I have no doubt that investors who adhere to these words will be handsomely compensated by avoiding many disappointments. Counterintuitively, I believe that this principle is most applicable to the technology sector which has not been traditionally associated with value investing. Nowhere is conservatism in estimates needed more than in the case of rapidly growing but often unproven companies.
 
In my job I apply the worst-case scenario analysis as a permanent part of my investment framework. I treat this as a natural extension of conservatism in forecasts. Thinking through the perspective of the most pessimistic case can give us the intellectual courage to buy a stock which has been impacted by some negative developments but which can actually offer a fantastic risk-reward ratio. When we see that even the worst case is manageable, we gain the confidence against the scaremongers who suggest that the world has ended after one bad quarter. 

The one size doesn’t fit all approach

The second crucial element of the margin of safety is the price paid. “The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, non-existent at some still higher price”.13  However, to think that in order to be value investors we need to focus on low multiple stocks would be completely wrong. Such an approach would cause us to miss out on opportunities present among many high-quality stocks.
 
So what advice would Graham give us today? I believe that he would emphasise the need to consider the price in the context of the quality of the underlying business. 

I apply this idea in my career by customising the valuation method to the type of business. For instance, I believe that businesses with high barriers to entry, good pricing power and a long-track record of shareholder value creation might often be more accurately compared to bonds rather than the broad equity market. In practice, I tend to set their valuation bar higher than usual and I consider their expected returns in comparison to fixed income instruments. These stocks might be considered attractively priced when their free cash flow yield is satisfactorily high when compared to the long-term government bond yields. On the other hand, businesses with no moat which are susceptible to constant market share fluctuations should be valued on conservative estimates and low multiples.
 
Graham’s teachings on achieving the margin of safety through the price paid are just as relevant today as they were in 1930s. What might have changed though are the yardsticks we use to measure the margin of safety, due to the change in the composition of the sectors listed on public markets. 

The owner mindset

The last major idea proposed by Graham which I would like to discuss is his approach towards stocks as business ownership. I believe that Graham’s views on this topic can be divided into two main ideas: long-term holding periods and active engagement with the managements.
 
Even the most diligent fundamental analysis is of little value if it is not accompanied by a long-term approach to portfolio management. Graham understood very well that the creation of business value rarely follows the calendar periods. After all, 12 months is merely the measure of time that it takes our planet to travel around the sun. Unless our investee is an agricultural company, there is little rationale to use a period of 365 days to measure the performance of any business. No serious entrepreneur would ditch his venture after one unsatisfactory year. This idea is best represented by the following excerpt: “Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings”.14 

Many people know Graham as the father of investing in bargain stocks. However, he has been hugely underestimated as one of the first activist investors, despite the fact that his achievements in this field match those in stock picking. In particular, his letter to the Rockefeller Foundation regarding the Northern Pipe Line from June 1927 is a superb example of his ability in unlocking shareholder value.15   

Graham wrote: “The choice of a common stock is a single act; its ownership is a continuing process. Certainly there is just as much reason to exercise care and judgement in being as becoming a shareholder”.  I believe that Graham’s ideas on exercising care as shareholders are becoming increasingly important in the light of the growth of passive funds. The diminishing active investor base must now pay even more scrutiny to the managements’ behaviour, to ensure the corporate executives fulfil their role as stewards of capital. What the critics of the active management industry forget is the huge benefit to the society stemming from the continuous oversight of the corporate managements by the equity investors. 

Although not many investors will face the same intensity of activism as Graham during his fight with Northern Pipe Line’s management, we should fulfil our oversight of the managements’ activity to the best of our abilities. Let’s not forget Graham words: “The stockholders as a class are king. Acting as a majority they can hire and fire managements and bend them completely to their will”.17  Our supervision of managements’ activity could include firmly expressing our key concerns with the executives, as well as using our votes if discussions bear no fruit. 

The sweet fruit of patience

In this essay I have attempted to prove that Graham’s core teachings are timeless. Whilst some of his minor observations have become less relevant due to the structural changes in the industry, there is no doubt that his intellectual framework for stock investing remains just as valid as it was 90 years ago.
 
I have only discussed a few ideas which are still relevant today and which I personally apply in my career: the psychological aspects of stock picking, the importance of solid and tailored margin of safety and an owners’ approach to investing. There are many other lessons which we have learnt from Graham which still hold true today however these are beyond the technical limitations of this essay.

I believe that the continuing relevance of Graham’s work comes down to fundamental analysis – looking back into the past and conservatively looking forward into the future – which should give us the numerical backing and the courage to invest our own way. If we manage to overcome the omnipresent fad of mediocracy, speculation and the never-ending search for a quick gain, we can still apply Graham’s lessons in investments today, certain of the gains that they will produce in the long run.  
 

_________________________

Footnote

Anon. (2018). Data Tables. Retrieved from icifactbook.org: http://www.icifactbook.org/data/18_fb_data [last accessed on 07/04/2019 at 1:51pm]

Williamson, C. (2018, January 19). Hedge fund assets end 2017 at record $3.2 trillion – HFR. Retrieved from pionline.com: https://www.pionline.com/article/20180119/ONLINE/180119827/hedge-fund-assets-end-2017-at-record-32-trillion-8211-hfr [last accessed on 07/04/2019 at 1:54pm]

Detrixhe, J. (2018, May 9). There are now almost as many equity funds as there are stocks for them to invest in. Retrieved from qz.com: https://qz.com/1272280/there-are-now-almost-as-many-equity-funds-as-there-are-stocks-for-them-to-invest-in/ [last accessed on 07/04/2019 at 1:53pm]

Authers, J. (2018, September 1). Have we seen a peak in passive investing for the US? Retrieved from ft.com: https://www.ft.com/content/99d13606-ad2a-11e8-94bd-cba20d67390c [last accessed on 07/04/2019 at 1:52pm]

Graham, B., & Dodd, D. L. (2009). Security Analysis. New York: McGraw-Hill. P625.

Tversky, A., & Kahneman, D. (1991). Loss Aversion in Riskless Choice: A Reference-Dependent Model. The Quarterly Journal of Economics, 1039-1061.

Graham, B. (2003). Intelligent Investor: The Definitive Book on Value Investing. New York : HarperBusiness Essentials. P524.

Graham, B. (2003). Intelligent Investor: The Definitive Book on Value Investing. New York : HarperBusiness Essentials. P310.

Graham, B. (2003). Intelligent Investor: The Definitive Book on Value Investing. New York : HarperBusiness Essentials. P516.

10 Graham, B. (2003). Intelligent Investor: The Definitive Book on Value Investing. New York : HarperBusiness Essentials. P517.

11Graham, B. (2003). Intelligent Investor: The Definitive Book on Value Investing. New York : HarperBusiness Essentials. P517.

12 Graham, B. (2003). Intelligent Investor: The Definitive Book on Value Investing. New York : HarperBusiness Essentials. P517.

13 Graham, B. (2003). Intelligent Investor: The Definitive Book on Value Investing. New York : HarperBusiness Essentials. P517.

14 Graham, B. (2003). Intelligent Investor: The Definitive Book on Value Investing. New York : HarperBusiness Essentials. P523.

15 Gramm, J. (2016). Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism. New York: HarperCollins Publishers. P203.

16 Graham, B., & Dodd, D. L. (2009). Security Analysis. New York: McGraw-Hill. P575.

17 Graham, B. (2003). Intelligent Investor: The Definitive Book on Value Investing. New York : HarperBusiness Essentials. P497.

________________________

Bibliography


Anon. (2018). Data Tables. Retrieved from icifactbook.org: http://www.icifactbook.org/data/18_fb_data [last accessed on 07/04/2019 at 1:51pm].

Authers, J. (2018, September 1) Have we seen a peak in passive investing for the US? Retrieved from ft.com: https://www.ft.com/content/99d13606-ad2a-11e8-94bd-cba20d67390c [last accessed on 07/04/2019 at 1:52pm].

Detrixhe, J. (2018, May 9) There are now almost as many equity funds as there are stocks for them to invest in. Retrieved from qz.com: https://qz.com/1272280/there-are-now-almost-as-many-equity-funds-as-there-are-stocks-for-them-to-invest-in/ [last accessed on 07/04/2019 at 1:53pm].

Graham, B. (2003) Intelligent Investor: The Definitive Book on Value Investing. New York : HarperBusiness Essentials.

Graham, B., & Dodd, D. L. (2009) Security Analysis. New York: McGraw-Hill.

Gramm, J. (2016) Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism. New York: HarperCollins Publishers.

Tversky, A., & Kahneman, D. (1991) Loss Aversion in Riskless Choice: A Reference-Dependent Model. The Quarterly Journal of Economics, 1039-1061.

Williamson, C. (2018, January 19) Hedge fund assets end 2017 at record $3.2 trillion – HFR. Retrieved from pionline.com: https://www.pionline.com/article/20180119/ONLINE/180119827/hedge-fund-assets-end-2017-at-record-32-trillion-8211-hfr [last accessed on 07/04/2019 at 1:54pm].

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