CFA UK and Brandes Essay Competition 2020 runner up essay

Thursday 19 November 2020

Jack and Beanstalk

Author: Alexander Laing, CFA

Despite ‘growth’ seemingly outperforming ‘value’, we should not confuse a cheaper price with greater value for a financial investor. However, when ‘value’ is defined as importance, we find that the central principles of value investing are of critical utility, not only now, when market exuberance is high, but indeed always.

Is there now ‘value’ in value investing ?

As someone newly feeling his way through the terra incognita of fatherhood, one of the more unexpected pleasures has been the rediscovery of the timeless classics of fairy tale fable which I am now reading to my daughter and remembering why they are indeed characterised as timeless. A particular favourite has been Jack and the Beanstalk. We all know the story; a young man impulsively exchanges the family cow for a set of magical beans and grows a towering beanstalk, at the top of which he discovers a giant’s castle. Our hero steals the golden goose, kills the giant and everyone, we are told, lives happily ever after. Which, of course, proves that most things are really just a matter of perspective. From another viewpoint, a comfortable giant, safe behind his fortified walls and enjoying a steady stream of income from his assets, finds himself abruptly and unwarrantedly overthrown by an upstart armed with nothing other than some speculative ‘magic beans’.

In recent times, this story has become the dominant narrative of the financial markets: industry giants (for which read Volkswagen, BT et al.) being felled by youthful challengers (Tesla, Zoom etc.) who manage to surmount previously impregnable moats, fuelled with often little more than the uncertain promise of growth from their own ‘magic beans’. It is an appealing tale and it is no surprise that it captures the headlines but, much like the original fairy tale, it overlooks one important participant.

The man who sells Jack the beans is never mentioned again but surely returned home pleased with his day’s work: the trade of a highly speculative opportunity with possibly attractive pay-off potential but conditional upon enormous risk with absolutely no margin of safety, in return for a tangible asset with intrinsic value far above its purchase price. This is the value investor of our tale and yet not only is he now being overlooked but his very future is being called into question, with market commentators ranging from media outlets1 to investment managers2 asking whether his obituary should be written.

This would be a myopic conclusion. The epigraph of Security Analysis, the iconic work of Benjamin Graham, universally acknowledged as the father of value investing, quotes Horace’s Ars Poetica: “many shall be restored that now are fallen and many shall fall that now are in honor [sic].” The inference was for stock picking but it may equally be attached to investment philosophy. Indeed, we shall find that not only is there great value in value investing now of all times, when ‘margin of safety’ is a forgotten watchword, but that this value, predicated upon perennial and universal truths, is as timeless as the fairy tales themselves.

For many, the term ‘value investing’ is synonymous with simply buying cheap and contrarian securities. Under this superficial heading, ‘value’ has undoubtedly never offered so much value. As of the time of writing, since its relative peak in 2007 the S&P Value has underperformed the S&P Growth by c.150% or a compound annual 7% (remarkably this underperformance is almost 40% just since the start of 2020). Likewise its relative valuation has never been cheaper, whether judged on earnings multiples such as P/E or asset-backed metrics such as price/book3. Surely this statistic alone should answer the question which the title of this essay poses?

This simplified approach, however, is unsatisfactory. The fact that a stock’s price has underperformed its peers may indeed mean that it offers more value, but this is nevertheless neither a necessary nor a sufficient condition. We do not want to become the person who, to paraphrase Oscar Wilde, knows the price of everything but not its value. These terms need to be disambiguated; as Graham himself wrote, “value…is a word of many meanings.” 4 Central to his own understanding of the concept was the idea of intrinsic value; indeed it formed the title of the very first chapter in Security Analysis. With this in mind, the relative underperformance of the S&P Value may therefore be irrelevant in the context of a broader over-valuation of the stock market. “The purchase of ‘cheap stocks’ when the market as a whole seems much higher than it should be…will not work out well” 5 is a warning that may be particularly pertinent when we note that, despite its relative divergence, the aforementioned S&P Value is still trading at 19x PE and >2x price/book, above its historical averages.

Instead, perhaps we could answer the question by arguing that the philosophy of value investing and the practices commonly associated with it, such as placing high importance on valuation multiples like price/earnings, are being undervalued by mainstream thought, especially in comparison to the overriding partiality for revenue growth that is in particular vogue across much of the market today. Here we are possibly on firmer ground. To those naysayers that claim old paradigms no longer apply in a world of global winners charging monopoly rents, where the size of addressable markets justify the attraction of unprofitable entities and where book value is meaningless in the context of high intangible net worth, we need only point to the oft-quoted adage of John Templeton that the four most expensive words in investing are ‘this time it’s different.’ One of the fundamental reasons why growth is so attractive at the current time is because long-term interest rates are anomalously depressed, thereby inflating the net present value of future earnings which are being discounted at ever lower rates6. At any moment this historically unique circumstance could unwind, reversing that entire trend and undermining growth’s credentials.

Yet, again, we find this unsatisfactory as a response. At worst it leans on the behavioural bias of the mean reversion heuristic; at best it attributes the future importance of value investing solely to interest rates, a function over which we have no control and limited foresight. For example, perhaps the disinflationary pressures of an aging population, more widespread adoption of automation and the prevalence of deflationary technology will mean that rates do indeed stay lower for longer. This is a debate whose complexity is not to be encompassed in the scope of this essay but its conclusion cannot be the only fulcrum around which the ‘value’ of value investing depends, not least because some of the most famous proponents of value investing do not concur with it. Warren Buffett, viewed by many as the natural successor to Graham’s crown, wrote in a 1977 article that low interest rates in the previous decade had made growth stocks with high earnings retention more attractive. But he did not suggest that this was antithetical to a value mindset; indeed he suggested that it was entirely compatible: “with bonds yielding only 3 or 4 percent, the right to reinvest automatically a portion of the equity coupon at 12 percent [the ROE] was of enormous value.” 7

 The reason that both of these attempted answers are so inadequate is due to their deficient understanding of what value investing actually constitutes. How indeed should we define it? Graham notably never uses the term himself, simply referring to its practise as ‘investing’, whereas everything else is merely
‘speculation’ 8. Thankfully, however, other doyens of the industry have outlined their own interpretations: Buffett defines it as looking “for values with a significant margin of safety relative to prices” 9; Seth Klarman as “the practice of purchasing securities or assets for less than they are worth” 10; and Christopher Browne neatly unifies both of these in the two simple but immutable principles of “what is it worth (intrinsic value) and don’t lose money (margin of safety).” 11

These definitions, though consistent with each other, do not align with the one-dimensional description we have previously considered, namely the search for quantitatively cheap securities, often characterised in opposition to growth. This latter approach, for example, sets the parameters for the S&P Value Index I have referenced above, which is merely comprised of those stocks whose multiples (using price/book, forward PE and dividend yield) are most divergent from the mean of the wider index. This, however, was not Graham’s advocated approach. It is true that he had a predilection for what Warren Buffett has termed ‘cigar butt stocks’ 12 but only because his was a philosophy forged out of the furnace of the Great Depression when an extreme margin of safety was the only protection against complete immolation. Nonetheless, he never promoted the purchase of securities simply because they looked cheap, nor did he caution against investing in growth. In fact quite the opposite; he was “emphatic” that “the investor who can successfully identity such growth companies when their shares are available at reasonable prices is certain to do superlatively well with his capital.” 13

Without the certainty of a discount to intrinsic price or the existence of an adequate margin of safety, it is not conclusive therefore that value investors should see more value in the market today, or the world see more value in them, simply due to the widening spread of multiples nor the proliferation of tech unicorns. Many banks may be trading below their book value but, if they aren’t making their cost of capital, perhaps this is justified. Likewise, high prices for profitless companies are defensible provided, as Howard Marks has written, “the possibility [of future profits] is real, not over-rated and not over-priced.” 14

Or perhaps, in answering this essay’s question, have we too been deceived by Graham’s “many meanings” of that protean word ‘value’? The Oxford English Dictionary’s first two definitions for it are monetary but its third expresses value in terms of how important or useful something is, and under this classification we can find greater validity. Buffett has written that “the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs” 15 and rarely has there been a time when the need for such prudence has been greater, a discipline that value investing can provide.

The central tenets of its process focus on “careful study… and sound logic” 16, which are a balm to the undeniable exuberance we see in the market today, whether manifested in the incessant chatter of financial talk shows or the accelerating volumes of Robinhood retail accounts. In a world where risk is defined as volatility or the ‘fear of missing out’, value investors remind themselves that true risk is the potential for capital loss. When 32% of the listed US tech sector is unprofitable 17, the maxim of ‘margin of safety’ (which Graham calls “the central concept of investment” 18) is essential to help us negotiate the potential pitfalls of disappointed expectations. And when societal and economic outlooks are so palpably uncertain, the concept of intrinsic value can help us ride out the vicissitudes of short-term price fluctuations.

None of this precludes the opportunity to invest in the new and exciting growth prospects of our ever-changing world (“the growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment” 19) but it does ensure that we do so rationally, with our eyes open to the risks and with an adequate buffer to protect us against the threat of unfavourable outcomes. Moreover, at a time when the momentum factor is setting new highs every day 20, it safeguards us against being lured into chasing the crowd and buying a security simply because it has already gone up (something Graham calls “the exact opposite of sound business sense” 21), setting ourselves apart from the impetuous enthusiasm of stock market speculators or, worse, the unthinking activities of passive and algorithmic trading.

I would argue that this categorically demonstrates that there is indeed ‘value’ to be found in value investing now. In fact, this can be taken further: there is always value to be found in it. An environment of exuberance, the attraction of growth and the neglect of a margin of safety are not unique to our own times. Whether one looks back to the ‘nifty fifty’ of the 1970s, the Japanese asset bubble of the 1980s or the ‘dot-com’ mania of the 1990s, there have always been those who, to quote Graham again, “are ready to abandon history and time-tested principles” 22 in their search for a return, often to their eventual detriment.

This is not to say that the principles of value investing will always be profitable for their practitioners. A review of the value investors who Warren Buffett specifically singled out as being exceptional shows that, although all had remarkable track records, none had invariable success 23. Indeed, some had periods of underperformance that lasted years.

Unfortunately this is an inevitable outcome of participating in a market that, as Howard Marks terms it, “is not an orderly and logical place” 24, especially over shorter periods of time. Even so, this does not undermine the critical importance of diligent analysis and having a clear appreciation of what one is paying for. Although it may not always seem so, over a longer-term horizon this is the only way we can be sure we will not be disappointed by the reality of our expectations.

It is unlikely that this is a conclusion which will appeal to many of today’s stock market enthusiasts, especially those that are new to its charms. In a world where quarterly numbers command the attention and where the most fascinating stocks are those that have already enjoyed stellar returns, the advocacy of such an approach will doubtless fall on many deaf ears. Likewise, nor will many heartbeats be set racing by Graham’s definition of investment as an operation which, “upon thorough analysis, promises safety of principal and an adequate return.” 26 Yet for myself, as someone who aspires to navigate these waters over the long-term, this is precisely the outcome that I would like to achieve. I am therefore happy to leave to others those dreams of magic beans and golden geese, and instead acknowledge the enormous and timeless value that value investing provides.



1 Many examples but as an illustration: CNBC, 23rd June 2019, “Is value investing dead? It might be and here’s what killed it”

2 R. Israel, K. Laursen, S. Richardson, AQR, 14th March 2020, “Is Systematic Value Investing dead?” [To be fair to them, they conclude that it is not]

3 All data from Bloomberg

4 B. Graham and D. Dodd, Security Analysis (Sixth Edition), p.100

5 Ibid, p.571

6 Amongst other examples, cf. W. Christian, R. Woltering, S. Sebastian, 1st July 2017, “The Interest Rate Sensitivity of Value and Growth Stocks - Evidence from Listed Real Estate”

7 W. Buffett, “How inflation swindles the equity investor”, Fortune magazine May 1977

8 B. Graham, The Intelligent Investor (Revised Edition), p.18

9 W. Buffett, ”The Superinvestors of Graham-and-Doddsville”, Hermes (Columbia Business School Magazine), Fall 1984

10 S. Klarman, Preface to Security Analysis (Sixth Edition), p.xiii

11 C. Browne, The Little Book of Value Investing, p.10

12 1989 Berkshire Hathaway Annual Shareholders Letter

13 B. Graham and D. Dodd, Security Analysis (Sixth Edition), p.368

14 H. Marks, “This Time it’s Different”, June 2019 Oaktree Memo

15 2017 Berkshire Hathaway Annual Shareholders Letter

16 B. Graham and D. Dodd, Security Analysis (Sixth Edition), p.61

17 A. Sacconaghi, Bernstein Research, 14th September 2020, “How does Tech compare with the 2000 bubble?”

18 B. Graham, The Intelligent Investor (Revised Edition), p.512

19 Ibid, p.517

20 Using the S&P Momentum Index as a proxy. Data from Bloomberg.

21 B. Graham, The Intelligent Investor (Revised Edition), p.2

22 Ibid, p.100

23 E. Shahan, “The Hare and the Tortoise Revisited”, Hermes (Columbia Business School Magazine), Spring 1986

24 H. Marks, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, p.133

25 B. Graham, The Intelligent Investor (Revised Edition), p.18

Alexander Laing, CFA

Alexander Laing, CFA is Equity Research Analyst at Fidelity International







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