"Market commentators and investment managers who glibly refer to 'growth' and 'value' styles as contrasting approaches to investment are displaying their ignorance, not their sophistication."
Warren Buffett, 2001
The stock market will present magnificent opportunities for those who know what to look for over the next ten years. It will also be littered with the same old traps for those unaware of the vital principles for good investing. Those using an intellectually cheap and easy way to fortune will find their path strewn with dangerous temptations. Valuegrowth investing will help investors move adeptly and avoid the potential pitfalls on the path to fortune.
Valuegrowth investing is an integrated approach that brings together the requirements of growth and value in selected shares and answers the key question for investors: "What are the crucial elements leading to the successful analysis of shares?" It provides a sound intellectual framework for understanding the behavior of shares and making investment selections, as well as providing a bulwark against emotions corroding that framework.
Valuegrowth Investing is divided into two parts. The first part describes the philosophies of the world's most influential investors:
The second part fuses the main elements of these approaches with modern strategic and financial analysis to develop a philosophy and set of guidelines for the valuegrowth investor.
All investors are searching for the Holy Grail of a set of sound and profitable investment principles to guide them in share selections. Valuegrowth Investing shows that the Grail has been found. It was hidden in the writings of the great investors of the twentieth century.
Part OneINVESTING PHILOSOPHIESPeter Lynch's niche investingJohn Neff's sophisticated low price-earning ratio investingBejamin Graham: The father of modern security analysisBenjamin Graham's three forms of value investingPhilip Fisher's bonanza investingWarren Buffett's and Charles Munger's buisness perspective- Investing - Part 1Warren Buffett's and Charles Munger's buisness perspective- Investing - Part 2 Part 2THE VALUEGROWTH METHODThe valuegrowth investorThe analysis of industriesCompetitive resource analysis
A few years ago I found myself in a position to start work trying to answer an important question: 'what are the crucial elements leading to the successful analysis of shares?' The task was a daunting one. There are many that would say it is impossible to devise an easy-to-understand evaluation technique that can cope with the variety and complexity of modern companies. A general framework to identify under-priced shares could not be devised, the nay-sayers, and my own nagging small voice, would proclaim.
There are two possible routes that could be taken on a quest of this nature. The first is to immerse oneself in the academic literature on share analysis. As a teacher of finance I had some familiarity with share valuation models, and as a result knew that this route would prove largely unfruitful. Don't misunderstand me, these models do serve a purpose. They are useful for appreciating the variables that should be included in a valuation formula to calculate share value, e.g. future earnings per share. The problem is that they are little help in figuring out the factors that create the actual input number, e.g. what it is that determines the future earnings per share.
The second route (the one I took) is to conduct a study of the key elements used by the world's most respected investors. We can learn from the experience of people who, through a lifetime of endeavour, have gained insight into stock price behaviour, and who have displayed enviable performance records. There are some investors who seem to stand head-and-shoulders above the crowd. It might be possible, I reasoned, to observe the range of factors that all the great investors look for when evaluating a company and its shares. If these common elements can be put into a set of rules or a framework, and combined with modern strategic analysis and financial techniques, then I may be able to produce something of value.
The result of that work is set down in this book. Looking at it from a purely selfish viewpoint, I now have something of great value to meI have developed my own coherent investment philosophy that will guide all future personal investments. I hope readers will find a set of principles that they can employ successfully.
'Valuegrowth' investing is an easily comprehended investment philosophy based on sound principles. At the core of this philosophy is a focus on the business that underlies the share. Investors must value a share by examining the potential for a business to generate 'owner earnings'. It is the present value of these owner earnings that gives a share its intrinsic value. The crucial factors determining intrinsic value are the strength and durability of the company's economic franchise, the quality (honesty and competence) of its managers and its financial position.
The outstanding investors of the last century have been more than willing to explain their philosophies and guiding principles. Far from being fearful that other investors will emulate them, and thus destroy their 'competitive edge', they seem mystified that so few people take the time to understand what, to them, seem self-evident truths. These masters, such as Warren Buffett, Philip Fisher, Benjamin Graham, John Neff, Charles Munger and Peter Lynch have bent over backwards to explain in essays, books and speeches the key elements of their approaches. Just as importantly they have vociferously denounced those ideas and approaches that destroy investor value, or at least, distract attention and divert energy from the real issues.
My day job throughout the period spent exploring investment philosophies was that of a university lecturer and professor, in which I taught finance and strategy. In some ways this worked against my quest. For example much of the academic literature on stock markets focuses on the 'Efficient market hypothesis' (EMH) that, in effect, says it is impossible for ordinary investors using publicly available information (i.e. they are not insiders) to out-perform the market index, except by chance. Or as it is put more picturesquely: to outperform a chimpanzee selecting a broadly based portfolio of shares. (This has been tried; generally the chimp did better than professional investors.)
Many finance theorists solemnly believe that this hypothesis reflects reality. Statistical analysis has been conducted and the 'evidence' is believed to show that the modern sophisticated markets of the developed world are good at pricing stocks. There is an old joke in the academic world concerning a professor of finance who wholeheartedly believed the efficient market hypothesis to be true. One day the professor was walking towards the lecture theatre with a few students. A student abruptly interrupted the conversation to declare that there was a 20 dollar bill lying on the floor. The professor told the student not to bother to stoop down 'because if it really had been there someone would have picked it up by now.'
Even within the academic literature doubts have emerged about the EMH: shares bought on simple value principles appear to out-perform the market average; small company shares have given exceptionally high returns (for some periods, at least), and bubbles in the stock market are a serious challenge to the EMH.
Naturally, if we turn to the practitioners we get scorn poured on the whole notion of EMH. Warren Buffett said:
I'm convinced that there is much inefficiency in the market...When the price of a stock can be influenced by a 'herd' on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical... There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It's likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish.
Benjamin Graham, arguably the most influential thinker on investment in the 20th Century, took a similarly scolding view:
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 and sell. The mistakes of the market are thus the mistakes of groups of masses of individuals. Most of them can be traced to one or more of three basic causes: exaggeration, oversimplification, or neglect.
My academic work led to the study and teaching of modern strategy analysis. This had a particular focus on the resource-based view of the firma discipline developed in the 1990s. Using these tools and frameworks it is possible to analyze a firm's economic (or industry) environment and competitive position within its environment.
This knowledge is a wonderful complement to some of the guiding principles followed by the successful investors. For example, Warren Buffett talks of the strength of the firm's 'economic franchise' as being of key importance in assessing its long term value, and Peter Lynch searches for niche businesses with exclusive franchises and high barriers to entry.
After spending many years reading and thinking about the various investment methods I eventually formulated the Valuegrowth approach. Putting value and growth into one word is intended to signify that the value investment approach is not opposite to, or inimical to, the growth approach. An investor selecting a share for qualities of value should, as part of the assessment, analyze its growth potential. On the other hand, an investor judging a so-called growth stock will not pay any price, and so will look to purchase at a low price relative to its future prospects. To separate growth and value is ridiculous. I cannot put the point any more effectively than Warren Buffett:
Most analysts feel they must choose between two approaches customarily thought to be in opposition; 'value' and 'growth.' Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.
We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion the two approaches are joined at the hip; growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
In addition, we think the very term 'value investing' is redundant. What is investing if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated valuein the hope that it can soon be sold for a still higher priceshould be labelled speculation (which is neither illegal, immoral norin our viewfinancially fattening).
Whether appropriate or not, the term 'value investing' is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristicsa high ratio of price to book value, a high price-earnings ratio, and a low dividend yieldare in no way inconsistent with a 'value' purchase.
Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get it off the ground at Kitty Hawk: the more the industry has grown the worse the disaster for the owners.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low return business requiring incremental funds, growth hurts the investor. ... The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investors should purchaseirrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.
The Valuegrowth method draws on the ideas and techniques of seven distinct investment approaches. These are explained and contrasted early in the book. So, at the very least, if the reader is not content with my conclusions that Valuegrowth is best, he or she may choose to be guided by the principles set out in one or more of the progenitor approaches.
The book is divided into two parts. Part One describes stock selection philosophies developed in the 20th Century, from Benjamin Graham's current asset value approach (buying at less than two-thirds the value of working capital), to Philip Fisher's bonanza stock investing, focusing on technology growth shares.
Knowing the fundamental principles behind good investment practice is merely the first stepand the easiest. There are plenty of books on the market describing these ideas but they never seem to take the reader on to establishing practical techniques that the investor can use. This is what Part Two is designed to do. It brings together the most sophisticated elements of these approaches with modern strategic appraisal techniques to develop the Valuegrowth method. This has seven key elements:
Valuegrowth investing is a demanding discipline. To do the task properly requires dedication and freedom from time consuming distractions. The financial press is full of such wasteful ephemera: short-term market moves, monetary policy panic, share price momentum figures and so on. Throughout the book investors will be reminded not to make investing too difficult. There has to be a focus on the business. That is, after all, what an investor is buying: a piece of a business. So avoid equations with Greek letters in them, forget charts and graphs, leave aside mathematical formulas and asset allocations rules, ignore the market moods, fads and fashions. Be very sceptical about tipsters, brokers' recom-mendations and forecasters. Leave turnaround situations alone and don't be tempted by those firms that offer jam tomorrow, but will have no profit to show for the next few years, and are currently trading on a multiple of turnover.
The book also provides guidance on the frame of mind needed for a successful valuegrowth investor, for example: don't gamble, control your emotions, be patient, set reasonable goals and admit and learn from your mistakes.
The private investor reading this may be thinking that they could not possibly compete with the professional fund managers, or achieve the same returns as the great investors. This is unreasonable self-deprecation. All the successful investors say that institutional fund managers suffer from some important disadvantages compared with the dedicated private investor.
Fund managers with hundreds of millions of dollars to invest suffer from a terrible wealth withering disease: liquidity-itis. They generally restrict their analysis and purchases to those firms which have a sufficiently large free float of shares to permit millions of dollars worth of investment and, perhaps more importantly to them, disinvestment without moving the share price. As a result their investment universe tends to consist only of company stocks (and other financial assets) that have the quality of high liquidity. This 'fetish of liquidity'4 leads to large numbers of smaller and medium stocks being ignored by analysts, brokers and fund managers. There is often a high degree of ignorance of the small and medium stocks, except for the hot sectors of the day. Even within the ranks of large companies, shares fall out of fashion and become ignored by the professional investors. You are far more likely to find bargains in the relatively under-analyzed areas of the market.
Furthermore, in these areas the aware private investor has a competitive edge. Imagine the difficulty facing the institutional investor. They are often compelled to hold hundreds of stocks. This may be due to the requirements of the funds' constitution or the rules for that type of institution (e.g. pension fund rules). These rules make some sense, up to a point. It would be unacceptable for a fund manager acting as a custodian of workers' retirement funds to place that money in one basket. However, the fundamentally sound rationale behind portfolio theory and the benefits of diversification can be taken too far, and this tendency can give the private investor (or the non-conventional fund manager) an opportunity. Because institutional investment vehicles tend to end up with hundreds of stocks the funds are bound to suffer from the problems of what I call 'diminishing marginal attractiveness'. This can be illustrated if you imagine yourself having the responsibility of investing $2 billion. What would you do? Well, you might start by listing, in order of attractiveness the stocks that you judge to be good buys. You know the list has to be a large one because you simply could not invest a high proportion of this fund in one stock without losing the sought-after quality of liquidity. So let's assume you settle on 100 stocks ($20 million per stock on average) as the minimum number needed. The first one on the list would be your number one choice for appreciation - an over-looked bargain. The second stock would still have a high attraction, but would be less attractive than the first. That is, the marginal (next) stock would have a diminished attractiveness. So each stock down the list would exhibit diminished marginal attractiveness compared with the previous one. So the 90th stock is considerably less attractive than the 10th stock. Ultimately, as the portfolio gets larger the performance will tend to the merely mediocre (and that is before expenses!).
The private investor, on the other hand, can afford to avoid plunging too far down the diminishing marginal attractiveness curve. Investments can be concentrated on the top ten, or, if you are prepared to accept slightly more risk, on the top five selections.
There is another respect in which the institutional fund manager is at a disadvantage. Stuck in their offices in the financial district, dealing with the day-to-day business of holding 100, 200 or 1,000 stocks, they are pushed for time to gain personal knowledge of the businesses they buy a piece of, or those that they might like to buy. Imagine the constant noise of takeover bids for elements of the portfolio, or all the annual meetings, or management crises. It must be deafening and highly distracting. 'Many a fortune has slipped through men's fingers by engaging in too many occupations at once.' The private investor has the benefit of being able to stand back from the hubbub of the financial markets, and to go down to the shopping mall and experience buying a shirt from a new retail chain which, although small now, could revolutionize the selling of shirts; or to take time to ask children about the latest craze; or to attend trade shows where you can talk to competitors and customers of firms whose shares you are thinking of purchasing. It is the knowledge that comes from everyday experiences, by you and, as related to you by others, of the company's product or service that can often gain you the competitive edge. No amount of balance sheet analysis or macro economic forecasts while sitting in a New York skyscraper will tell you that McDonalds produce great hamburgers and have high approval rating from their customers (if you were investing in the 1950s), or that Intel (in the 1970s) have a great team of technologists much respected by their peers. But, if you are a small investor with an interest in restaurants or computer technology you can find out these key facts. The Wall Street manager is generally too busy or too distracted by the latest fashion in the markets. The manager's personal awareness has to be spread thinly whereas the private investor can specialize and focus; 'When a man's undivided attention is centred on one object, his mind will constantly be suggesting improvements of value'; or, as Azariah Rossi, a 16th Century Italian physician put it: 'None ever got ahead of me except the man of one task.'
Fund managers may also suffer from a short-term focus. Their ability is often judged through the use of quarterly performance tables. Few fund trustees or mutual fund holders would cry 'sack him' if one quarter was relatively poor, but by the time five or six poor quarters have passed, the manager might need to start brushing up the old curriculum vitae. The leading investors discussed in this book agree that a period of several quarters is far too short to appraise performance in the fickle markets of today, with their slow reaction to underlying fundamental value. Many fund managers would concur. But sadly, they are aware that their shoulders are being peered over, forcing many to behave in a short-termist fashion. They are simply unable to hold for the long term.
In contrast to these frustrated long-termists a high proportion of funds are run by people who think that the best way to outperform is to trade in the market looking to benefit from short-term trends, momentum or the current flavour of the month. These managers often believe in the 'greater fool' method of investing, in which the objective of the game is to pass on a share which is currently of great interest to the market speculators and traders after making a return on the 'investment' without really bothering to understand the fundamentals of the business. Eventually, of course, in this game of high stakes pass-the-parcel an investor pays a very high price, after being attracted by the upward price momentum of the past. Then the music stops, as the market starts to chase the next big story, and the greater fool suffers.
Institutions also have a tendency to 'churn'buying and selling shares frequently. They incur high transaction costs reducing the effective annual returns. A buy and hold strategy can make private investors wealthy rather than their brokers and advisers. Another important advantage the private investor possesses is the ability to leave the market for a while. 'Don't just do something, stand there.'7 You don't have to be in the stock market all the time. There are occasions when cash can be a valuable asset. This flexibility is much reduced for institutions.
The professional managers as a group show a strong tendency to form a consensus view. This may be due to cultural homogeneity, similarity of data sources or dominance of a few 'lead steers.' Whatever the cause, a lemming-like mentality can develop, and the shares of companies are excessively bid-up or sold off. These extreme occasions present opportunities for the patient investor able to cut himself or herself off from the crowd, think independently and really get to grips with understanding the underlying businesses.
To cap all these arguments we have the accumulating evidence that explodes a popular myth: active professional institutional fund managers do not, on average, perform better than the market index. This observation, backed up by mountains of academic research, is severely damaging for the investment industry, and therefore does not receive much publicity. But, if you dig into academic studies, you will find, time and again, evidence of poor returns, especially after transaction and management coststhese people, it seems, must be paid a great deal for dull performance, just like many CEOs.
The image of these managers being emotionally anchored and rational beings, who coolly evaluate stocks, buying when the supposedly less informed, less experienced and less emotionally controlled general public is selling in stock market panic; or who sell stocks when the over-excited private investor is piling in and pushing the market to mania levels is plain wrong. Of course there are some private investors who behave like this, but the evidence is that irrationality is as prevalent, if not more so, among professional fund managers. David Dreman comments that Securities and Exchange Commission evidence clearly shows that:
The much abused and supposedly emotional individual investor sold securities near the 1968 market top and sold at the market bottom of both 1970 and 1974. The institutional investor on the other hand, bought near market tops and sold at the bottoms. In the 1987 crash the individual investor was scarcely involved. The market panic in the third quarter of 1990 ... demonstrated once again that professional, not individual, investors were the largest, and most desperate sellers.
He goes on:
The same pattern shows clearly with mutual funds.... Rather than supporting stocks when prices plummet, they get trampled at the exit. When prices soar, they buy aggressively. The pros seem to judge the market direction poorly.
In sum: do not feel intimidated by the 'professional'. Peter Lynch and Warren Buffett call the professional investors the oxymorons. Armed with sound principles, the right emotional attitude and a modicum of intelligence, you can outperform the highly paid managers who suffer from severe con-straints created by the institutional setting, by cognitive errors and by a range of social maladies, including herd mentality.
The chapters that follow are not addressed to the complete novice. It is assumed that the reader has some acquaintance with the simpler concepts and terminology of finance and investment.
This is intended to be more than a descriptive work. It tries to convey fundamental concepts, provide practical methods and sound reasoning to guide investment selections. Theory is introduced where it is of practical benefit. However, this is kept to a minimum, not only because the reader should not be overburdened with complexity or technical methods, which are more trouble than they are worth, but, more importantly, because much of the modern theory has limited practical value.
The standards and techniques detailed are within the capabilities of all reasonably intelligent and informed investors. They are definitely not the exclusive preserve of the professional investor. Indeed being a trained 'professional' may be a distinct disadvantage in the acquisition of the skills and attitude of the Valuegrowth investor.
One aim of the book is to provide defences, in the form of principles and the strengthening of an appropriate attitude of mind, against the mood swings of the market and against the superficial and the temporary:
To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.
For those of us less than intellectually gifted, Peter Lynch offers further hope:
In terms of IQ, probably the best investors fall somewhere above the bottom 10 per cent but also below the top 3 per cent. The true geniuses it seems to me, get too enamoured of the theoretical cogitations and are forever betrayed by the actual behaviour of stocks, which is more simple-minded than they can imagine.
I hope this book will be useful in guiding you to a sound intellectual framework for making decisions, to keep emotions from corroding that framework and to understanding the actual behaviour of shares.