- What works best in individual stock and bond selection (1): buying them with a margin of safety—at a discount valuation, which helps to mitigate the risk of overpaying for a company at the outset, the chief pitfall in investing.
- This is the common-sense reason why cheap valuation multiples is a factor that delivers excess returns in study after study.
- What works best in individual stock and bond selection (2): looking for companies that are profitable and inherently stable—companies with a long, consistent track record of solid historical financial results.
- Investment portfolios that adhere to these ideas maximize the likelihood for successful investment results, including premiums over the market return, over the long-term.
In this section, we get to the heart of what works in investing, specifically the investment criteria used in building portfolios of stocks and bonds. I outline the few critical principles and methods of successful investing, as we have defined it in the Investing, Rightly Understood tab to the left. Investment funds that employ these disciplines are likely to provide the highest possible return on your investment dollars over the long-term. Stick with funds whose investment practices are founded on and adhere to these proven, common-sense disciplines. Above all, adherence to a value discipline.
Investing As a Discipline – Let’s Tip Our Caps to Graham & Dodd
As noted in the previous section, study after study has demonstrated that stocks of companies with low valuation multiples provide higher returns over the long term. As a result of this observation, proponents of the efficient market hypothesis have incorporated valuation into their models of efficient pricing, with valuation as a factor. They use the word factor as valuation can be quantified (in the same way, as discussed earlier, volatility can be quantified), and so it can be used in mathematical calculations that support approaching investing in a more scientific manner, which is a good thing.
In reality, though, investing is not a pure science like physics. Because investing is a human affair, it is rather both science and art. So, in thinking about investing, and the critical role of valuation in investing, I prefer the word discipline. First, investing is a discipline in the way medicine is a discipline, as a field of careful inquiry and practice with the purpose of achieving successful outcomes. Second, valuation is a discipline in the sense of a specific, objective criterion in evaluating and arriving at a reasoned decision on whether an investment is a good one. Finally, discipline captures an aspect of constancy, which is sticking with an established, if flexible approach—as opposed to haphazardness or giving in to temptation.
Benjamin Graham is the father of investing as a discipline, again in the way the practice of medicine is a discipline. He ran an investment firm and was a lecturer in finance at Columbia University. His two most important books are Security Analysis, which he co-authored with Columbia professor David L. Dodd, and The Intelligent Investor. As the titles of his books suggest, he championed the concept that investing, properly considered, must entail the application of reason and careful analysis. The first chapter of Security Analysis begins with this sentence: “Analysis connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic.” Enough said.
Fundamental Analysis: What Does the Company Actually Do? How and Why Does It Make Money?
The analysis Benjamin Graham elaborated and taught is today referred to as fundamental analysis. This means studying the facts available about the companies that issue stocks and bonds. Put with the utmost brevity, the analysis includes: what the company actually does (its business); the financial results the company has generated in carrying on this business, as reflected in its financial statements; an assessment of the company’s position in its markets (including relative to its peers) and of its future prospects; and finally, and quite importantly, what it is worth. The point of this analysis is to make an informed, reasoned decision on whether the stock or bonds of the company would make a good investment and should therefore be purchased. The analysis entails studying both quantitative and qualitative facts, though Mr. Graham and Mr. Dodd emphasized the primacy of the quantitative facts, the company’s financial record and current financial position above all.
Intrinsic Value: What Might the Company Be Worth?
Mr. Graham and Mr. Dodd referred to making an informed, reasoned decision as the “selective function” of analysis. Central to this selective function is valuation. All the elements of analysis, briefly listed above, feed into and inform the final element—assessing what the company is worth. What the company is worth is the summation of the analysis and the ultimate basis for selection. They referred to this assessment of a company’s worth as its “intrinsic value.”
They went to great pains to distinguish this intrinsic value from the price of the company’s shares or bonds in the market. Each day and over weeks and months, a company’s market (or trading) price is influenced by people’s decisions, and these in turn are influenced by behavioral (emotional) and speculative impulses, as much as by reasoned analysis. As a result, at any time, the price of a company’s stocks or bonds may or may not coincide with intrinsic value. In fact, the relationship between intrinsic value and current market price is the ultimate basis for selection. If a company’s shares or bonds are currently quoted above the analyst’s assessment of its intrinsic value, then it is not a good investment.
Similar to our discussion of financial returns in the Investing, Rightly Understood section, Mr. Graham and Mr. Dodd based their intrinsic value concept on future cash flows. The price a bond is worth today relates to the interest payments (coupons) over the term of the bond and the repayment of principal at the end of the term. For stocks, they discussed looking at what a company’s assets could be sold for (for example, in a liquidation of the business), net of its obligations, for one measure of intrinsic value. But a more important measure, in practice, proved to be an assessment of the intrinsic value of the company as a “going concern.” That is, what a stock is worth today based on the profit streams the company can generate going forward from running the business with its assets. To return to the car wash example we used in that earlier section, in thinking about what you’d be willing to pay to build or buy the car wash, you’d assess the free cash flow you expect the operation of the car wash to throw off each month over the (hopefully) many years to come. Mr. Graham and Mr. Dodd’s intrinsic value concept for the stock of a publicly-traded company rests on the same basic financial logic.
Mr. Graham and Mr. Dodd were quick to warn of the dangers in taking too concrete a view of intrinsic value. Intrinsic value is an assessment, however well-analyzed and reasonably considered. So, intrinsic value must be looked at as an estimate. This is particularly true for the intrinsic value of a stock, which is based on your share of the future profits of the business. Those future profits are not defined and in fact are unknown. Even when we judge a stock to meet the criteria of an investment—when we have a reasonably solid basis for estimating what the profit stream is likely to be based on the company’s financial track record—intrinsic value remains an estimate. We will make mistakes in our analysis, and even where we do not, future business conditions can change in unpredictable ways.
Margin of Safety: The Most Important Concept in Investing
In light of this acknowledged uncertainty, Benjamin Graham emphasized the concept of “margin of safety” above all others in investing. In the first edition of The Intelligent Investor, published in 1949, the title of Chapter XVI is: “’Margin of Safety’ as the Central Concept of Investment”. And here are the opening lines of that chapter, as they bear repeating:
IN THE OLD LEGEND the wise men finally boiled down the history of mortal affairs into the single phrase, “This too shall pass.” Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.
For Benjamin Graham, the chief downfall to successful investing was overpaying in the first place. That’s the most real risk we face, full stop. So, his margin of safety idea is simply to give ourselves a buffer against this risk, which will provide some room for error. Think of it like the shoulder on a parkway—even if we make a slight mistake behind the steering wheel, our tires still remain on the asphalt. With respect to intrinsic value, the idea is to require a margin of safety between our estimate of intrinsic value and the market price at which a stock or bond could be purchased. Quite pragmatically, to use a numerical illustration of our own making, if we think a share of a certain company is worth $100, that’s its intrinsic value, we should only buy it at a share price of $70 or less. This provides a $30 buffer should our estimate be off, as it may very well be, and a cushion should future events take a turn for the worse.
In discussing an inherent flaw in index investing in the last section, we noted that “a strategy of investing in stocks with low valuation multiples provides higher returns without taking any additional risk.” Having introduced you to Benjamin Graham’s margin of safety concept, we now need to amend this statement: a strategy of investing in stocks with low valuation multiples provides higher returns because it mitigates risk. Specifically, the risk of overpaying for stocks in the first place.
The truth of this statement is well illustrated by the graph below, which again looks at returns from stocks with low P/E multiples versus those for the S&P 500, again the most popular index. I focus on the period 1995 to 2003, which covers the rise and subsequent bursting of the stock market bubble. I specifically look at the annual growth of $1,000 invested in the S&P 500 versus a portfolio of those S&P 500 stocks with the lowest P/E ratios (cheapest 20%, as measured by the ratio of stock price to earnings per share over the last twelve months, after excluding companies with negative earnings), measured and rebalanced at the end of each month. I likewise look at returns on a monthly basis in order to see performance with more granularity during this period. For comparability, I market-cap weight the low P/E portfolio, consistent with the S&P 500 methodology.
In the back half of the 1990s, the market, as measured by the S&P 500, grew increasingly expensive (increasingly higher P/E ratios for the index as a whole). With the rise of the internet, exciting new technology companies saw their stock prices bid up, many of which were in or came to be placed into the S&P 500 index, given their new-found size and prominence. The technology and telecom sectors together had grown to an astounding 42% weighting in the S&P 500 by March 2000! Adding fuel to the fire, index mutual funds were growing more popular, and exchange traded funds had been introduced in the early 1990s (including the S&P 500 as the first), making it increasingly easy to buy the index as a whole, including for short-term trading and speculative purposes. Index investors simply went along for the ride.
Investors who adhered to a valuation discipline (here represented by the cheapest 20% of stocks in the index) made fine returns as well for several years. But starting in April 1999, their faith in the discipline was sorely tested. As technology stocks soared, investors plowed into them, pulling money from “old economy”, “bricks-and-mortar” stocks, many of which traded at low multiples. As value stocks turned down and technology stocks continued to rise, this “confirmed that this was the right thing to do”—the self-fulfilling prophecy stage—and the herding picked up pace. As the bubble reached its climax, the divergence in returns became dramatic in a very short period of time. From April 1999 to March 2000, the S&P 500 outperformed value stocks (bottom 20% on P/E) by over 30%.
But, in going along for the ride, index investors had committed the cardinal sin in investing, as taught by Benjamin Graham, overpaying in the first place. They paid a steep price—as the outrageously valued companies within the index fell to earth, the S&P 500 declined relentlessly for over two years, by nearly 50% when it was all over. By contrast, March 2000 marked the bottom for value stocks. As prices returned to reason, stocks trading at low valuations began to climb and they never touched that low again.
Even when the market, as measured broadly by indices, is badly inflated, there continue to be individual stocks—typically of companies in businesses viewed as out of fashion—that are not. By sticking to these stocks, those investors who stayed true to a value discipline mitigated the risk of overpaying. And they were rewarded. From June 1995 to the S&P month-end low in September 2002, S&P 500 stocks provided a 68% cumulative return—not bad given the terrible bear market—but the value stocks had more than doubled that, with a 139% cumulative return. And as we saw in an earlier graph, as a bull market began in 2003, the value stocks continued to provide higher returns for many more years.
The extreme nature of the stock market bubble that came to an end in 2000 makes for an excellent case study to illustrate the downfalls of trend following and the common sense virtues of a valuation discipline. But the lesson applies always and throughout market history. Studies, across different time periods and geographic markets, consistently show that valuation, as a factor in quantitative frameworks, provides excess return over the long-term. But it is Mr. Graham and Mr. Dodd’s intrinsic value concept and Ben Graham’s margin of safety motto that are the common sense underpinnings of why this is so. These are the concepts that must inform the practice of investing, if it is to be most successful.
Inherent Stability: Businesses Likely to Endure
Before I finish with omy homage to Mr. Graham and Mr. Dodd, we want to introduce one more of their concepts that is often less emphasized by their adherents, the concept of “inherent stability.” We think this concept is particularly relevant and useful in investing in stocks. Especially when doing in a systematic, quantitative manner—the approach we advocate and use.
In the section on Investing, Rightly Understood, I discussed how there must be a well-founded, analytical basis for our expectation of future cash flows, which ultimately are the basis for any investment. Mr. Graham and Mr. Dodd preached great caution however with respect to forecasts. Forecasting is a difficult and dangerous undertaking. It is prone to being influenced by our biases and hopes; and, in any event, the future is always uncertain, with new developments often quite out-of-the-blue.
Their caution bears on investing in stocks in particular, where, as an owner, you share in the future profits of the business; those future profits are not defined, and in fact are unknown. Nevertheless, these future cash flows are the basis for what a stock is worth, so there is a forecast, explicit or implicit, in any fundamental stock purchase. Mr. Graham and Mr. Dodd therefore emphasized an analysis of companies’ historical financial record as the truly factual basis for analysis. Forecasts (again, whether explicit or implicit) become considerably more solid when they are based on a record of historical results. They referred to this as compiling the “statistical exhibit,” which includes most importantly the useful items from a company’s historical financial statements.
Given their respect for an uncertain future, they also emphasized the concept of assessing a company’s “inherent stability,” which “means resistance to change and hence greater dependability for the results shown in the past.”(1) This assessment again relies first and foremost on quantitative analysis. To begin, the length of the track record is clearly important—as always, data becomes more informative when viewed over long stretches. We must also assess the reliability of the company’s accounting and the stability of its financial performance, even if it has varied somewhat over time, including as a result of changing economic conditions (through business cycles).(2)
In investing, the most reliable fact is a solid financial track record. And we can feel even more comfortable when the business, as measured by its historical track record, is inherently stable. Focusing on these types of companies helps reduce the likelihood of bad outcomes.
To sum up, A Sensible Approach to investing entails:
- looking for companies that are profitable and inherently stable—companies with a long, consistent track record of solid historical financial results and that offer a product or service that is likely to endure—and,
- most critically, buying them with a margin of safety—at a discount to an estimate of the company’s intrinsic value, which helps to mitigate the risk of overpaying for a company at the outset, the chief pitfall in investing and the reason why low valuation multiples is a factor that delivers excess returns in study after study.
Following these common sense principles maximizes the likelihood for successful investment outcomes. Under the Invest tab above, I discuss in detail how certain funds adhere to these sensible disciplines, Stock Funds most importantly.
(1)Benjamin Graham and David L. Dodd, Security Analysis, Sixth Edition (McGraw-Hill, 2009), 86.
(2)There is scope for qualitative assessment, relating to the fundamental nature of the business. We can best illustrate this point with examples. Let’s again take our car wash and compare it to a local retailer that designs and sells clothing to teenagers based on the popular show The Vampire Diaries. Both businesses have shown consistently solid profits over the last 5 years. We must, however, acknowledge that while people will always have a need to wash their cars (even when they become electric), interest in The Vampire Diaries among fickle teens will likely wane and their desire to wear gothic black clothing along with it. Even though the recent historical record for both look solid, the car wash is an inherently stable business, while the vampire-inspired retailer is probably not.