The Evolution of Value Investing

Sris ChatterjeeFeb 26, 2015

The mission of the Gabelli Center for Global Security Analysis is to support and promote security analysis in the tradition of Graham & Dodd, Murray and Greenwald; to serve the academic needs of Fordham students, faculty and alumni; and to foster dialogue between the academic community and practitioners.

Brief Introductions

Benjamin Graham• Graduated from Columbia College, 1914• Received teaching offer from Columbia in

Philosophy, English and Mathematics• Joined Newburger, Hendersen and Loeb• Brought statistical analysis to stock investment• Started to teach at Columbia in Fall, 1927• Founder of NYSSA and Financial Analysts

Journal• Security Analysis published in 1934• Intelligent Investor published in 1949

David Dodd• Bachelor of Science, U. Penn., 1920• Master of Science, Columbia University, 1921• Instructor at Columbia, 1922-1930• Transcribed Ben Graham’s Class Notes• Ph.D., Columbia, 1930• Co-Author of Security Analysis, 1934• Professor of Finance, 1947-1961, Columbia

Business School.; Associate Dean, 1948-52• Doctor of Letters, Columbia, Honoris Causa,

1984

Roger F. Murray• Ph.D., NYU, 1942; joined Bankers Trust• Took over the Value Investing Program at

Columbia in 1956 (upon Graham’s retirement)• Appointed S. Sloan Colt Professor of Banking and

Finance, 1958 • President of AFA, 1964• Founding Trustee of the Common Fund, 1971• Chairman of Finance Committee, CREF• Co-authored the 5th edition of Security Analysis.• Delivered the Paley Center Lectures in 1993

Bruce Greenwald• Joined Columbia Business School in 1991• Relaunched Value Investing at Columbia in 1993, jointly

with Roger Murray• Appointed as Robert Heilbrunn Professor of Finance

and Asset Management, 1993• Currently, Co-Director of the Heilbrunn Center of

Graham and Dodd Investing• Author of several highly acclaimed books :

– Value Investing from Graham to Buffett and Beyond– Competition Demystified

• Strong supporter of Fordham’s Gabelli Center of Global Security Analysis

What Is Value Investing?

“We had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when the market price was at a large discount from underlying business values” (Warren Buffett, Berkshire Hathaway Annual Report, 1985, p 19).

What Is Value Investing?“We select such investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business: (1) favorable long-term economic characteristics; (2) competent and honest management; (3) purchase price attractive when measured against the yardstick of value to a private owner; and (4) an industry with which we are familiar and whose long-term business characteristics we feel competent to judge” (Warren Buffett, Berkshire Hathaway Annual Report, 1977).

What Is Value Investing?

“The value approach to common stock investment starts from the principle that a given issue is fairly ‘worth’ some suitable multiplier of its indicated earning power” (Benjamin Graham, The Intelligent Investor, p 175).

What Is Value Investing?

“A carefully selected diversified group of common stocks, purchased at reasonable prices, [can] be characterized as a sound investment policy” (Graham and Dodd – A Durable Discipline, Roger Murray, Financial Analysts Journal, Sep-Oct, 1984).

“Search for small, obscure, undesirable, mispriced companies (Greenwald et al, Value Investing, p 26-27).

The Main Ideas of Value Investing

1. Mr. Market2. Intrinsic Value

2a. Earnings Power Value and Growth2b. Private Market Value

3. Margin of Safety

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Weekly data at adjusted close from 1995 to 2015

Mr. Market and the Intrinsic Value

Mr. Market“Let us close this section with something in the nature of a parable….One of your partners, Mr. Market, …. every day tells you what he thinks your interest is worth…..Often Mr. Market lets his enthusiasm or fear run away with him” (The Intelligent Investor, page 42).

Warren Buffett describes the mood swings of Mr. Market as “euphoric” or “manic-depressive” (Letter to Shareholders, Berkshire Hathaway Annual Report 1987).

In other words, Mr. Market has “Sentiment”, and Sentiment is Irrational.

A Digression on Market Timing“Some may think that an intelligent investor should have been able to sell out much closer to the high and to buy back much nearer to the low” (The Intelligent Investor, p 34). “We are convinced that investors cannot learn to… beat the stock market. It is not that they are deficient in intelligence. The trouble is just the opposite. Too many clever and experienced people are engaged simultaneously in trying to outwit one another in the market. The result is … no more dependable than the toss of a coin (The Intelligent Investor, p 176).

On Technical Analysis

“If everybody could predict tomorrow’s or next week’s price changes, everyone could make money continuously by buying and selling at the right time. This is patently impossible. The very ‘dependability’ of such a prediction will cause human actions that will invalidate it” (Security Analysis, Sixth Edition, p 699).

On Efficient Markets

“In particular, the hypothesis of ‘efficient markets’ in its extreme form, makes two declarations: 1) The price of nearly every stock at nearly all times reflects whatever is knowable about the company's affairs; 2) Because the market has complete or at least adequate information about each issue, the prices it registers are therefore ‘correct’, ‘reasonable’ or ‘appropriate’.

I deny emphatically that because the market has all the information it needs to establish a correct price, the prices it actually registers are in fact correct”. (The Future of Common Stocks, Financial Analysts Journal, Sep-Oct 1974)

Academic Research on “Sentiment”

Investor Sentiment in Stock Market (Malcolm Baker and Joseph Wurgler, Journal of Economic Perspectives, Spring 2007)

“Sentiment and limits to arbitrage explain which stocks are likely to be most affected by sentiment. Sentiment effects are likely to be large for stocks that are hard to value and hard to arbitrage, i.e., small, unprofitable, high-volatility, unknown stocks.”

Sentiment Index (based on Trading Volume, Dividend Premium, Closed-End Fund Discount, IPO volume and First-Day Return, and Equity Share in New Issue)

A Theory for Over-Pricing

Divergence of Investor Opinion & Short Sales Constraint

When investors with heterogeneous beliefs are subject to short-sale constraint, security prices will reflect the opinion of the optimistic investors and securities will sell at a premium over their fundamental values (Risk, Uncertainty and Divergence of Opinion, Edward Miller, Journal of Finance, Sep 1977).

Takeovers and Divergence of Investor Opinion (Sris Chatterjee, Kose John and An Yan, Review of Financial Studies, v 25, no 1, 2012)

Intrinsic Value

Three Slices of Value

Asset ValueReproduction Cost of Assets• Free Entry• No Competitive

Advantage

Earnings Power Value:• Franchise

value from current competitive advantage

Value of Growth:• Only if the

growth is within the franchise and benefits from the competitive advantage

Greenwald, Kahn, Sonkin, Biena. Value Investing, 2001, pg. 44

Valuing Growth

1. Growth in Shareholder Value Depends upon a simple Intuition (most elegantly presented in Miller & Modigliani, 1961):

Invest in Projects that Give ROIC > Cost of Capital

2. How Can We Implement This Simple Rule?Through Long-Term Sustainable Competitive

Advantage

Private Market Value with a Catalyst(1)PMV is a concept used in Investment Banking to

estimate a value for the target company in M&A, based on comparable preceding transactions. In the context of Value Investing, “it is the value that an informed industrialist would pay to purchase assets with similar characteristics” (Gamco Investors, Inc. website www.gabelli.com, Value Investing _ US).

(2) Often, we need a catalyst to activate this valuation. Research in M&A shows that a “catalyst” can arise from Change in Regulation, Activist Hedge-Fund, or a Disruptive Technology.

Academic Research on Catalysts

(1) What drives merger waves? (Jarrad Harford, Journal of Financial Economics, 2005)

DeregulationGlobal Competition & MarketsFinancial Innovations and Financial MarketsChanges in Technology and Industry Condition

(2) Hedge Fund Activism, Corporate Governance, and Firm Performance (Alon Brav, Wei Jiang, Frank Partnoy and Randall Thomas Journal of Finance, 2008)

“Hedge fund activists tend to target companies that are typically "value" firms, with low market value relative to book value. The market reacts favorably to activism, consistent with the view that it creates value”.

“Fish Where the Fish Are”Evolution in the Search for Value Stocks

Results of Empirical Research

1. What has Worked in Investing (Tweedy Brown & Company)

2. Book-to-Market as a Proxy for Value Stocks

3. Global Markets and Other Securities

4. Refining the Search

Extreme Growth

Decile 2 Decile 3 Decile 4 Decile 5 Decile 6 Decile 7 Decile 8 Decile 9Extreme

Value

1926-2014 7.20 8.47 8.43 8.46 9.06 9.49 9.53 11.56 13.05 13.87

1963-2014 5.22 6.48 6.89 6.93 6.68 7.38 8.49 8.69 9.95 11.74

Source: Ken French Database and Tano Santos

The Value Premium cannot be explained by CAPM Beta, leading to the so-called Value Premium Puzzle. Using a habit-formation model, Santos and Veronesi (Journal of Financial Economics, 2010) show that solving the CAPM-puzzle produces a Cash-Flow-Risk Puzzle, i.e., value stocks have to have ‘‘too much’’ cash-flow risk compared to the data to generate empirically plausible value premiums.

Value-weighted Average Annualized Excess Returns (in percentages) for Ten Portfolios

sorted on Book-to-Market

Evidence from Global MarketsNusret Cakici and Sinan Tan, JIMF, June 2014

CountryValue

Premium(%)   CountryValue

Premium(%)  Av. Monthly     Av. Monthly

Austria 0.77 Portugal 0.37Belgium 0.49 Spain 0.29Denmark 1.35 Sweden 0.69Finland 0.44 Switzerland 0.40France 0.68 UK 0.36

Germany 0.82 Australia 0.77Greece 0.88 Hong Kong 0.89Ireland 1.51 Japan 0.97

Italy 0.55 New Zealand 0.82Netherlands 0.49 Singapore 0.99

Norway 0.97 Canada 0.80USA 0.37

Evidence from Global Markets

Value and Momentum Everywhere, Clifford Asness, Tobias Moskowitz and Lasse Pedersen, Journal of Finance, 2013

This paper finds consistent value premia across 8 diverse markets and asset classes, spanning 4 equity markets (USA, UK, continental Europe and Japan), plus global equity indices, currencies, global government bonds, and commodity futures.

The Quality Dimension of ValueValue-weighted average excess returns to double-sorted portfolios; July 1963 – Dec 2010 (Robert Novy-Marx, The Other Side of Value, Journal of Financial Economics, 2013)

Gross profits-to-asset quintiles

Low 2 3 4 High

Book-to-market quintiles

Low -0.08 0.19 0.27 0.26 0.56

2 0.19 0.30 0.40 0.70 0.90

3 0.38 0.39 0.74 0.69 0.87

4 0.50 0.60 0.94 1.04 0.93

High 0.65 0.83 0.96 1.09 1.08

Returns to Value/Glamour Strategy Conditional Upon Firm Fundamentals (J. Piotroski and Eric So, Review of Financial

Studies, vol 25, no 9, 2012)

12-Month ReturnsGlamour Middle Value V-G Diff. (t-statistic)

Unconditional -0.0549 0.0143 0.0632 0.1181 (9.813)

FSCORELow (0-3) -0.1438 -0.0328 0.0221 0.1659 (13.799)Mid (4-6) -0.0511 0.0172 0.0693 0.1204 (17.562)High (7-9) 0.0207 0.0382 0.0826 0.0619 (5.107)

High-Low 0.1644 0.071 0.0604(t-statistic) (14.010) (7.348) (5.398)

Congruent V/G Strategy 0.0014 (0.128)Incongruent V/G Strategy 0.2264 (18.727)

Final Words from Ben Graham

The Future of Common Stocks(Ben Graham, Financial Analysts Journal, Sep-Oct,

1974)

But I cannot leave my subject without alluding to another menace to equity values. This is the loss of public confidence in the financial community growing out of its own conduct in recent years. I insist that more damage has been done to stock values and to the future of equities from inside Wall Street than from outside Wall Street.

Does Finance Benefit Society?(Address to American Finance Association)

Luigi Zingales Harvard University, NBER, and CEPR

January 2015

Academics’ view of the benefits of finance vastly exceeds societal perception. This dissonance is at least partly explained by an under-appreciation by academia of how, without proper rules, finance can easily degenerate into a rent-seeking activity. I outline what finance academics can do, from a research point of view and from an educational point of view, to promote good finance and minimize the bad.

Finance and the Good SocietyRobert Shiller

“I conclude that redesigning finance to advance the Good Society entails consideration of a wide variety of factors, both from theoretical finance and from psychology, history and culture. We as educators are in our best element when we represent the full complexity of the subject to our students.”

A Proposition &

A Question