Evolution of Value Investing: How it has Changed Since the Days of Graham

Value investors are thought to be a staid lot. Spendthrift, and always looking to the long term. The key principles of value investing have not changed since Benjamin Graham picked up his first cigar butt. But beneath the surface, things are quite different now. Before we examine how value investing today is different from value investing as practiced by Graham, let's look at the ideas that remain the same.

The Enduring Principles of Value Investing

At the very basic, value investing means paying less than the intrinsic value of an asset. If you ever bought something at a discount, you know what I mean. After getting a sweet deal, you may have considered putting the item up for sale at the regular market price, thereby netting a profit. Do it many times, and it turns into a business. In fact, if you think about it, this is what business is. If you keep your cost of goods sold lower than your revenue, you generate a gross margin. If you are in a highly liquid commodity business, as a business person, your first act is to figure out the market price, and then find out the ways of making or procuring the product at a discount, so you can then sell it to the market and make a profit. Value investors do the same. They believe that the market will bear the price that equals the intrinsic value of the stock, eventually. So, the goal of a value investor is to either,

1. find ways to buy the desired stock at a discount to the intrinsic value, or,
2. find stocks that can be purchased at a discount to the intrinsic value today

Ben Graham said, "Investing is most intelligent when it is most businesslike." Some people believe that he was referring to the fact that a stock is a fractional ownership in a business. While this is true, I think he was rather commenting on the attitude that separates an intelligent investor from the rest. An intelligent investor is businesslike because he ensures that a profit margin exists. An intelligent investor pursues profit, and the projects where profit cannot be ensured are termed speculative and avoided. How do we ensure a profit? We do this by doing everything necessary to avoid a loss. So not only we want a stock at a discount, we want the discount to be large enough to provide a margin of safety (just in case we were not smart enough when judging the intrinsic value of the stock). This is the key concept of value investing, and it doesn't change.

How Value Investing Has Changed?

What has indeed changed over the years is where investors hunt for undervalued stocks. In the days of Graham, the following were quite commonly found, but are becoming increasingly uncommon:

1. A stock with Net Current Asset Value that exceeds the market value

Net Current Asset Value or NCAV is defined as Current Assets - Total Liability. If the market value of the company is less than the NCAV, theoretically an enterprising investor can pay the market value and purchase the entire company, then use the current assets to pay off all the liabilities of the company. After the liabilities are taken care of, the investor (and now the owner) will be left with the left-over current assets, ALL the long term assets, and the business operations that can continue to create value for him, if he wishes to continue. He could also choose to sell the operations and long-term assets and generate a profit for himself. As you can see, this hypothetical company is massively undervalued. An enterprising investor gets paid to own this business. These stocks are also called net-net stocks. We have invested in several net-nets in the past. Once upon a time, there were many net-nets available in the market. Now we are lucky if we find 1 or two each year, sometimes none. 2. Underfollowed and misunderstood stocks A value investor avoids the segments of the market that are heavily scrutinized. When you have a stock where each bit of information is widely available and analyzed to death, a value investor has no edge. In the past, wall street was much smaller, and many stocks were simply not covered by an analyst. Additionally, stock quotes were available with a time lag. Most investors checked the quotes in the daily newspapers, or if they had a direct line to their broker, they might get information a few times a day. A typical investor would check even less often. Making transactions also took time. In those days, liquidity was scarce, and if a stock became undervalued, there was time for value investors to find it and do something about it. In today's market where information is widely available the instant, it is released, and the large institutional investors have bots sniffing out every possible mispricing and taking positions thousands of times per second, a value investor has lost his edge to the supercomputers and instant trades. From a large swathe of the market anyway. There are still corners and pockets of the market where analysts do not tread, and it is not worthwhile for the hedge funds to unleash their robots. These pockets are mostly within the small and micro-cap stocks. Buffett could once find a Coca Cola, or other large companies as undervalued. Today it is almost impossible to find undervalued stocks among the large-cap names. Large-cap and mid-cap markets are highly efficient. 3. Cigar buttstocks There is the last puff or two left over in a typical cigar butt that is thrown out when the smoker is done. It may be gross (poor quality), but this puff is free. Cigar butt investments are similar. It may be a dying company, but if the price of the stock is cheap enough, it can be purchased. There is always a reason for the stock price to go up one last time. Perhaps, the management goes into an aggressive cost-cutting initiative. Or activists push through a change of control. Or there is a temporary respite in the lawsuit that is bleeding the company dry. The goal is to pay the low price, and the first time the stock goes up, for any reason, sell and book profit. But what if the puff never materializes? The low price of the stock is your hedge. Likely you will not lose money. But if you do (if the stock price goes even lower), you could go ahead and buy more and buy a controlling position. Since the stock is undervalued, you may be able to sell off the assets and book a profit out of this whole deal. The concept is elegant. And if you can get past the bottom feeder connotations, these can be very attractive opportunities to make money. Graham did a bunch of these. When Buffett started his partnership, cigar butts were his main source of returns. Eventually, and under Munger's influence, Buffett moved away from underpaying for poor quality companies, to paying up for good quality companies. Now the cigar butts do still exist, it is now more likely to be infested with activists and vultures, and the last puff may never occur. The opportunities for retail investors tend to be small or non-existent. We have invested in a few cigar-butts in the past and have mostly broken even on those investments.

The Reasons why these Changes Took Place

As I see it, there is a significant difference in the market environment in Graham's days and now. Today,

1. The market is more liquid
2. Wall Street has more analysts covering many more stocks
3. Automated trading and bots close any and every small price-value variance close to instantly
4. More uninformed investors push more money to the market through index funds, that do not discriminate based on valuations, and inflate prices for all stocks in the index at the same time, and,
5. Skills have been supplanted with data-driven investing models, removing the edge investors could have had in the past
6. Buffett and Munger changed over from classical value investing to investing in quality, and many other investors followed suit

So How does a Value Investor Adapt to Today's Environment?

Every adversity creates an opportunity. So it is in investing. Where once value could be found in any part of the market, now we hunt for value on the fringes. We accept that the wall street, the bots, and the indexes have captured a large part of the stock market. However, this ubiquity creates new dislocations in the markets that value investors can take advantage of. Let's go through a few: 1. Small and micro-cap companies You can still find many stocks of smaller companies in the market that have no analyst coverage and are not included in any popular index. These stocks are small enough that the hedge funds and the automated traders have no interest in them. Even if they were interested, there is not enough liquidity in the shares for them to actually do anything much with these stocks. This is where value abounds. In fact, if you follow the factor investing models, small-cap value stocks encompass two different factors that have been observed to deliver outsized returns over the years - Value Factor and the Size Factor. Fama and French termed these Value Premium and Size Premium. 2. Special Situations These could be due to corporate actions such as a spin-off or a merger. These actions create a temporary dislocation in the market for the affected shares. For example, when Pepsi spun off Yum Brands, many Pepsi investors did not want to hold Yum Brands in their portfolio, so they sold. Some of the funds could not hold Yum Brands as their mandate will not allow it (for example, it needed to be part of an index, or it needed to be a certain size company, etc). They sold too. This spin-off and many other similar spin-offs create a temporary undervaluation in the company that is being divested. An enterprising investor can take advantage of this. Another possible special situation is investing in a company that is being acquired. There is always a discount built into the stock price (compared to the acquisition price) because there is always a risk that the acquisition may not close. Also, the stock price is marked down to reflect the time value of money. While we do know many acquisitions that fall through, the fact is that most acquisitions are not hostile and eventually go through. If this holds true, you will capture the time value of money as well as the embedded discount in the stock price. 3. Go where Most Investors Won't Go Some investors today have made a career out of investing in distressed debt and bankrupt companies. This is however not a very popular way to make a buck, because it requires a special kind of investor. It can be very lucrative, and it can carry much less risk, provided you understand the ins and outs of the bankruptcy code, know how to deal with other investors at the table who are all looking for the leftover meat on the carcass and can hold your own in the courts. You also need to be comfortable knowing that you are entering a highly illiquid world and you will not be able to unwind your position quickly if you want. 4. Be the Activist Some companies are value traps because of the entrenched management that has no interest in increasing shareholder value. Or they may be incompetent. As a value investor, you know that the value can be realized if certain changes are made in the company. But how do you impress on the company to make these changes? The fastest way to do this is to get on the board so you can participate or direct strategic and management decisions. This also gives you the opportunity to push the company towards dissolution or a merger or some other corporate action that, if not enhances, at least preserves the value that exists today. 5. Generate Returns with Proper Capital Allocation This applies to every portfolio, not just value investing portfolio. Historically, if you find a great value stock, the answer to the question "How much should I invest in it?" tends to be "As much as you can". This is not very helpful and can be dangerous advice for most investors. There is a data-driven answer to this question that maximizes your portfolio growth. It takes into account your confidence, your past win-loss ratio, and the potential rewards. I explain this more in this article where I explain how James Holzhauer is using this strategy to win big on the Jeopardy game show.

Conclusion and Next Steps

In my opinion, most investors can definitely do #1 and #2. Investing in small-cap value stocks is just a matter of focusing yourself in this sector. Special situations are a little bit rarer but common enough, and if you stay aware of what is going on in the market, you will be able to find a few on a regular basis. #3 and #4 are hard for a retail investor to do. The best bet would be to find funds that do this well and invest in that fund. Many hedge funds tend to be activists. If you can't invest in a hedge fund directly, it may be possible to purchase stocks issued by the fund company. For example, you can purchase shares in Icahn Enterprises, or Apollo Global Management. The Third Avenue mutual funds tend to go into distressed debt situations. #5 takes time as you have to build up a track record first. Once you do, you can slowly start the capital allocation strategies to increase your returns. Over time, with more data, your returns will become better and better. Finally, if you are diligent, you can still find net-nets and other classical value stocks. They are much rarer but do show up every now and then.