For nearly the last century, Value Investing has been one of the most popular investing strategies out there. However, in the modern world, is the method being taught by people like Benjamin Graham, Warren Buffett and Phil Town still applicable?
What is Value Investing?
Put simply, value investing is an investing strategy whereby the investor finds companies whose stock price represents a good value, meaning that it is trading at a lower price than the investor believes it is really worth. The idea is that over time, the true value of the company will be realised, and the investor will make a gain.
This hinges on a particular view on the efficiency of capital markets – that the markets are not efficient in the short term, but in the long term they are. This is something I will explore later in this blog post, but I first want to explain how the value investing process works.
Now, the idea is to find an excellent company, and to buy that excellent company at a good price. A recent iteration of this strategy is taught by Phil Town, and provides a framework for valuation. It is commonly summarised by the Four Ms method.
The Four Ms
The four Ms method or, more appropriately, framework, goes as follows: Meaning, Moat, Management, Margin of Safety. I will spend some time here going through what these mean.
Meaning: Essentially this is a part of the framework that requires the investor to both care about and understand the company. Essentially this is trying to encourage newer investors to steer away from companies which are overly complex, or to blindly invest on numbers alone.
Moat: This is a nice way to talk about the competitive landscape of a business. The way that it is taught talks about a series of moats that a business may have, such a switching moat, toll moat or price moat. These are all fun ideas designed to neatly wrap up different considerations when determining the competitive landscape of a business. By the value investing methodology, it is important that the business is secure in it’s position in the industry, and won’t have its margins squeezed by expensive competition.
Management: We could devote an entire blog to the topic of what makes good managers. In fact, there are degrees that cost tens of thousands of dollars that attempt to teach you just this. Essentially, the management portion wants you to pick companies with solid management teams.
Margin of Safety: This is really the crux of value investing. The idea of a margin of safety, is to find the ‘intrinsic value’ of the business, and then to buy the stock at some margin below that, to account for any errors you may have made during your valuation. This is where the idea of buying the business at less than it is worth is expressed.
So why doesn’t this work?
This seems like a pretty solid idea, right? In fact, it is possibly the most logical way of investing. Think about it – when you have conversations with people about stocks, they will always point out how good a business is when they think it is good buy. So where does this go wrong?
The answer really lies in the sophistication of the stock market today. This may be a good time to take an aside and talk about the infamous Efficient Market Hypothesis.
The idea of the Efficient Market Hypothesis (EMH) is that the market will always reflect all information in it’s pricing. Essentially, this makes it impossible to outperform the market. Now, clearly this is wrong right? What about those hedge funds, and famous investors who earn huge returns? Well, the fact that they earn outsized returns does not necessarily break the hypothesis, and I’ll show you why.
Markets move because people trade in them. Stock prices aren’t a number that is magically generated. The stock price is just the most recent price that the stock was traded at. If was accept the premise of the EMH, nobody would earn excess returns in the market, and so nobody would bother trading in the market. But, if nobody was trading in the market, there would be no way for the information about companies to be reflected in prices, because prices can’t move without people trading.
In addition, doing research into companies, and acting on that information is costly. So, the outsize returns that people can earn by doing research is essentially the compensation that the market gives them for keeping markets efficient.
Now, getting back to our idea of value investing. The basis of the strategy is to rely on inefficiency in the markets (the stock trading below its intrinsic value) for you to make your returns.
Now, this may have worked well in Benjamin Graham’s day. In fact, we know that this has worked well by seeing the returns that Warren Buffett has achieved. But, if you look at the returns of Berkshire Hathaway’s stock over time, you will see that those returns are getting smaller and smaller.
Now, I will point this out: I am not putting the decline in Berkshire’s returns just down to my opinions on value investing. There are other reasons for it, but I do think that the returns available from value investing are declining, and here is why.
Markets are more efficient in 2019 than they were in 1959. This, I believe, is obvious. Information is more available now than ever before. In addition to that, we have more computing power available to us now than ever before. So, not only do we have more information, we also have more ability to process, analyse and act on that information. Just by this fact, we have to see that markets are more efficient, and that the ability to find stocks that are not trading efficiently much lower.
Additionally, the democratisation of markets means that there are more people out there looking for opportunities and the value investing strategy is one of the easiest out there. The central tenet that the value investor has to rely upon is that they find the opportunity first, and then others find it later, driving the stock price up and providing returns. If you are not first, then your chances of making returns are very low.
I would like to conclude this post by pointing out that I am not an expert on these topics. Nor am I arguing with the obvious wisdom and knowledge that people like Buffett have. I am simply making my own observations at to the operations of the stock market as we see it today.
My observation is that with the sophistication of technology, and the availability of information, value opportunities will be hard to come by in the market. The value investing approach relies on the inefficiency of markets, however, as I have shown, the efficient market hypothesis stands up to a good amount of scrutiny.
If you would, however, like to learn about value investing for yourself, and I encourage this, the below books will be a great starting point.