The Evolution Of Value Investing

As much as value investors wish this weren't the case, some things have changed.

I have been thinking about how Value Investing has evolved over time and reading the just-released 7th Edition of Security Analysis prompted me to dive in deeper into this topic. Seth Klarman, as the editor, assembled a group of experts to bring Graham’s timeless ideas into modern context. His own essay addressed the topic of what has changed – and what hasn’t as far as value investing is concerned.

The More Things Change…

First, what hasn’t changed? Well, the idea that all rational investing involves purchasing securities below their intrinsic value has stood the test of time. While only a small minority of market participants approach investing in that way, nothing can really change this being the only rational approach to investing.

Second, intrinsic value is still, just as in Graham’s days, based on the present value of future cash flows plus any excess assets not used to generate those cash flows. That holds true whether we are talking about a boring old railroad company or the latest AI start-up.

Finally, temperament and the mental game of investing being the key to a successful implementation of any value investing approach holds as true now as it did during Graham’s day. Recall that the father of value investing had his partnership’s portfolio decline by over 50% during the Great Depression. Furthermore, he was no spring chicken by that point, having started his career as an investor two decades prior.

To quote Seth Klarman:

Investors must be resolute in the face of withering criticism from clients and superiors and their own self-doubt during protracted periods of underperformance.

I remember when 20 years ago I, as a young analyst at Fidelity Investments, got a chance to attend a Behavioral Investing conference at Harvard. A grizzled value investing veteran presented data that even a basic value investing approach defined as buying the lowest quartile of stocks based on simple valuation statistics such as Price-to-Book and Price-to-Earnings ratios outperformed the market every rolling 10-year period.

Embarrassed to ask what was probably an obvious question in front of much more experienced practitioners, I came up to him after his talk and asked “So if value investing works so well, how come everyone doesn’t do it?” Fidelity had very few real value investors, and most portfolio managers practiced what seemed like some form of an earnings momentum strategy. The presenter gave me an understanding smile, and patiently explained:

I said that it works every 10 years. But it doesn’t work every 3 years. And that’s the amount of time it takes to lose a client or get fired. Which, in turn, would make you never see those 10 years to be proven right.

And Yet Things Have Changed

First, Graham’s reliance on low valuation statistics as the main determinant of value is less relevant today. Sure, Graham paid homage to the necessity to make sure that the business is sustainable and not facing rapid adverse change before looking at the cheapness of its securities. However, he never really gave us much of a roadmap for how to go about doing that in Security Analysis.

Klarman makes this point explicit:

While some might mistakenly consider value investing a mechanical tool for identifying statistical bargains (i.e., stocks whose price-to-book or price-to-earnings ratio falls below a certain level), it is, in actuality, a comprehensive investment philosophy based on performing in-depth fundamental analysis, pursuing long-term investment results, resisting crowd psychology, and limiting risk.

One thing that has changed since the time when Graham wrote Security Analysis is the pace with which companies can see their businesses erode. I am not sure that’s true for every business. However, there are far more businesses today where it would be easy to imagine some technological or business change occurring that would in short order reduce their profits to a shadow of their former selves.

That is a big reason why it’s so dangerous to assume that low-multiple stocks are necessarily, or even highly likely, to be undervalued. The alternative possibility – that they are the victims of the success of others must be considered much more strongly and thoroughly than in Graham’s days. I saw this firsthand early in my career as many experienced value investors jumped in to buy “cheap” newspaper stocks being impacted by the Internet, only to lose oodles of money as the business deterioration proved far worse than expected.

Or, as Klarman puts it:

… because of new technologies spurring astonishing growth in many industries and technological disruptions mortally wounding many incumbent businesses, tomorrow is much less likely to look like today than it was in Graham’s time; for some businesses, it will look significantly better, and for many others, much worse.

Intangibles have become a much bigger determinant of future success than they were in Graham’s days. That makes the Balance Sheet a much less relevant yardstick of business value than it was decades ago and makes in-depth fundamental competitive analysis much more important to arrive at an appropriate estimate of intrinsic value.

The flip side of rapid change creating losers faster and leading to historical results being a far less reliable predictor of future cash flows is that there are now more businesses which are the beneficiaries of rapid positive change. Whether and how to seek to profit from such companies is one of the most difficult questions that modern value investors face. Klarman lays out his views:

Today, business growth may have become more predictable for some companies. Many firms have built what appear to be better mousetraps, high-quality businesses with distinct capabilities that are speedily increasing their market shares. These businesses seem destined to grow well into the future, and investors who won’t pay something for that growth may miss out on owning some of the best businesses in the world. Assessing the moats and scalability of such companies has become just as important in ascertaining value today as the reported book value of a company was in Graham and Dodd’s time.

This was the section of Klarman’s commentary that I found both the most thought-provoking and most challenging to the conventional view of many value investors. Several questions came to mind:

Aren’t these businesses also the most analyzed by investors in the world, thus making it that much harder to find them at meaningfully undervalued prices?

Haven’t past eras had their own share of predictably and rapidly growing companies, such as the radio companies of the 1920s and the Nifty Fifty companies of the 1960s? If so, then why were value investors able to do just fine ignoring those in the past but are not going to be able to do so now?

Is the necessity of throwing one’s hat into the ring of trying to find an edge in analyzing these companies true only for very large, multi-billion-dollar funds that cannot necessarily pursue some of the most mispriced opportunities, or would it also apply to smaller, more nimble pools of capital?

The discussion around these questions is likely to continue for many years to come. They are not answerable on a purely theoretical basis. Over long periods of time the results of practitioners following different approaches to value investing will need to be considered as strong circumstantial evidence, albeit not decisive proof.

I will end with this thought from Seth Klarman, which I view as right on the money:

In general, for a value investor, companies that disappoint or surprise with lower-than-expected results, sudden management changes, accounting problems, or ratings downgrades are more likely to be sources of opportunity than the consistently strong performers are.

That’s just how human nature works, and how it causes the minds of market participants to under- and over- react to new information in setting security prices.

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About the author

Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.