Value Investing Strategy: Does Graham Investing Still Work?

This article on value investing strategy was written by Luis C. Sánchez. Luis is a lawyer and private investor in Bogotá, Colombia who focuses on net net stocks. He is an expert in corporate law and he passed the CFA Level I exam. He manages stocks for his personal account and for clients. Article image (creative commons) by 401(K) 2012, edited by the Broken Leg Investing.

What’s a value investing strategy?

For starters, I can tell you what it’s not.

You probably have a friend who drives to his nearest store every week to buy the lottery. In the typical 6/49 lottery game, each player has a chance of winning the jackpot of only 1 in 13,983,816. The odds of dying in a car accident are about 1 in 5 million.

Show these numbers to your friend, and I bet he’d still drive his car every week to buy his lottery ticket.

Well, buying lottery tickets is the opposite of a value investing strategy.

Any value investing strategy relies on a few simple principles that Ben Graham laid out more than fifty years ago — principles that require patience and long-term thinking, which your average lottery player isn’t interested in.

However, a decade of below-average returns for value investors has some of them asking: Does Graham investing still work?

In the long term, it does, but let me tell you a story first, so that you can see why.

How Cryptocurrencies Ruined My Smart Friends

In July 2017, I took a cab in Bogota, Colombia, and the taxi driver told me he was going to quit driving soon, as he had made good money investing in Bitcoin.

He offered me a membership in a club of cryptocurrency investors. As a member of the club, I’d have the right to attend weekly lectures on cryptocurrency investing and other events. I declined.

A couple of months later, my cousin asked me what I thought about Bitcoin. She had some money to invest and wanted to buy Bitcoin “because it is going up like crazy!” I told her I didn’t know much about Bitcoin, but that she shouldn’t invest in the cryptocurrency just because it was going up.

She didn’t invest, and I felt a little weird because a month after our conversation, the price of Bitcoin doubled.

In October 2017, five friends came to me with an investment idea. They are very smart guys — all of them are engineers with masters degrees, working in great companies. I bet they all have above average IQs.

“Bitcoin is a very dangerous investment because it has gone up so fast,” one of them said. I agreed. “However, if we add other cryptos to Bitcoin in a basket, we have a very high upside potential with very limited risk,” said my other friend.

I asked why it would work, so they showed me a spreadsheet. It was advanced math with a lot of Greek letters in it. I didn’t understand a thing.

“We can double our money in less than a year. Are you in?” they asked.

I respectfully declined their offer.

They bought the basket of cryptos in November 2017. By mid-December, the price of their investment had gone up 30%. They put more money in. Now, I felt stupid.

By the end of January 2018, I read the news: Bitcoin was down 25% on the year. The other cryptos were down as well. By mid-2018, my friends had lost 90% of their principal.

Very smart guys, but they bought a lottery ticket, and lost their money accordingly.

A value investing strategy is in the opposite side of this spectrum. Value investors place their bets where the odds are in their favor.

Value Investing Strategy: Always Buy with a Margin of Safety

Talking to a group of MBA students, Warren Buffett once said:

“On my honeymoon, I traveled out west. When I visited the casino and saw all these smart well-dressed people participating in a game with the odds against them, it was then that I realized I won’t have a problem getting rich.”

Why did Buffett say that?

Because as long as people invest in the stock market hoping to get rich quick, there will be room for a value investing strategy. Value investors don’t buy lottery tickets; they buy stocks when they are cheap. They buy with a margin of safety.

So, the first principle of value investing is to always buy with a margin of safety. When is that? When the stock price is considerably lower than its intrinsic value.

Ben Graham also called this the margin of error. Say you estimate the intrinsic value of a stock is 100, but it is selling for 50. You should buy. Even if you are wrong and the stock isn’t worth 100 but only 80, you still bought with a discount.

But companies that sell at huge discounts to their intrinsic values are often troubled, forgotten, and ugly.

On the other hand, there are stocks that sell for prices far above their intrinsic value. Their prices have gone up “like crazy,” and everyone wants to buy the lottery ticket and get rich quick.

In this case, there is no margin of error. Even if you are right and company earnings keep growing, the price you paid already reflected that, so the stock price could actually stall or fall. If you are wrong and the company disappoints the market, you’re lost.

Aside from value investors’ great long-term performances, this hypothesis is also supported by academic research.

In 1985, Richard Thaler and Werner FM De Bondt published a paper in which they studied the prices of stocks on the New York Stock Exchange from 1932 to 1977.

They created two portfolios every three years. The first one, dubbed the “excellent” portfolio, had the 35 stocks that had outperformed the market in the last five years. The second one, dubbed the “bad” portfolio, had the 35 stocks that had underperformed the market in the same period. During the period studied, on average, the “bad” portfolio outperformed the market in the following 36 months by about 19 percent. The “excellent” portfolio lagged the index by about 6 percent in the same period.

While most investors focus on the “excellent” stocks, pushing their prices above their intrinsic values, the “bad” stocks are punished and their prices tumble — some of them below their intrinsic values.

“Excellent” stocks are just lottery tickets.

Value Investing Strategy: Forget About The Market

This takes me to the second principle of value investing: forget about the market — i.e. forget about market swings, the news, forecasts, your stock broker, and investment bankers.

Market swings are irrational in the short term, reflecting human emotions of greed and fear. Trying to predict market fluctuations is a waste of time.

Just focus on buying cheap stocks whenever you find them.

This is easier said than done, though. Back in the ’90s, if you were a value investor, you looked like a fool.

Remember that new tech stock your broker tried to sell you last week because its price had been going up “like crazy”?

Everyone was making money with tech stocks, while you were buying boring companies, forgotten by the crowd, with boring returns.

But then, in the year 2000, the crowd realized it was buying lottery tickets disguised as tech stocks of all sorts and panicked. The market crashed. The crowd lost it all.

Meanwhile, value investors kept patiently stacking their portfolios with bargains. The tortoise beat the hare yet again.

As Buffett likes to say, “You never know who’s swimming naked until the tide goes out.”

Value Investing Strategy: Stick to What You Know

So, value investors always buy with a margin of safety, and they forget about the market. Is there anything else?

Value investors also stick to what they know. Buffett and Charlie Munger both call this the circle of competence — only considering investments in businesses they can easily understand.

Anything that falls beyond their circle of competence is immediately dismissed.

There are, however, different value investing strategies and the circle of competence applies to the specific value investing strategy you select as well.

Most individual investors fall into the trap of trying to follow Buffett’s current investment strategy — i.e. buying excellent businesses at fair prices — instead of his initial investment strategy — i.e. buying a basket of fair businesses at excellent prices, also known as “cigar butts”.

A myriad of intelligent financial analysts and hedge fund managers follow excellent businesses and try to buy them at a fair price. But individual investors don’t have the time and resources needed to study such companies thoroughly — and even if they had the time, they probably wouldn’t find anything new.

For individual investors, the circle of competence means selecting an adequate value investing strategy from the start. Buying a diversified portfolio of deep value stocks —i.e. fair businesses at excellent prices — such as net nets, Ultra stocks, Acquirer’s Multiple stocks, or Pay Daddy stocks is actually a better choice for individual investors.

Where can you find these deep value stocks today?

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