“The Little Book of Value Investing” by Christopher Browne is an amazingly simple and interesting book on Value Investing. Christopher was part of Tweedy, Browne company – one of the oldest value investing firms on Wall Street. This firm boasts of having served customers like Dean of Wall Street – Benjamin Graham and other legends on investing such as Walter Schloss, Warren Buffett etc.
Some valuable insights from the book are captured here and can help you on your journey towards investing.
The Concept of Value Investing
Value investing is rooted in the differentiation between price and value. We pay a ‘Price’ to buy the business and receive the ‘Value’. This value from the business flows to owners as claims on its Earnings/Cash flows (as a going concern) and Assets (as a dead business). Roger Lowenstein in the foreword of this book states “Value investing is buying securities for less than their intrinsic worth – of buying them on the basis of their underlying business value, as distinct from what is happening at the superficial level of the stock market.”
As value investors are looking for great businesses at cheap prices, they are excited when markets are down. As Christopher states “Buy stocks as you would buy groceries – when they are on sale, and not when they are high priced because everyone wants to own them. Just as it makes sense to buy groceries, cars and jeans on sale, it makes sense to buy stocks on sale, too. Stocks on sale will give you more value in return for your dollars invested. Bargains are found in the sales flyers and the new low lists, not in highfliers.”
The behavioural aspect of investing
The author states, “Most investors are driven by emotions that run the gamut from extreme pessimism to jubilant optimism. These emotions can drive valuations (read prices). The job of a smart investor is to recognize when this is happening and to take advantage of the emotional swings of the market. A rational investor sits back and waits for the market to offer stocks for less than they are worth and to buy the same stocks back for more than they are worth.” He further states, “Caution should not be seasonal. One should not rediscover caution when markets are falling and forget about it when they are rising. Maintaining a steady state of mind, whether we are in good times or bad, is the key to successful long-term investing.”
Value Investing requires the ability to go against the herd – and risk of being called a dummy from time to time. It requires a mettle to buy those stocks that the majority of investors don’t want to own. Of course, why else would they be cheap? He further states ‘Value investing does not always work’. Indeed, it works in some years precisely because it does not work in some years. The mantra of success is doing the same thing religiously year after year without deviation.
Mr Market’s Behaviour
Liquidity, Sentiments and Fundamentals influence market prices in the same sequence. The First factor to contribute to price rise is always liquidity; with increasing prices, psychology comes into play – driving people to put more cash on the table to buy businesses. Both Liquidity and Sentiments create a positive feedback loop and the market keeps rising until it is taken away significantly from the Fundamentals. Then, some prudent investors start talking about markets being away from Fundamentals. All sorts of psychology – refusal, denial and then acceptance would come in to play off and on. On the downside, again, liquidity sucked from the system, along with psychology would create a negative feedback loop to restart the process of the market being quite away from fundamentals – this time on the downside. And, this is what moves the market up and down.
The stock market always moves with expectations and unexpected results – called surprises in the market language. As surprises happen on both positive and negative sides, stocks keep reflecting them on prices continuously.
Sources of Value in Business
There are primarily two sources of value from a business – Consistent Earnings (Cash Flows, to be precise) and then Assets as a dead business. Now, as a principle, investors need to pay as little as possible in comparison to these two sources of value. Therefore, it is critical to go beyond financials and understand where the business is headed. I believe – Quality results in quantity – Qualitative parameters would reflect in Annual Reports only over a period of time.
Christopher states, “Book value, cheap earnings, balance sheet analysis and other metrics are key in identifying good prospects. But, if successful investing was a mathematical formula, everyone would have nothing but winners in their portfolios. There is some art to identifying the best prospects, and you should analyze your list of companies in greater detail.” Analyzing qualitative dimensions of the company today would ensure you have great quantities tomorrow.
Buying Value with Growth
Value with growth is an amazing combination from an investors’ perspective. It is important not to view ‘value’ and ‘growth’ as contradictory. Warren Buffett once said, “Growth and value are joined at the hip.” Value buying may give upside on a standalone basis without any growth in the business. But, if layered with earning growth, would definitely be better – because, at the same P/E, higher earnings will enhance the price of the stock and if the perception of investors towards growth opportunity shifts, it may result in complete rerating of stock and so expansion of P/E. All put together, it could offer a significant opportunity for stock appreciation to the investors.
The Value Trap
Value Trap is the term used when you catch a bad business in the falling market thinking this is a great value buy. It is like when there’s a sale in a retail store, one needs to be really careful on choosing merchandise. Buying things recklessly without quality consideration on sale may be a pain later. Christopher states “Don’t try to catch an overpriced, cheaply made falling knife.” But, how do we know whether we are in a value trap? The answer lies in awareness about the features of the product one is buying and a reasonable sense of its valuation. In the context of investments, it means understanding the businesses you buy and their valuation.
Christopher captures this point interestingly, “Screening for stocks that seem cheap on the surface is only a beginning. Blindly buying the new low list or the results of the screen could well end in investment disaster. These names are just a list of possible candidates for the shelves of our wealth-building store. We still need to examine the merchandise to make sure we are being offered quality goods at low prices and not shabby obsolete articles that are hopelessly overpriced even while appearing to be cheap.” We have to remember that winning in an investment game begins with not losing.
An Insider’s actions
How can you look at an insider’s actions? Do these actions give us some clues? What if promoters, directors and top management are buying their own stock? Is it worth looking at the business at that point in time? Yes!
There could be several reasons for promoters to sell, but there is only one reason for them to buy – make money. In most cases, we have found that whenever management is buying, there are turning points in the business which is generally not seen to the public at large or are not there in the public domain. Obviously, insiders – promoters, directors and senior management have an intimate knowledge of the business and would be the first ones to know.
Timing the market
Timing the market is virtually impossible. “Fooled by Randomness”, a book written by Nassim Nicholas Taleb, is all about that – success generated in short term by random events may make us believe that we have learnt the art of being successful, but that is not true.
Christopher states, “In more than 35 years in the investment business, I have yet to find a short-term timing strategy that works. I simply do not believe that there is a way to accurately and consistently time short-term market movements, and again, the research of scholars seems to bear me out. Predicting short-term stock market direction, however, is a fool’s game and a disservice to the investing public.” Similarly, Warren Buffett stated quite rightfully, “it is time in the market, not market timing, that counts.”
Diversifying your investments
Benjamin Graham always emphasized investment as an “operation.” In other words, performance needs to be analyzed on a portfolio basis and not on an individual stock basis and that too over a period of time. Christopher states “In any given year, every stock portfolio will hold winners and losers, and it is virtually impossible to sidestep every loser. The point is to hold more winners than losers. By diversification, you provide yourself with insurance that if one of your stocks blows up, it will not severely impact your net-worth.”
But, how many stocks would suffice from a diversification perspective – 10, 20, 30, 50 or more. While there is no hard and fast rule on the subject, if we are holding so-called top tier companies in the portfolio, we may live with 10-15 stocks. But, if it is the small and mid-capitalized stocks, diversification needs to be wider to 25-30 stocks as chances of accident (stock selection risk) are higher here.
There are two major things investors look for in a money manager – Competence and Track Record. However, other important personality traits investors should look for in their money manager are – simplicity, investing philosophy, transparency, commitment and fee primarily linked to return to investors rather than fixed, less portfolio churn (believes in the power of compounding), no conflicting interest like broking arm etc. Another important point is that money managers should not be ‘Asset Under Management (AUM)’ focused but ‘performance-focused.’
A prominent question that arises here is whether professional money managers can control their emotions and take an independent and prudent view and decide on the investments. The answer probably is ‘No’. Christopher states “It is not just everyday individual investors who fall prey to the herd mentality; it also happens to professional portfolio managers. If they own the same stocks as everyone else owns, they are unlikely to be fired if the stocks go down. After all, they won’t look quite so bad compared with their peers, who will also be down. This unique situation fosters a mindset that allows investors to be comfortable losing money as long as everyone else is losing money, too.”
Measuring performance from quarter to quarter or even year to year as a value investor is not correct. In a few years, it could be at par with the market or even worse and in some years it could be better than the market. Performance needs to be evaluated over say 5 yrs or so. Finding that kind of patient investor is really tough.
“Trees grow in silence and it takes time to produce fruits. We can’t precipitate the process. So is the case with Value Investing.”
Christopher states “By paying attention to the basic principle of buying below intrinsic value with a margin of safety and exercising patience, investors will find that the value approach continues to offer investors the best way to beat the stock market indices and increase wealth over time.” I think, a piece of knowledge, until it becomes an experience, is only theory. But, we need to make conscious and intense efforts to transform knowledge into experience.
“Invest when you don’t feel like investing and quit when you feel like investing”.