The Evolution of
Value Investing
Sris Chatterjee
Feb 26, 2015
The mission of the Gabelli Center for Global
Security Analysis is to support and promote
security analysis in the tradition of Graham
& Dodd, Murray and Greenwald; to
serve the academic needs of Fordham
students, faculty and alumni; and to foster
dialogue between the academic community
and practitioners.
Brief Introductions
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Benjamin Graham
Graduated from Columbia College, 1914
Received teaching offer from Columbia in
Philosophy, English and Mathematics
Joined Newburger, Hendersen and Loeb
Brought statistical analysis to stock investment
Started to teach at Columbia in Fall, 1927
Founder of NYSSA and Financial Analysts Journal
Security Analysis published in 1934
Intelligent Investor published in 1949
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David Dodd
Bachelor of Science, U. Penn., 1920
Master of Science, Columbia University, 1921
Instructor at Columbia, 1922-1930
Transcribed Ben Graham’s Class Notes
Ph.D., Columbia, 1930
Co-Author of Security Analysis, 1934
Professor of Finance, 1947-1961, Columbia
Business School.; Associate Dean, 1948-52
Doctor of Letters, Columbia, Honoris Causa, 1984
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Roger F. Murray
Ph.D., NYU, 1942; joined Bankers Trust
Took over the Value Investing Program at
Columbia in 1956 (upon Graham’s retirement)
Appointed S. Sloan Colt Professor of Banking and
Finance, 1958
President of AFA, 1964
Founding Trustee of the Common Fund, 1971
Chairman of Finance Committee, CREF
Co-authored the 5th edition of Security Analysis.
Delivered the Paley Center Lectures in 1993
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Bruce Greenwald
Joined Columbia Business School in 1991
Relaunched Value Investing at Columbia in 1993, jointly with
Roger Murray
Appointed as Robert Heilbrunn Professor of Finance and
Asset Management, 1993
Currently, Co-Director of the Heilbrunn Center of Graham
and Dodd Investing
Author of several highly acclaimed books :
– Value Investing from Graham to Buffett and Beyond
– Competition Demystified
• Strong supporter of Fordham’s Gabelli Center of Global
Security Analysis
What Is Value Investing?
“We had learned from Ben Graham that the key to
successful investing was the purchase of shares in good
businesses when the market price was at a large discount
from underlying business values” (Warren Buffett,
Berkshire Hathaway Annual Report, 1985, p 19).
What Is Value Investing?
“We select such investments on a long-term basis, weighing
the same factors as would be involved in the purchase of
100% of an operating business: (1) favorable long-term
economic characteristics; (2) competent and honest
management; (3) purchase price attractive when measured
against the yardstick of value to a private owner; and (4) an
industry with which we are familiar and whose long-term
business characteristics we feel competent to judge”
(Warren Buffett, Berkshire Hathaway Annual Report,
1977).
What Is Value Investing?
“The value approach to common stock investment starts
from the principle that a given issue is fairly ‘worth’ some
suitable multiplier of its indicated earning power”
(Benjamin Graham, The Intelligent Investor, p 175).
What Is Value Investing?
“A carefully selected diversified group of common stocks,
purchased at reasonable prices, [can] be characterized as a
sound investment policy” (Graham and Dodd – A Durable
Discipline, Roger Murray, Financial Analysts Journal, SepOct, 1984).
“Search for small, obscure, undesirable, mispriced
companies (Greenwald et al, Value Investing, p 26-27).
The Main Ideas of Value Investing
1. Mr. Market
2. Intrinsic Value
2a. Earnings Power Value and Growth
2b. Private Market Value
3. Margin of Safety
Mr. Market and the Intrinsic Value
S&P 500
2,500
2,000
1,500
1,000
500
0
Weekly data at adjusted close from 1995 to 2015
Mr. Market
“Let us close this section with something in the nature of a
parable….One of your partners, Mr. Market, …. every day
tells you what he thinks your interest is worth…..Often Mr.
Market lets his enthusiasm or fear run away with him” (The
Intelligent Investor, page 42).
Warren Buffett describes the mood swings of Mr. Market as
“euphoric” or “manic-depressive” (Letter to Shareholders,
Berkshire Hathaway Annual Report 1987).
In other words, Mr. Market has “Sentiment”, and
Sentiment is Irrational.
A Digression on Market Timing
“Some may think that an intelligent investor should
have been able to sell out much closer to the high and
to buy back much nearer to the low” (The Intelligent
Investor, p 34). “We are convinced that investors
cannot learn to… beat the stock market. It is not that
they are deficient in intelligence. The trouble is just the
opposite. Too many clever and experienced people are
engaged simultaneously in trying to outwit one
another in the market. The result is … no more
dependable than the toss of a coin (The Intelligent
Investor, p 176).
On Technical Analysis
“If everybody could predict tomorrow’s or next
week’s price changes, everyone could make money
continuously by buying and selling at the right
time. This is patently impossible. The very
‘dependability’ of such a prediction will cause
human actions that will invalidate it” (Security
Analysis, Sixth Edition, p 699).
On Efficient Markets
“In particular, the hypothesis of ‘efficient markets’ in its
extreme form, makes two declarations: 1) The price of
nearly every stock at nearly all times reflects whatever is
knowable about the company's affairs; 2) Because the
market has complete or at least adequate information about
each issue, the prices it registers are therefore ‘correct’,
‘reasonable’ or ‘appropriate’.
I deny emphatically that because the market has all the
information it needs to establish a correct price, the prices
it actually registers are in fact correct”. (The Future of
Common Stocks, Financial Analysts Journal, Sep-Oct
1974)
Academic Research on “Sentiment”
Investor Sentiment in Stock Market (Malcolm Baker and
Joseph Wurgler, Journal of Economic Perspectives, Spring
2007)
“Sentiment and limits to arbitrage explain which stocks are
likely to be most affected by sentiment. Sentiment effects are
likely to be large for stocks that are hard to value and hard to
arbitrage, i.e., small, unprofitable, high-volatility, unknown
stocks.”
Sentiment Index (based on Trading Volume, Dividend
Premium, Closed-End Fund Discount, IPO volume and FirstDay Return, and Equity Share in New Issue)
A Theory for Over-Pricing
Divergence of Investor Opinion & Short Sales Constraint
When investors with heterogeneous beliefs are subject to shortsale constraint, security prices will reflect the opinion of the
optimistic investors and securities will sell at a premium over
their fundamental values (Risk, Uncertainty and Divergence of
Opinion, Edward Miller, Journal of Finance, Sep 1977).
Takeovers and Divergence of Investor Opinion (Sris Chatterjee,
Kose John and An Yan, Review of Financial Studies, v 25, no 1,
2012)
Intrinsic Value
Three Slices of Value
Value of Growth:
• Only if the
growth is within
the franchise and
benefits from the
competitive
advantage
Earnings Power
Value:
• Franchise value
from current
competitive
advantage
Asset Value
Reproduction Cost of
Assets
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Free Entry
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No Competitive
Advantage
Greenwald, Kahn, Sonkin, Biena. Value Investing, 2001, pg. 44
Valuing Growth
1. Growth in Shareholder Value Depends upon a simple
Intuition (most elegantly presented in Miller &
Modigliani, 1961):
Invest in Projects that Give ROIC > Cost of Capital
2. How Can We Implement This Simple Rule?
Through Long-Term Sustainable Competitive Advantage
Private Market Value with a Catalyst
(1) PMV is a concept used in Investment Banking to
estimate a value for the target company in M&A, based
on comparable preceding transactions. In the context of
Value Investing, “it is the value that an informed
industrialist would pay to purchase assets with similar
characteristics” (Gamco Investors, Inc. website
www.gabelli.com, Value Investing _ US).
(2) Often, we need a catalyst to activate this valuation.
Research in M&A shows that a “catalyst” can arise from
Change in Regulation, Activist Hedge-Fund, or a
Disruptive Technology.
Academic Research on Catalysts
(1)
What drives merger waves? (Jarrad Harford, Journal of Financial
Economics, 2005)
Deregulation
Global Competition & Markets
Financial Innovations and Financial Markets
Changes in Technology and Industry Condition
(2)
Hedge Fund Activism, Corporate Governance, and Firm
Performance (Alon Brav, Wei Jiang, Frank Partnoy and Randall
Thomas Journal of Finance, 2008)
“Hedge fund activists tend to target companies that are typically
"value" firms, with low market value relative to book value. The
market reacts favorably to activism, consistent with the view that it
creates value”.
“Fish Where the Fish Are”
Evolution in the Search for Value Stocks
Results of Empirical Research
1. What has Worked in Investing (Tweedy Brown &
Company)
2. Book-to-Market as a Proxy for Value Stocks
3. Global Markets and Other Securities
4. Refining the Search
Value-weighted Average Annualized Excess Returns
(in percentages) for Ten Portfolios sorted on
Book-to-Market
Extreme
Decile 2
Growth
Decile 3
Decile 4
Decile 5
Decile 6
Decile 7
Decile 8
Decile 9
Extreme
Value
1926-2014
7.20
8.47
8.43
8.46
9.06
9.49
9.53
11.56
13.05
13.87
1963-2014
5.22
6.48
6.89
6.93
6.68
7.38
8.49
8.69
9.95
11.74
Source: Ken French Database and Tano Santos
The Value Premium cannot be explained by CAPM Beta, leading to the so-called
Value Premium Puzzle. Using a habit-formation model, Santos and Veronesi
(Journal of Financial Economics, 2010) show that solving the CAPM-puzzle
produces a Cash-Flow-Risk Puzzle, i.e., value stocks have to have ‘‘too much’’
cash-flow risk compared to the data to generate empirically plausible value
premiums.
Evidence from Global Markets
Nusret Cakici and Sinan Tan, JIMF, June 2014
Country
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Netherlands
Norway
Value Premium(%)
Av. Monthly
0.77
0.49
1.35
0.44
0.68
0.82
0.88
1.51
0.55
0.49
0.97
Country
Portugal
Spain
Sweden
Switzerland
UK
Australia
Hong Kong
Japan
New Zealand
Singapore
Canada
USA
Value Premium(%)
Av. Monthly
0.37
0.29
0.69
0.40
0.36
0.77
0.89
0.97
0.82
0.99
0.80
0.37
Evidence from Global Markets
Value and Momentum Everywhere, Clifford Asness, Tobias
Moskowitz and Lasse Pedersen, Journal of Finance, 2013
This paper finds consistent value premia across 8 diverse
markets and asset classes, spanning 4 equity markets (USA,
UK, continental Europe and Japan), plus global equity
indices, currencies, global government bonds, and
commodity futures.
The Quality Dimension of Value
Value-weighted average excess returns to double-sorted
portfolios; July 1963 – Dec 2010 (Robert Novy-Marx, The Other
Side of Value, Journal of Financial Economics, 2013)
Gross profits-to-asset quintiles
Low
2
3
4
High
Low
-0.08
0.19
0.27
0.26
0.56
2
0.19
0.30
0.40
0.70
0.90
3
0.38
0.39
0.74
0.69
0.87
4
0.50
0.60
0.94
1.04
0.93
High
0.65
0.83
0.96
1.09
1.08
Book-to-market quintiles
Returns to Value/Glamour Strategy Conditional Upon Firm
Fundamentals (J. Piotroski and Eric So, Review of Financial Studies, vol
25, no 9, 2012)
Unconditional
Glamour
-0.0549
12-Month Returns
Middle
Value
V-G Diff.
0.0143
0.0632
0.1181
FSCORE
Low (0-3)
Mid (4-6)
High (7-9)
-0.1438
-0.0511
0.0207
-0.0328
0.0172
0.0382
0.0221
0.0693
0.0826
High-Low
(t-statistic)
0.1644
(14.010)
0.071
(7.348)
0.0604
(5.398)
Congruent V/G Strategy
Incongruent V/G Strategy
(t-statistic)
(9.813)
0.1659
0.1204
0.0619
(13.799)
(17.562)
(5.107)
0.0014
0.2264
(0.128)
(18.727)
Final Words from Ben Graham
The Future of Common Stocks
(Ben Graham, Financial Analysts Journal, Sep-Oct, 1974)
But I cannot leave my subject without alluding to another
menace to equity values. This is the loss of public
confidence in the financial community growing out of its
own conduct in recent years. I insist that more damage has
been done to stock values and to the future of equities from
inside Wall Street than from outside Wall Street.
Does Finance Benefit Society?
(Address to American Finance Association)
Luigi Zingales
Harvard University, NBER, and CEPR
January 2015
Academics’ view of the benefits of finance vastly exceeds societal
perception. This dissonance is at least partly explained by an
under-appreciation by academia of how, without proper rules,
finance can easily degenerate into a rent-seeking activity. I
outline what finance academics can do, from a research point of
view and from an educational point of view, to promote good
finance and minimize the bad.
Finance and the Good Society
Robert Shiller
“I conclude that redesigning finance to advance the
Good Society entails consideration of a wide
variety of factors, both from theoretical finance
and from psychology, history and culture. We as
educators are in our best element when we
represent the full complexity of the subject to our
students.”
A Proposition
&
A Question