The Curious Investor

Be warned, this is a rather long and comprehensive posts. So, here are few quickies before we get started.

• To purchase this book click the following link: Value Investing: From Graham to Buffett and Beyond (Wiley Finance).
• To check out a little stock screen that I’ve proposed based on EPV and value driven investing, check out this post at my column at Investors Paradise

After finally getting some free time, I’m happy to finally be able to post some thoughts on the book I’ve left in my sidebar for almost the entire year. I have not quite finished the “Graham to Buffett and Beyond” part of the book which actual takes up almost half of the volume of the book. It’s several profiles of the more famous practitioners of value investing and actually quite informative albeit a little bit dull. The first half of the book on the other hand is riveting. Or, as riveting as a book on company analysis can be. The book is written by value investing guru and (as I was recently informed) a very in-demand professor at Columbia, Bruce Greenwald, and several other authors whom the cover jacket describe as having equally impressive pedigree - Judd Kahn, Paul D. Sonkin, and Michael van Biema. It’s published by Wiley Finance which seems to be the ultimate source for good investing books though as the “For Dummies” series will teach you, you can’t judge a book by its publisher (if you can’t tell, my personal opinion is that the “For Dummies” series can be rather hit or miss).

Value Investing: from Graham to Buffett and Beyond (which I will just refer to as “Value Investing“) is actually a pretty short read but does require a little bit of background knowledge to understand fully. I started this book last year and spent a lot of time struggling with some of the finance and accounting concepts. After putting it down for most of the school year (not because I wanted to but due to other priorities), I found myself coming back to it and getting through it in two days. I think this is because of some of the work I put in to learning basic accounting terms and valuation techniques (namely a Discounted Cash Flow) in preparation for some interviews recently. Also, the class I took in Industrial Organization which deals with how companies compete proved to be very valuable for understanding some of the later discussion in the book.

Basically, the first half of the book introduces value investing and the characteristics of the analysis that goes into it. Essentially, value investing is true investing and is driven by a need to understand the company you’re going to invest in without the rose colored lenses of growth or projections. It is predicated on the principle of what return you could get if you bought not just shares of a company, but all of that company. Benjamin Graham, the so-called inventor of value investing, used to do this by calculating the liquidation cost of a company (the so-called net-net value) which is how much you could sell a company for if you owned it and were inclined to try to get rid of it as soon as possible. Knowing that sometimes you can’t sell something for all of what it is supposedly worth on paper, Graham developed the discipline of buying only companies which were trading at 66% of their liquidation cost. Simply put, you can’t lose if you buy a company at such a discount. If the company doesn’t manage to generate cash flow or earnings to warrant the money you invested in it, you could just sell the company and make a profit.

The authors of Value Investing point out that this strategy, while highly effective in the post-Depression economy, is less so effective today where there are fewer companies trading at such deep discounts and those who are valued so poorly by the market tend to be valued poorly for a reason. The book then presents a novel method for today’s value investor. It starts by teaching the basic method to calculating liquidation cost or net asset value using publicly available income statements. It then augments this value with another valuation technique known as Earnings Power Value which is essentially is the sum of potential earnings assuming given the current discount rate and assuming that earnings of the company are sustainable. The idea, here, is that when buying a company you are not necessarily looking to be able to sell it for profit but instead you are hoping it is a strong company which can generate a return for your investment through its earnings power. EPV since it makes some assumptions about the sustainability of earnings and the discount rate would seem to be an inherently flawed analysis but it doesn’t suffer from the multiple errors that could possibly be found in a traditional DCF and is easier to rationalize through a proper understanding of the drivers of the company in question’s earnings.

The authors of this book then provide a few case studies to show the added thought that must go into using this method for company analysis. Unlike Graham’s approach to investing which does not concern itself with the business at hand, this new method requires that a savvy investor truly understand the nature of the business he’s investing in and be able to rationalize the EPV that the company is generating for him. For a company to generate EPV greater than its net current asset value, it must have some sort of competitive advantage over its competitors, all competitors should be able to buy the assets necessary to generate the same earnings. The book describes in detail how one can go about ascertaining that the valuation provided by an EPV greater than the valuation found through the Net Current Asset Value makes sense. Armed with these two valuations, the modern value investor can now find a whole plethora of investment opportunities rather than the very narrow sphere that is provided by Graham’s traditional Net-Net Approach (according to ValueSeeker.net, there were only 4 Graham-ian Net-Nets in the US stock market at the end of 2006).

Overall, I think this book is a must read for any budding investor. While those of us with smaller sums of money to invest are less likely to be using a buy and hold strategy much less a true value strategy since we are not able to purchase enough shares of a company to be meaningfully invested in the sense that we would feel some sort of ownership of the firm, it is important to understand the principles behind value investing. First, unlike technically driven investing, it allows one to get a true understanding for why the stock market exists (no, it’s not just to allow you to make money on price anomalies). Second, investing based on fundamentals even if it is not necessarily driven by a desire to own a company and leverage its cash flow for your own benefit is one of the best ways to make high-performing, long term investments. Why do you think so many mutual funds and now ETFs offer almost mechanically driven P/E and dividend based strategies? They aren’t in it for the ownership of the company. These types of stocks do, empirically, outperform the markets. And, after reading Value Investing by Bruce Greenwald, you’ll know why and how to find them.

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