Among the numerous approaches conceptualized for stock selection over the decades, the strategy that has been most successful is the value investing approach. Benjamin Graham and David Dodd from the Columbia Business School are the fathers of the value investing school. The most successful of value investors have included Berkshire Hathaway’s Warren Buffett and advocate buying stocks at less than their intrinsic value.
Value investing is an investment approach that aspires to buy stocks of companies that the stock market currently undervalues or overlooks. The basic tenet of this investment philosophy is to regard owning a stock as owning a business and then to calculate the intrinsic value of the stock. Stocks that apper to be underpriced are of interest to value investors. One other significant aspect of value investing is a focus on the fundamentals of the business than external and environmental influences on the stock’s price. The basic conviction is that the movement of the stock price might not be in sync with the fundamentals of the company’s business and therefore the markets are likely to overreacts to good and bad news. Many such discrepancies present investors with opportunities to buy underpriced stocks of sound companies.
The Art of Value Investing: How the World’s Best Investors Beat the Market is a great compilation of interviews with successful investors on the practice of fundamental value investing. High-profile author Whitney Tilson is the founder and Managing Partner of Kase Capital Management and manages three value-oriented hedge funds. Here are some insightful excerpts from The Art of Value Investing.
Gotham Capital’s Joel Greenblatt on the Decision Process for Value Investing
Hedge fund manager, investor, and academic Joel Greenblatt on clarity and simplifying the decision process for value investing. Greenblatt was the founder of hedge fund Gotham Capital and co-founder (with John Petry) of the Value Investors Club.
There’s a clarity that comes with great ideas: You can explain why something’s a great business, how and why it’s cheap, why it’s cheap for temporary reasons and how, on a normal basis, it should be trading at a much higher level. You’re never sitting there on the 40th page of your spreadsheet, as Warren Buffett would say, agonizing over whether you should buy or not. If you find yourself there, it’s either not yet clear enough in your head or it’s not as striking an idea as it should be.
Artisan Partners’ James Kieffer on Fear and Uncertainly
You can usually only pay an undemanding price when there’s fear or uncertainty associated with a name. If I was stranded on a desert island and was given only one way to come up with investment ideas, I’d want to see the daily list of biggest percentage decliners. There’s no better indicator of fear and uncertainty.
Greenlight Capital’s David Einhorn on Hesitation and Self-confidence
David Einhorn is an American hedge fund manager and founder and president of Greenlight Capital, based on New York. He has authored “Fooling Some of the People All of the Time” about the various accounting irregularities at private equity investment firm Allied Capital. That book also provides great insight into the mind and deeply analytical thought processes of David Einhorn.
As our positions have gotten larger, we often find ourselves in situations where we can’t trade out positions quickly. There have been cases where we own, say, one million shares and we think we want to sell, but we can only sell 25,000 shares right away. You could say, “Why bother, it’s only 25,000 shares?” But our feeling is that’s silly–it might only help solve 2.5 percent of the problem, but the problem is now 2.5 percent smaller than it was. We also find that as you begin to exit a position, sometimes the stomach tells you whether you want to keep going, accelerate, or whether it isn’t really necessary.
Daruma Capital Management’s Mariko Gordon on Evaluating Management
Daruma Capital Management’s Mariko Gordon developed her investing skills first observing her parents manage their Hertz rent-a-car franchise in Pointe-a-Pitre, the economic capital of the French Caribbean island of Guadeloupe.
We’re looking for the prospect of an accelerating rate of positive change. That means we’re naturally drawn to management changes, turnarounds, or, more generally, to situations in which changes in the macroeconomic, competitive or regulatory landscape require a company to remake what it does or how it does it. Sometimes it’s even more straightforward, where we see unrecognized assets that can generate significant value, or when a company blew something like an acquisition or a product rollout and we believe the fix will happen more quickly and with less pain than the market expects.
Scharf Investments’ Brian Krawez on Favorability Ratio for Stock Pricing
Since we’re trying first and foremost to limit our downside, our valuation screening is centered on where a stock is trading relative to its own history. We look at various measures, but we basically go back as far as we can and calculate for each calendar year the high multiple of cash flow, say, and the low multiple of cash flow at which the stock traded. (The cash flow number we use is for that entire calendar year.) From that, we determine the median high multiple over the entire history and the median low. We’ll then look at the upside to that high and the downside to that low from today’s multiple on current-year estimated cash flow and calculate what we call a favorability ratio. We want to do further work only on companies where the favorability ratio is at least 3:1, meaning the upside to the median-high valuation level is at least 3x the downside to the low. In other words, for the multiple part of the return equation, we want the odds in our favor.