What Is Value Investing?
Value Investing Definition, History, and Overview
At Kennon-Green & Co., we are committed value investors. Every single allocation decision we make for our private clients is processed through that value investing lens combined with our fiduciary operating model. Beyond that, for more than twenty years, I have written and educated generations of investors about practical ways value investing can be applied to making their own fortune, and, to one extent or another, chronicled how the investment philosophy played a major role in achieving my financial independence early in life. Yet, every day, innumerable new investors enter the market who may not understand what value investing is, why it matters, and the reason for its well-studied historical record.
First, let’s start with the foundation by answering the question, “What is value investing?”
The Definition of Value Investing
At its core, value investing can be defined as an investment philosophy in which a rational, prudent person seeks to calculate the true value, known as the “intrinsic value”, of a productive asset. In practice, intrinsic value is best thought of as a range of values and is calculated by attempting to conservatively estimate all the cash flows the asset will generate between now and doomsday, then using time value of money formulas to discount those cash flows back to the present at an appropriate discount rate. The investor then seeks to buy those assets that represent a better-than-reasonable chance of a satisfactory outcome.
Real-World Intelligent Implementation of a Value Investing Strategy Is Much More Complicated
Actual implementation of a successful value investing strategy is more complicated, of course. As we live in an uncertain world, and all investments possess the potential for losses, a good deal of thought will go into overall portfolio construction in addition to the intrinsic value of each holding so that when one or more components of the portfolio invariable disappoint, success can still be achieved over the longer term. For example, for a wealthy retiree who needs to live upon his or her capital for the rest of their life, a well-designed investment portfolio that factors in their unique needs, circumstances, and risk tolerance might involve a heavy allocation in reasonably priced consumer staples stocks, even if paying at or near estimated intrinsic value, because the stability of cash flows, balance sheet strength, and history of growing dividends has significant utility.
Central to the definition of value investing are two concepts developed by Benjamin Graham, who we will discuss in a moment.
The first is a concept known as the “margin of safety”. The margin of safety represents the discount the investor pays relative to his or her estimate of intrinsic value. The bigger the discount, the greater the buffer for something to go wrong while still having the investment work out over the years and decades. For example, if the conservatively estimated intrinsic value of a stock is $100 per share, and an investor buys it for $60 per share, it should work out in the long run even if the stock collapses to $30 subsequent to acquisition. Provided that the enterprise is churning out cash, and intrinsic value is stable and/or growing, getting upset about the 50% drop post-purchase is, in the words of the father of value investing, Benjamin Graham, to allow yourself to get upset at “other people’s mistakes in judgment”.
The second is the concept of “Mr. Market”. Graham correctly realized that the quoted market price of a stock is not always efficient nor rational; that it can sometimes deviate materially from the real value of the business. Yet, over and over investors blew up their own portfolios because they would be consumed with either fear or greed at precisely the wrong time, influenced by what was happening on the ticker tape. They bought when stock prices were increasing. They sold when stock prices were decreasing. It was folly and madness. To combat it, Graham encouraged his students to think of the stock market as a gentleman named Mr. Market with whom the student had entered into partnership. Mr. Market was a fine fellow except he suffered from severe mental distress and was prone to wild swings of emotion. Each day, he showed up at your office and offered to buy your stake, or sell you his stake. The choice was yours. Depending upon the vacillation of his mood, the price may range anywhere from offensively low to absurdly high. The logical thing to do under such circumstances was to think of Mr. Market’s offer as being there for you to take advantage of if, and only if, you felt it made sense to do so in light of the actual business operations. That is, a prudent person would not grow despondent if he quoted a too-low price, each quote coming in below the offer he made yesterday, or last week, because it was perfectly evident that the actual value of the business arose from its assets and cash flows; the money it produced as a result of selling real products and/or services to real customers. Graham felt the construct of Mr. Market was essential because he noted the psychological benefit enjoyed by many real estate investors during the Great Depression. Unlike stock investors, real estate owners were not forced to watch a constant stream of declining quotes on their property despite economic reality being quite similar – had any of them tried to sell, they would have found the price they could realize would have been far below what could have been achieved a couple of years earlier as the worst economic collapse in six hundred years unfolded – dramatically reducing the propensity to panic.
Benjamin Graham – The Father of Value Investing
Ben Graham was born on May 9th, 1894 and passed away on September 21st, 1976. A brilliant man, Graham had a long and interesting career operating the Graham-Newman investment partnership and, later, teaching as a professor at Columbia University in New York then UCLA in California. Early in his life, he was wiped out when the Great Depression hit, causing him to devote his considerable intellect to developing a quantitative and qualitative philosophy that could be applied consistently to portfolio management, including the selection of individual portfolio components, that would dramatically improve the probabilities of a successful outcome while minimizing the chances of economic disaster.
Working with fellow professor David Dodd, Graham published the first edition of Security Analysis in 1934. The Security Analysis series, which was extraordinarily detailed and meant for professional investors, laid out his newfound value investing philosophy by demonstrating that the single most important aspect of investment returns came down to the price an investor paid for the asset; that a great asset, bought at a terribly high price, would likely not work out well whereas a mediocre asset, bought at a sufficiently low price, could generate a handsome profit. Later, in 1949, Graham published the first edition of The Intelligent Investor, a book meant for non-professional investors. Both investment series would be updated many times over the decades, enjoying a phenomenal publishing run with copies still in print today.
During Graham’s academic career, a good portion of the students he taught went on to become successful self-made millionaires and billionaires. Arguably no single professor before or since has helped such a large proportion of their students generate the kind of personal wealth and success that Graham did. In terms of second-order and third-order effects, the consequences are unfathomable. For example, Ben Graham’s most famous student was Warren Buffett, the Chairman and CEO of Berkshire Hathaway, Inc. Buffett worked for Graham’s investment partnership before striking out on his own in the 1950s which, in turn, and through a strange quirk of fate, helped the Omaha-based capital allocator transform a poorly performing textile company into one of the largest conglomerates in history, making scores of individuals and families wealthy beyond comprehension during the journey.
The Different Types of Value Investing
One of the more remarkable things about Benjamin Graham’s value investing philosophy was that his students did not practice it in the same way despite the outsized success they enjoyed. Some were deep value investors. Some were growth-at-a-reasonable price value investors. Some focused on international value investing. Some value investors even focused on “special operations” such as convertible securities arbitrage.
Walter Schloss: To provide some real-world examples, some of Graham’s students, such as the late value investing legend Walter Schloss, bought terrible companies at deeply discounted prices and, over a roughly 45-year period, proceeded to generate compounded annual returns of 15.3% versus 10% for the S&P 500. [Source: Investment Leadership: Building a Winning Culture for Long-Term Success. by James W. Ware, Beth Michaels, Dale Primer. Published by John Wiley and Sons, 2003. pg. 124] Schloss was well-known for not caring much about what a business did, or how good or bad it was to own long-term, provided he could get a large enough discount to intrinsic value.
Sir John Templeton: Another of Graham’s students, Sir John Templeton, went on to make a fortune first by purchasing wide swaths of stocks at severely discounted prices during the Great Depression then, later, launching an asset management firm that specialized in international value investing. Templeton became a billionaire in no small part to his willingness to accumulate deeply undervalued Japanese stocks at a time when most investors eschewed the international equity markets.
Warren Buffett: Mentioned earlier as Ben Graham’s most famous student and former employee, Warren Buffett transformed the value investing philosophy by combining it with the lessons found in Philip Fisher’s Common Stocks and Uncommon Profits thanks, in part, to the influence of another self-made billionaire value investor, Charles Munger. Rather than buying poor businesses for a cheap price, Buffett modified his approach and, by the 1970s, was routinely searching for excellent businesses that he could buy at a discounted price or, in some cases, even full fair value, opting to hold many of those stakes for decades in order to benefit from the compounding process and lack of capital gains taxes. The “secret sauce”, in Buffett’s case, was combining this approach with the float generated from the insurance and reinsurance companies he had Berkshire Hathaway acquire and/or establish, effectively giving him the benefit of leverage with few of the drawbacks.
The list is far more considerable than the few names detailed here, each of whom is worth a detailed case study of their own.
What Kind of Value Investing Does Kennon-Green & Co. Practice?
In summary, our preference is to find truly extraordinary businesses – companies that generate what we believe are likely to be sustainably high returns on capital with defensible competitive advantages that we hope give us a better-than-average chance of compounding for decades without having to sell the position absent client-specific reasons – and to pay reasonable, or better yet, deeply discounted, prices. As I alluded in a recent article, Investing in Stocks as a Long-Term Inflation Hedge, we are perfectly happy owning businesses that the rest of the world considers boring – those that don’t make the headlines and which sell things like chocolate, spices, coffee, toilet paper, whiskey, carbonated beverages, general and industry-specific software-as-a-service enterprises – as we think profitability is exciting enough on its own.
For a more detailed explanation of our value investing strategy, including the characteristics and traits we look for in a holding, please read Our Investment Philosophy.
