THE EVOLUTION of VALUE INVESTING Past, Present and Beyond

THE EVOLUTION OF VALUE INVESTING Past, Present and Beyond

20 FINANCIAL HISTORY | Spring 2014 | www.MoAF.org By Joseph Calandro, Jr. (where risk is defined as the possibility of and Frederick J. Sheehan loss) due to the “margin of safety” afforded by the discount from liquidation value. Considering the popularity of value Over time, some investors would come to investing, it is somewhat surprising that a base margins of safety off of earnings power paper recently published by Joseph Calan- and even growth value in addition to the dro in the Journal of Investing was the first balance sheet. Exhibit 1, taken from Profes- formal attempt to categorize the develop- sor Bruce Greenwald’s popular book Value ment of this highly-effective and influential Investing: From Graham to Buffett and school of thought over time. The following Beyond, profiles the different approaches article summarizes this categorization of of modern value investing, as well as some value investing’s past and present and offers of the professionals associated with each suggestions on what its future may hold. approach as of the book’s publication. The cornerstone of value investing has Founding Era: 1934 to 1973 always been, and will always remain, firmly grounded in the margin of safety principle, The “official” founding of value investing regardless of how any specific margin may can be dated to 1934 with the publication be estimated. The Founding Era effec- of Benjamin Graham and David Dodd’s tively ends with the publication of the 1973 seminal book, Security Analysis. The stra- edition of Graham’s immensely popular tegic concept upon which value investing book, The Intelligent Investor, which dis- was founded is as insightful as it is simple; tills lessons from Security Analysis to a namely, that assets purchased at prices for non-professional audience. Shortly after less than their liquidation value (estimated the book’s publication, in 1976, Graham as current assets less total liabilities or passed away at the age of 82. “net-net value”) provide an opportunistic and relatively low risk form of investment Post-Graham Era: 1973 to 1991 The start of the Post-Graham Era coincides with the great 1973–74 bear market which, Benjamin Graham (left) with amongst other things, presented numer- General Robert E. Wood, 1955. ous investment opportunities akin to those

Exhibit 1: Approaches to Value Investing

CLASSIC MIXED CONTEMPORARY

Graham Gabelli Buffett Tweedy, Browne Neff Greenberg Schloss & Schloss Price Ruane, Cuniff Heine Royce Heilbrunn Greenblatt Klarman Whitman Sonkin

Diversified portfolio Replacement value Concentrated portfolio Tangible assets Sufficient research Intense research Cursory research Private market value Franchise value Unpresentable Catalyst Attractive but not sexy “Wounded ducks” Relative value Owning the business In the shadows Bland “Wounded eagles” Normalized earnings Hiding in plain site Temporarily offstage

Source: Bruce Greenwald, et al., Value Investing: From Graham to Buffett and Beyond (NY: Wiley, 2001),

www.MoAF.org | Spring 2014 | FINANCIAL HISTORY 21 seen at the beginning of the Founding Era. Klarman’s book, coupled with his invest- uncommon for many businesses to pay Therefore, it was not coincidental that such ing track record, set the tone for the Mod- $40,000 or more per year for $1 million of a market environment saw the ascendancy ern Era of value investing. general liability insurance, which equates of a number of highly-successful value Support for this position can be found to a “rate on line” of $0.04. investors such as Gary Brinson, Jeremy in the influence thatMargin of Safety has Grantham, John Neff and others. had on all of the prominent value invest- Post-Modern Era Nevertheless, it was during this period ing books that were published after it, from that modern financial economic theories Bruce Greenwald’s aforementioned book With value investing being applied to so were beginning to take hold. In his best- (chapter 13 of which profiles Klarman), to many asset classes — stocks, bonds, real selling book, Capital Ideas, Peter Bern- the sixth edition of Security Analysis (for estate, derivatives, etc. — what could a “Post- stein summarized these theories, all of which Klarman served as lead editor) to Modern Era” possibly entail? The future which tend to find disfavor with profes- Howard Marks’s recently-published value could witness the application of core value sional value investors. For example: investing book, The Most Important Thing investing principles, especially the margin of • Economists believe that markets are Illuminated (which was endorsed by, and safety principle, to corporate management. “efficient,” while value investors know contains annotations from, Klarman). Throughout their history, value inves- that, at times, markets can behave One of the strengths of modern value tors have been skeptical of corporate man- extremely inefficiently; investing theory is that it can be applied agers. For example, in Security Analysis, to all forms of investments, not just stocks Graham and Dodd observed that “It is • Economists believe that capital struc- and bonds. For example, consider deriva- nearly always true that the management ture is “irrelevant,” while value investors tives. Bestselling books, like Michael Lew- is in the best position to judge which know that capital structure is always rel- is’s The Big Short,demonstrate that a policies are most efficient. But it does not evant (for example, a company financed number of investors really did “catch” follow that it will always either recognize with 100% debt is quite different from the recent financial crisis by purchasing or adopt the course most beneficial to one financed with 100% equity); credit default swaps (CDS) at margin of the shareholders. It may err grievously • Economists believe that investments safety-consistent prices prior to the crisis. through incompetence.” In modern times, should be guided by modern portfolio Significantly, one of those investors was this can be seen in many corporate risk theory and asset pricing models, while Klarman. How did the investors do it? management activities. value investors understand, and care- While the specifics of their investments Since the recent financial crisis, many fully exploit, the fact that volatility and are not publicly available, there is a real- government regulators have focused on statistical measures of it are not risk; and time record of similar investments in enacting a wide variety of controls, con- • The option pricing models of financial the influential and long-running value ducting “stress tests” and ensuring that economics do not consider underlying investing newsletter, Grant’s Interest Rate highly-leveraged firms have enough capi- value; conversely, to a value investor, Observer, published by investor/historian/ tal on hand to satisfy their liabilities. value is a component of option pricing financial analyst/journalist James Grant. A Therefore, a great deal of corporate risk just like it is a pricing component for compendium of Grant’s newsletters lead- management activity is undertaken to every other economic good. ing up to “the big short” was published in ensure compliance with various govern- a bestselling book titled Mr. Market Mis- mental mandates. Unfortunately, much of Despite the success of professional value calculates (Mr. Market being Graham’s this activity involves simply documenting investors during this era, the challenge for euphemism for the short-term-oriented what firms are already doing to manage the school’s theorists and practitioners trading environment that dominates the risk, which in some cases may not be was to determine how the basic insights financial markets). On page 171 of the very effective given the condition of cer- of value investing could be reinterpreted book, which was taken from the Septem- tain corporate balance sheets. Therefore, for modern investors, and to demonstrate ber 8, 2006 edition of Grant’s Interest Rate it makes a great deal of intuitive sense to the significance of that reinterpretation Observer, it was noted that a hedge fund “stress test” those balance sheets. given the market conditions investors was “expressing a bearish view on housing Regardless of its intuitive appeal, many were wrestling with. in the CDS market by buying protection stress tests are informed by Value-at-Risk on the weaker tranches of at risk mortgage models, and their “economic capital” out- Modern Era: 1991 to Present structures. At the cost of $14.25 million a puts, even though it is well-known that year, the fund has exposure to $750 mil- these models are thin-tailed and thus “at To address the above challenge, value lion face amount of mortgage debt.” risk” of underestimating actual stressful investor Seth A. Klarman, co-founder and To see how margin of safety-rich this market environments. president of The Baupost Group, picked investment was at the time, consider the Furthermore, once a government entity up where Graham left off. The 20th and following: one way that commercial insur- specifies either a risk mandate and/or capital final chapter of The Intelligent Investor is ance companies evaluate risk pricing is to standard it tends to become the market stan- titled, “‘Margin of Safety’ as the Central divide the premium of risk transfer (in dard. An unintended consequence of this is Concept of Investment,” while the title of this case, $14.25 million) by the amount that firms seen to comply with governmen- Klarman’s 1991 book is Margin of Safety: of risk being transferred (in this case, tal standards often begin to incrementally Risk-Averse Value Investing Strategies for $750 million), which here gives a “rate on expand their risk appetites in manners fre- the Thoughtful Investor. The lucidity of line” of $0.014. By comparison, it is not quently deemed de facto appropriate given

22 FINANCIAL HISTORY | Spring 2014 | www.MoAF.org Exhibit 2: Margin of Safety-based Hedging

Source: Dowling & Partners, IBNR Weekly #39, October 5, 2007, p. 8. The names of the remaining 31 insurers are available from Dowling. the compliant status of the firms in question, the balance sheet he was managing, which the founder, chairman and CEO of Tele- regardless of the effect that expansion has on is to say hedging. dyne Corporation. According to invest- their risk profiles over time. In general, there are three ways to man- ment advisor and author John Train, To make matters worse, the above con- age the risk of a significant balance sheet “Buffett considers that Henry Singleton of siderations often interact, thereby magni- concentration: (1) reduce it, (2) diversify it Teledyne has the best operating and capi- fying potential losses. Consider the case of or (3) hedge it. Each of these alternatives tal deployment record in American busi- Enron, whose “quants” pegged the amount can be informed by value investing in gen- ness.” Leon G. Cooperman, the founder, the firm could expect to profit from or lose eral and by the margin of safety principle in chairman and CEO of Omega Advisors, at $66 million in a single day, within a 95% particular. In the case of hedging, the result was both an investor in Teledyne and a probability. According to Frank Partnoy, of Watsa’s hedge speaks for itself: Exhibit 2 student of Dr. Singleton’s strategies and author of Infectious Greed, “Enron’s VAR profiles 10% or greater changes in property management practices for decades, which measure was based on the inordinately and casualty insurance company perfor- he insightfully summarized in a seminal smoothed profits its traders reported; in mance in the third quarter of 2007. The study that was presented to the New York reality, the volatility of its trading range financial performance of Fairfax Financial Society of Security Analysts in 2012. was much greater [than $66 million]. In Holdings — shown at the extreme left of Consider also the case of the late Larry fact, traders frequently made and lost the exhibit — is materially greater than the Tisch, who was the co-founder, chairman more than their reported VAR; on a single rest of the insurance industry. and CEO of Loews Corporation. As Christo- day during 2000, traders made more than For another example of how to apply pher Winans reflects in his aptly-titled book, $500 million. On December 12, 2000, they value investing to corporate management, The King of Cash, Tisch and his brother Bob lost $550 million.” Such dynamics obvi- consider mergers and acquisitions (M&A). founded, built and managed their highly- ously magnified Enron’s risk profile prior It is well-known that many corporate M&A successful company in a margin of safety- to its historic failure. deals fail to create the value expected at the oriented manner, especially with respect to In light of the above, is it any wonder time they were announced. It is also well- M&A and cash management. why Graham and Dodd generally felt the known that the primary reason for these To understand how value investing can way they did about corporate managers? failures is that the transactions occur at practically be applied to corporate M&A, Fortunately, not all firms are managed the price levels that are simply too high; in other consider that because its valuations are built same way. Consider, for example, the case words, the deals do not contain a margin from the bottom-up, all value investing of value investor Prem Watsa, the founder, of safety. Given the nature of private mar- assumptions are completely transparent. As chairman and CEO of Fairfax Financial ket values and the control premiums con- a result, assumptions requiring clarification Holdings. Prior to the recent financial tained therein, many executives apparently are natural candidates for formal due dili- crisis, Watsa also purchased economically believe that value investing principles can- gence. Additionally, the M&A information priced CDS, and those purchases report- not be applied to M&A. One can, of course, generated from the value investing process edly generated a gain of more than $2 bil- cite examples of Warren Buffett’s various can be compared with the known drivers lion against an investment of $341 million. acquisitions here, but Buffett is primarily of value realization risk to determine if a While the specifics of Watsa’s position are an investor. Fortunately, there are corporate deal’s private market value offers a margin of not publicly known, one can surmise that management-specific examples as well. safety even considering its control premium. because he is a corporate manager, the First and foremost, consider the case of CDS he purchased were appropriate for the late Henry Singleton, Ph.D., who was » continued on page 36

www.MoAF.org | Spring 2014 | FINANCIAL HISTORY 23 Value Investing New Bedford continued from page 23 continued from page 31

Bach, Graham and Beyond ___, “Henry Singleton: a pioneer of corporate was passed in 1994. New Bedford-based strategic leadership and value creation.” banks were all but obliterated by the finan- Classifying the different eras of a popular Strategy & Leadership. Vol. 38, No. 6 (2010), cial industry’s consolidation. school of thought is a subjective endeavor, pp. 29–37. Big banks with national or regional foot- and as such frequently requires anchoring prints now dominate the local scene. Even to key dates. For example, the Baroque Era ___, Applied Value Investing, NY: McGraw- many of the city’s lesser-known banks are of music “officially” ended with the death Hill, 2009. headquartered elsewhere. Admiral’s Bank of J.S. Bach. Maestro Bach, of course, never Calandro, Joseph, et al., “Deal or no deal: is out of Boston; BCP is headquartered in knew that his death would end an era any Methods, processes, and models for the new New Jersey; Eastern Bank is from Salem more than Benjamin Graham could have M&A environment,” FS Viewpoint, June and Webster Bank from Waterbury. That known that some future authors would 2012, http://www.pwc.com/us/en/financial- has hurt the city’s efforts to rebound date the close of the Founding Era of services/publications/viewpoints/financial- because the remaining institutions — St. value investing with the 1973 edition of institution-merger-and-acquisition-risks Anne Credit Union, BayCoast Bank, Bris- his classic book, The Intelligent Investor. .jhtml tol County Savings and St. Anthony-New Nevertheless, such classifications are use- Cooperman, Leon G., “A Case Study in Finan- Bedford Federal Credit Union — are too ful for both practitioners and researchers, cial Brilliance,” Presented at The NY Society small to matter much to large or growing especially when contemplating what the of Security Analysts, June 28, 2012. businesses. future may hold. Graham, Benjamin, The Intelligent Investor 4th The second largest bank, BayCoast, Whether the future develops as we have Ed., NY: Harper & Row, 1973 (1949). barely had $1 billion in assets as of the end theorized, and value investing comes to Graham, Benjamin and David Dodd, Security of the first quarter of 2014 and the largest, influence and define corporate management Analysis 6th Ed., NY: McGraw-Hill, 2009 Bristol County Savings, had assets just or not, investors and corporate managers (1934). over $1.5 billion at that time. While a bil- can benefit from studying the lessons of ___, Security Analysis, NY: McGraw-Hill, 1934. lion may sound like a lot, 101 US financial Graham and his followers over time. Their institutions had assets greater than $10 bil- school of thought has been applied to a vari- Grant, James, Mr. Market Miscalculates: The lion at the end of May 2014. St. Anne dates ety of asset classes and market environments Bubble Years and Beyond, Mt. Jackson, Va: back to 1911, a long time for a credit union, and, when it has been applied skillfully, it Axios, 2008. but it has assets of only about $18 million. has helped to produce exceptional returns at Greenwald, Bruce, et al., Value Investing: From And like other credit unions, it can’t lend relatively low levels of risk. Graham to Buffett and Beyond, NY: Wiley, 2001. much to businesses. Joseph Calandro, Jr., is a Managing New Bedford and its surrounding Klarman, Seth A., “The Timeless Wisdom of Director of a consulting firm, Fellow at area was heavily taxed and regulated and Graham and Dodd” In Graham and Dodd, the Gabelli Center for Global Security largely devoid of local innovative sparks as 2009 (1934), Security Analysis 6th Ed., pp. Analysis at Fordham University, and the most of its banks, insurers, hospitals and xiii–xl. author of Applied Value Investing (NY: universities were mere branches of insti- McGraw-Hill, 2009; Korean translation, ___, Margin of Safety: Risk-Adverse Value tutions headquartered elsewhere. Much of 2011; Chinese translation, 2014). He can Investing Strategies for the Thoughtful Inves- the indigenous human and financial capi- be contacted at [email protected]. tor, NY: Harper Business, 1991. tal, once copious, has long since passed Lewis, Michael, The Big Short,NY: Norton, on or moved away. The city is currently Frederick J. Sheehan is the author of the 2010. in dire need of some “Rotches,” not the Panderer to Power: The Untold Story Marks, Howard, The Most Important Thing six-legged variety, but people with money of How Alan Greenspan Enriched Wall Illuminated, NY: Columbia, 2013. and business acumen who care about the Street and Left a Legacy of Recession Partnoy, Frank, Infectious Greed: How Deceit community and can command sizeable (NY: McGraw-Hill, 2009; Chinese trans- and Greed Corrupted the Financial Markets, sums through intermediaries. lation, 2014), serves on several investment NY: Times Books, 2003. committees, and is the author of speeches, Train, John, The Money Masters: Nine Great Robert E. Wright is the Nef Family Chair articles, and interviews on his website, Investors, Their Winning Strategies and How of Political Economy at Augustana Col- AuContrarian.com. He can be contacted You Can Apply Them, NY: Harper & Row, lege in South Dakota and the author of at [email protected]. 1980. 17 books, including Corporation Nation Sources Scott, Alec, “The $2-Billion Man,” Toronto (UPenn 2014) and The Genealogy of Bernstein, Peter, Capital Ideas, NY: Free Press, Life, April 1, 2009, http://www.torontolife American Finance (Columbia 2015). He 1993 (1992). .com/informer/random-stuff-informer/ has been a member of the editorial board of this magazine since 2008. Calandro, Joseph, “Graham and Dodd: A Per- 2009/04/01/2-billion-dollar-man/ spective on its Past, Present, and Possible Winans, Christopher, The King of Cash: The Future,” The Journal of Investing,Spring 2014, Inside Story of Laurence Tisch, NY: Wiley, pp. 7–16. 1995.

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