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THE EVOLUTION of VALUE INVESTING Past, Present and Beyond

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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), © Bettmann/CORBIS p. 159. 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.
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