The myriad styles of value investing In a great book “Wall Street on Sale”, the author, Timothy P. Vick, writes about the great value investors and their different investment styles. “We have the track record of value investors themselves to validate the superiority of the method. It is no coincidence that many of the great money managers of the twentieth century and many of today’s top-- performing fund managers hail from the value camp. Nearly all of the money managers who have consistently beaten the market use variations of the blueprint created 65 years ago by Benjamin Graham. In 1984, Warren Buffett was asked to speak at Columbia University on the fiftieth anniversary of the publication of Benjamin Graham’s and David Dodd’sSecurity Analysis; the topic: whether financial markets were efficient, as leading academics argued. For years, academics had placed Buffett and other value investors in the category of “six-sigma events,” people who owe their fortune to random chance rather than intellectual prowess. To the academics who judged him, Buffett was merely the one person out of 10 million who happened to flip a nickel and drop 15 heads in a row. Buffett countered their attacks. If his success was due to chance, Buffett asked, how could they explain the fact that the most successful investors all studied Graham’s value methods? Surely this was no statistical coincidence, Buffett suggested: In this group of successful investors that I want to consider, there has been a common intellectual patriarch, Ben Graham. But the children who left the house of this intellectual patriarch have called their flips in very dif- ferent ways. They have gone to different places and bought and solddif ferent stocks and companies, yet they have had a combined record that simply can’t be explained by random chance…. The common intellectual theme of the investors of Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small Pieces of that business in the market…. Our Graham-and-Dodd investors, need- less to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value. Indeed, what sets great investors apart from the crowd is their willingness to shun most of the accepted dogmas and theories Wall Street foists upon the public. Interestingly, many great value investors do not hail from New York City. Nor did they see a need to gravitate to Wall Street or another financial center. They came from midsized towns across America and conquered Wall Street, having learned their brand of patience hundreds of miles away. www.capitalideasonline.com Page - 1 The myriad styles of value investing MICHAEL PRICE’S AGGRESSIVE VALUE APPROACH In 1974, after graduating from the University of Oklahoma, Michael Price took a modest-paying position working for Max Heine at Heine’s Mutual Shares fund. The two developed an instinct for locating undervalued companies and scoring quick gains playing companies in liquidation. Through the years, Price’s stock picking leaned more and more toward large-cap going concerns, but he remained fixed on grossly undervalued companies. Price’s style is piranhalike. With several funds under his direction, he stakes big positions in individual companies, then forces management to make the changes he feels are needed to raise the stock price. His behind-the-scenes maneuvering in 1995 forced Chase Manhattan and Chemical Bank to merge. He would later take similarly hostile, but ultimately profitable, positions toward management at Sunbeam, whose stock soared after it replaced top management, and Dow Jones. When his funds were smaller, Price focused more on small, undervalued companies and junk bonds. But as money poured into his Mutual series FIGURE 1 Record of top value fund managers. Source: Morningstar Inc. 1990 1991 1992 1993 1994 1995 1996 1997 Michael Price -9.8% 21.0% 21.3% 21.0% 4.6% 29.1% 20.8% 26.4% Mario Gabelli -5.8% 18.1% 14.9% 21.8% -0.2% 24.9% 13.4% 38.1% David Schafer -10.1% 40.9% 18.7% 24.0% -4.3% 34.2% 23.2% 29.3% Ruane and Cuniff -3.8% 40.0% 9.4% 10.8% 3.3% 41.4% 21.7% 42.3% John Neff -15.5% 28.6% 16.5% 19.4% -0.1% 30.2% S&P 500 -3.1% 30.5% 7.6% 10.1% 1.3% 37.5% 23.0% 33.4% of funds in the mid-1990s, he channeled more resources toward large-cap turnaround plays such as General Motors, Sunbeam, Philip Morris, Dow Jones, and McDonnell Douglas. His eight-year track record at his flagship Mutual Shares Z from 1990-1997 exceeded that of nearly all other equity fund managers (see Figure 1). JOHN NEFF’S “WOEBEGONE” APPROACH For 31 years, Neff piloted the Windsor fund, now part of the Vanguard family, and turned it into one of the strongest-performing funds before he retired in December 1995. Over those 31 years, the Windsor fund beat the S&P 500 twenty-one times and sported a compounded annual return of 13.7 percent, versus only 10.6 percent for the index. Neff’s stodgy style reflected his Ohio roots and disdain for Wall Street’s cutthroat sales bias. He www.capitalideasonline.com Page - 2 The myriad styles of value investing staked money on what he called “dull and woebegone” companies that brokers shunned and the media held in disrepute, if they paid attention to the company at all. While a student at the University of Toledo, Neff studied and adopted Graham’s methods and never strayed far from the master after that. Like Graham, Neff looked for certainty of returns and tended to buy companies with dividend yields much higher than the market average. The strategy reflected his conservatism and allowed Neff to rely less on bull markets and capital gains to obtain good returns. During Neff’s tenure, dividends accounted for about 40 percent of the fund’s total return. Neff also emphasized a company’s balance sheet (debt levels, liquidity, and returns on equity), another holdover from Graham, and was reluctant to buy high P/E stocks regardless of market conditions or the company’s growth rate. He fished the bottom on occasion, as when he placed big bets on down-and-out auto companies, airlines, and banks in the 1980s. Neff demonstrated great patience, often holding shares in a company for years if that’s what it took for the market to appreciate the company’s hidden value. Once the market bid up the company to a fair price, Neff sold. MARIO GABELLI’S “BREAK-UP VALUE” APPROACH The outspoken Gabelli, the founder of Gabelli Asset Management in Rye, New York, is among the most astute business appraisers in the industry, a signature crafted early in his career as an auto parts and broadcasting analyst. Broadcasting remains his specialty, and Gabelli is not averse to loading up his family of mutual funds with media, broadcasting, and niche telephone service companies. A Bronx native, Gabelli is at heart a bottoms-- up analyst-he values businesses based on their expected cash flow, then determines whether the stock can rise appreciably over the next few years to at least its cash-flow value. His style combines several value approaches, and he places a great deal of emphasis on the quality of management and other intangible factors. Gabelli also has developed a specialty in break-up analysis. He appraises companies based on what their major divisions could sell for individually. Gabelli looks for a company capable of returning 50 percent within two years and is wont to hold a company at least that long to give the market time to reprice the company. But unlike Graham and the early value investors, who relied heavily on annual reports and avoided scuttlebutt, Gabelli is known for practicing due diligence and will amass as much information as he can on a company and its industry before investing. DAVID SCHAFER’S “RELATIVE VALUE” APPROACH Indiana-bred Schafer, founder of Schafer Capital Management and manager of the Strong Schafer Value fund, has built an enviable track record in the 1990s following a strict, disciplined strategy. Schafer tends to focus on large-cap companies and believes in keeping his portfolio rather small. Typically, his fund will hold no more than 30 to 35 large-cap stocks, each equally weighted. The secret to his success has been discipline, his focus on the www.capitalideasonline.com Page - 3 The myriad styles of value investing most successful companies, and his ability to cherry pick large-cap companies with the best growth prospects. Schafer’s basic strategy is to find companies whose earnings can grow faster than the S&P 500 but whose P/E ratios are below the index. If the index trades at a P/E of 20 and earnings for stocks within the index are growing at 10 percent rates, Schafer looks for stocks within that index with P/Es under 20 and earnings growth of at least 10 percent. This strategy, when successful, leads to returns that beat the index. WILLIAM RUANE AND THE SEQUOIA FUND Ruane, who has comanaged the Sequoia fund with Richard Cuniff since 1970, practices a form of value investing as similar to Warren Buffett’s style as anyone in the business. They created the fund at the behest of Buffett, who had closed his investing partnership but wanted to recommend a fund for his clients.