The Case for Value

The widely acknowledged father of value investing was an American academic, investor, and author, Ben Graham, and the widely acknowledged founding text of the discipline is the book he published with David Dodd in 1934: ‘Security Analysis’.

Famously, Warren Buffett was a student of Graham at Columbia University in the 1940’s and has turned his value investing credo into one of the greatest fortunes ever.

The fundamental tenet of value investing is that value does not equal price. Consequent to that, the market can be beaten.

Value investing fundamentally rejects Modern Finance Theory, and the key assumptions underpinning the Efficient Markets Hypotheses. By contrast, it can rightfully claim to be a forerunner of the breakthroughs in behavioural economics and finance pioneered in recent decades by the likes of Daniel Kahneman, Richard Thaler, Robert Schiller, and others.

As stock investors, we should always remember that we are owners of a share in a business and that the value of the business to us is ultimately determined by the cash that we take out of it.

In practice, the challenge is to make a credible assessment of what Buffett calls intrinsic value:

‘Intrinsic value can be defined simply: it is the discounted value of the cash that can be taken out of a business during its remaining life. As our definition suggests, intrinsic value is an estimate rather than a precise figure and two people looking at the same set of facts will almost inevitably come up with different intrinsic value figures.’

Before investing, the challenge is to apply the approach of Graham and Dodd and since built on by their followers such as Buffett, to estimating intrinsic value. Only then can a decision be made as to whether this value is sufficiently attractive relative to its market price to warrant an investment.

Importantly, the choice of a discount rate is an unavoidable decision in the valuing of any asset, linking the value to the cash the asset will generate in the future. Everything else being equal, the lower the discount rate, the higher the value, and vice versa.

A key ingredient in the calculation of an ‘appropriate’ discount rate is the rate on offer from a broadly ‘risk-free’ alternative such as a 10-year government bond. Again, everything else being equal, the lower the yield the higher the asset value, and vice versa.

In his letter to Berkshire Hathaway shareholders in 1998, Buffett summarised his approach to this key decision:

‘We don’t discount the future cash flows (of our stock holdings) at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.’

While different value investors often arrive at different decisions by using different techniques or will differ on the importance accorded to the various inputs to their valuations, they are united in their goal to seek and exploit the difference between value and price.

Importantly, value investing is constantly evolving and should not be viewed as a narrow focus on specific metrics. For example, just having a low Price to Book or low Price to Earnings ratio should not necessarily be defined as the same as buying something for less than its intrinsic value.

A particularly useful tool for thinking about the divergence between value and price is the Graham creation of Mr Market.

In varying moods swinging from greed to fear, Mr Market shows up every day offering to buy and sell you securities at constantly changing prices. As a value investor this is your opportunity. Your goal is to exploit the moods of Mr Market to buy and sell at prices different from your assessment of value and to do so with as large a margin of safety as possible. It is therefore when Mr Market is most pessimistic about a security that the opportunity is greatest, and vice versa.

The case for value investing is compelling. Value does not equal price, the market can be beaten, and the way to beat it is to exploit the moods of Mr Market.

But narrowly seeking value alone can be misleading. Many poor businesses are ‘cheap’ for good reasons, and many great businesses are sometimes available at ‘good’ prices. To help avoid the former while finding the latter, the successful value investor also seeks quality.

The Case for Quality

In seeking quality, the words of Buffett quoted by Laurence Cunningham in his book ‘Essays of Warren Buffett’ are especially helpful:

‘In each case we try to buy into businesses with favourable long-term economics. Our goal is to find an outstanding business at a sensible price.  Charlie and I have found that making silk purses out of silk is the best we can do; with sows ears we fail.

It must be noted your chairman, always a quick study, required only 20 years to recognise how important it is to buy good businesses.  In the interim, I searched for ‘bargains’ and had misfortune to find some.  My punishment was an education in the economics of short line farm implement manufacturers, third place department stores and New England textile manufacturers. 

In addition, we think the very term ‘value investing’ is redundant. What is investing if it is not the act of seeking value at least sufficient to justify the amount paid? Growth benefits investors only when the businesses in point can invest at incremental returns that are enticing.  In other words, only when each dollar used to finance growth creates over a dollar of long-term market value.’

The Buffett case for quality is illustrated by a simple quantitative example of how quality is fundamentally determined by returns:

Quality & Returns

  • Investment:                 $100 million
  • Cost of Funds:             10% (i.e., required break-even return = $10m)
  • Returns:                       Case A: 5%, Case B: 10%, Case C: 20%

For stock investors, the lessons are clear:

  • Investing at a competitive disadvantage destroys value.
  • Investing on a level playing field neither creates nor destroys value.
  • Only investing with a return greater than the cost of funds/required return creates value.

In the timeless words of Buffett:

‘Time is the friend of the wonderful business, the enemy of the mediocre.’

But to benefit from time, the quality business must be able to withstand the inevitable shocks of business life. They must possess the balance sheet strength to survive. Arguably, this fundamental aspect of quality was never more important than in the aftermath of the recent pandemic.

The cessation of economic activity created significant problems for corporate cashflows especially in consumer dependent and more cyclically sensitive sectors. Many companies suspended corporate guidance and were forced to suspend buybacks. Dividend distributions were also affected as survival became paramount in these challenged industries. With reduced cashflows but bills still falling due many companies needed cash, or access to cash, to meet liabilities.

In practice, the assessment of balance sheet strength requires a focus on the following:

  • Cash: cash on the balance sheet relative to short-term debt, and relative to dividends. This gives comfort on a company’s ability to pay the bills in the absence of cash flow.
  • Debt: there are several issues to monitor here. The level of net debt relative to equity, the coverage of net debt by funds from operation, and interest cover.
  • Debt profile: the final issue is the maturing debt profile, when it must be repaid and the proportion falling due in the next year or two.

Compared to value, the debate about quality is often more contested. But simply put, quality companies have the capacity to generate value-adding returns from a sufficiently strong balance sheet. The case to buttress this further by focussing on dividends is also strong.

The Case for Dividends

Assuming a business is broadly happy with its capital structure, when it makes a profit it has two options for deploying it:

1) Re-invest it – in either the existing business, or by acquiring all or part of a new one.

2) Distribute it to shareholders – in either a dividend, or by buying back and cancelling some outstanding shares.

Ideally, as shareholders we want the management of the business to take the first option up to the point where it generates a positive net present value to us, and to take the second option with the residual.

But in the real world there is a high barrier to realising this ideal. The danger of management making decisions inconsistent with the interests of shareholders is an unavoidable fact of modern corporate structure. It is a classic principal-agent problem where the agent – in this case the management – are no longer necessarily aligned with the interests of the principal – in this case the shareholder. This agency problem can either be deliberate or inadvertent on the part of management, but from a shareholder perspective the negative risk is the same.

A common expression of this agency problem is the tendency of management to over-pay for growth. Driven by varying combinations of badly designed incentives, hubris or misplaced hope, management displays a consistent tendency to destroy value in pursuit of size.

A dividend-oriented strategy can be an important weapon in the armoury of shareholders in this perennial battle. The discipline of paying and growing a dividend serves to lessen, if not eliminate, the imbalance in the modern corporate relationship between shareholders and management.

Stock investing has been a rollercoaster in recent years. Arguably more than ever, pandemic and war have made the wrenching reality of radical uncertainty painfully clear. Facing into the unknowable future, it seems timely to ponder some timeless beliefs: the case for value, quality and dividends.

More memorably, it seems apt to leave the final word to Buffett:

‘Ships will sail around the world, but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.’