Chapter Twenty-One
Stick to Your Guns
Years of practical experience have taught me that the patient exercise of value investing principles works, and works well. My partners and I have all had long, successful careers and have done very well for ourselves and our investors using the techniques outlined in this book, as have numerous other value devotees. In fact, I don’t know a single poor value manager who has been in the business more than 10 years. Value investing requires more effort than brains, and a lot of patience. It is more grunt work than rocket science. But over time, investors should continue to be rewarded for buying stocks on the cheap.
Through the years, there have been changes in the methods of finding value stocks, and in the criteria that define value. When Ben Graham began managing money in the late 1920s, there were no databases, there was no Internet. The information age had not arrived. Back then, the search for undervalued stocks meant poring through the Moody’s and Standard & Poor’s tomes for stocks that fit the value criteria. Now, you can accomplish this with the click of a mouse. We can access almost all the data we need off a CD-ROM or our Bloomberg terminals. We no longer have to run around gathering 10k reports or annual shareholder letters. They are all right there on the Internet for us to access for U.S. and non-U. S. stocks all over the world.
Trading has changed as well. For the most part, trading is now done electronically with no effort at all. We can trade stocks in Tokyo or London just as easily as we can in New York. When we need to discuss a stock or enter orders, we can communicate from the office or anywhere else we may be via cell phone or wireless laptop computers.
However, this change has been relatively recent. For 60 years, from the days when Benjamin Graham went into the business in the late 1920s beyond when I started in 1969, the improvements in communication, the way people traded stocks, and the availability of information remained much the same. We had touchtone phones and direct lines, but not much else. I can remember buying the firm’s first calculator. It was clunky and heavy, and cost a lot even by today’s standards, but it did have a new invention called memory. There was no NASDAQ Stock Market in 1969. Over-the-counter stocks were still listed on the Pink Sheets and you had to call brokers for quotes. Everything was recorded on paper, and stock certificates were still delivered by runners.
Ben Graham pored over Moody’s and Standard & Poor’s manuals and so did I. The first database of company filings appeared in the mid-1970s from a firm named Compustat. In the beginning, we would call Compustat, tell them the criteria we wanted them to use in screening stocks, and they would send us a tape we could run on our own computer. We had a computer by then, but the term desktop had not yet come into being. We now take for granted the explosion in information availability that has taken place in the past 10 or 15 years and wonder how anyone functioned before e-mail, Windows, and Google.
Just as the access to information and the methods of trading stocks have changed in the past two decades, so have the criteria for value changed. One of my first jobs when I began my career in 1969 was looking through the Standard & Poor’s monthly stock guide for stocks selling below net current assets. This was a primary source of cheap stocks in those days. The method had been pioneered by Graham and was very successful. Generally, we were buying stocks that sold for less than their liquidation value. Back then, manufacturing companies pretty much dominated the U.S. economy as they had for decades.
As the U.S. economy grew in the 1960s, 1970s, and 1980s, it began to move away from the heavy industrial manufacturing companies such as steel and textiles. Consumer product companies and service companies became more a part of the landscape. These companies needed less physical assets to produce profits, and their tangible book values were less meaningful as a measure of value. Many value investors had to adapt and began to look more closely at earnings-based models of valuation. Radio and television stations and newspapers were examples of businesses that could generate enormous earnings with little in the way of physical assets and thus had fairly low tangible book value. The ability to learn new ways to look at value allows you to make some profitable investments that you might well have overlooked had you not adapted with the times.
Along the way I also learned that there was a great deal of money to be made buying companies that could grow their earnings at a faster rate than the old industrial type companies. I believe it was Warren Buffett who made the statement that growth and value are joined at the hip. The difference between growth and value was mostly a question of price. I paid a little more than I might have in the old days of just buying stocks based on book value but found great bargains like American Express, Johnson & Johnson, and Capital Cities Broadcasting. Companies like these were able, and in many cases still are able, to grow at rates significantly greater than the economy overall and were worth a higher multiple of earnings than a basic manufacturing business.
In the mid-1980s, the leveraged buyout business was born. The U.S. economy was emerging from a period of high inflation and high interest rates. Inflation had increased the value of the assets of many companies. For example, if ABC Ice Cream had built a new factory 5 years ago for $10 million and was depreciating it over a 10-year period, it would have been written down to $5 million on ABC’s books. However, after 5 years of inflation, it might cost $15 million to replace that factory. Its value is understated on the company’s books. Using the factory as collateral, the company might have been able to borrow 60 percent of its current value, or $9 million. This is what LBO firms did with all sorts of assets in the 1980s. They would borrow against a company’s assets to finance the purchase of the company.
Additionally, the record high interest rates of the late 1970s and early 1980s drove stock prices to their lowest levels in decades. The price-to-earnings ratio of the Standard & Poor’s 500 was in the single digits. With long-term Treasury bonds yielding 14 percent, who needed to own stocks? The combination of significant undervalued collateral and low P/E ratios made many companies ripe for acquisition at very low prices. A typical deal in the mid-1980s might be done at only 4.5 times pretax earnings. Today, that number is more in the range of 9 to 12 times pretax earnings. This period was a once-in-a-lifetime opportunity to buy companies at record cheap prices in terms of both assets and earnings.
I try to track as many acquisitions as I can, noting the price in relation to book value and pretax earnings. By doing so, I can construct a model of acquisition values. I use this model to screen for companies that are selling in the stock market at a significant discount to what an LBO group might pay. The LBO model gave me one more way of defining “cheap.” I call it the appraisal method. I still use low price-to-book value ratios and low P/E ratios to search for undervalued stocks, but I have added the appraisal method as a third leg of my value stool. If there is another way to find stocks that sell for far less than they are worth, I like to take advantage of it.
The methods and criteria have changed over the years, and they will evolve further with the march of time and inevitable change. What is important is that the principles have not changed. The basic idea of buying stocks for less than they are worth and selling them as they approach their true worth is at the heart of value investing. On balance, value investing is easier than other forms of investing. It is not necessary to spend eight hours a day glued to a screen trading frenetically in and out of stocks. By paying attention to the basic principle of buying below intrinsic value with a margin of safety and exercising patience, investors will find that the value approach continues to offer investors the best way to beat the stock market indexes and increase wealth over time.
Patience is sometimes the hardest part of using the value approach. When I find a stock that sells for 50 percent of what I have determined it is worth, my job is basically done. Now it is up to the stock. It may move up toward its real worth today, next week, or next year. It may trade sideways for five years and then quadruple in price. There is simply no way to know when a particular stock will appreciate, or if, in fact, it will. There will be periods when the value approach will underperform other strategies, and that can be frustrating. Perhaps even more frustrating are those times when the overall market has risen to such high levels that we are unable to find many stocks that meet our criteria for sound investing. It is sometimes tempting to give in and perhaps relax one criterion just a bit, or chase down some of the hot money stocks that seem to go up forever. But, just about the time that value investors throw in the towel and begin to chase performance is when the hot stocks get ice cold.
Benjamin Graham laid out the basic concepts of the value approach to investing many decades ago. Like Graham, I have no faith in my ability, or in the ability of most others, to predict the direction of stock prices over the short term. I do not believe that many people can detect which technology stock will be the next Microsoft or which ones will bomb. What I do know is that owning a diversified portfolio of stocks that meets the standards of a margin of safety and are cheap, based on one or more valuation methods, has proven to be a sound way to invest my money. I have no reason to believe it will not continue to be so.
