Value Investment is a model of investment which has been originated from speculating ideas regarding investment and working on speculation by two great personalities Benjamin Graham and David Dodd. Benjamin Graham and David Dodd began their career with teaching in the Business School of Columbia in the year 1928 and in the year 1934; both of them developed a text book on Security Analysis which was a great achievement for their career.
An approach to value investment may take many names but it is mainly implemented for those securities whose shares are considered to be underpriced because of few fundamental analyses. In this context we can support this fact with an example of those securities which are considered as stock in the private holdings which are sold at a certain percentage of discounts at the book value of the stock. Few other examples can also be quoted for the same; investment analysis or approach to the value investment is mainly concerned with the securities which have higher yields of dividend, they are also concerned with the securities which have lower ratio of price to book or have lower multiples of price to earning.
There are various people who have a bright recognition in the field like Warren Buffett, chairman of Berkshire Hathaway, have pointed out several facts about value investment approach. He said that value investment is mainly important because this is concerned with buying of stocks or securities at a price lower than the intrinsic value. This discount i.e. difference between the market value and intrinsic value is termed as Margin of Safety by Benjamin Graham. Intrinsic value is considered as the discounted value of entire distribution of the future. (Benjamin Graham: The Father of Value Investing)
Benjamin Graham was concerned with the future distribution and proper discount rate of the securities but these were the assumptions made by him. There were several future works done on the same which had taken value investment approach to a further level. This further approach was given by Warren Buffett who mainly focused on "finding a terrific company at rational price". He was not making his research confined to the general companies at price at the discounted.
Few facts about Benjamin Graham
Approach of value investment was given by the two great researchers, Benjamin Graham and David Dodd. Benjamin Graham was born in May 8, 1894. Benjamin Graham was a professor in Business School of Columbia and he was a teacher of various investors. Benjamin Graham's first evolution was a book on Security Analysis and he also authored a book called The Intelligent Investor in which he introduced the concept of Margin of Safety; which was a great hit and considered to be a careful approach to investment. He mainly concentrated and recommended the investors that while making investment one should always trade on the stocks lower than their book value in order to safeguard the future development often met in stock markets. This great economist died on September 21, 1976.
Benjamin Graham was a great analyst of economics and he has given great theories over investment fundamentals. In this section we are going to analyze some of his big achievements in the field of value investment. There are several recommendations given by Benjamin Graham about value investment which are analyzed in the following section.
Marginal safety was one of the most interesting concepts taught by Benjamin Graham which is still referred by several scientists or the economist at the present time. Margin of Safety was a concept which became very much popular according to which it was recommended for the customers that they should always go for purchasing those security element which are available at the discounted price to that of the booked value. They should always purchase the securities at the intrinsic value. Main advantage of this strategy is that it would help in making the worth of the business according to the time or present era. Benjamin Graham also told that in order to do this process it is very much necessary for the investors to accurately determine about the intrinsic value of the securities that a company might offer. In order to tell the investors about the intrinsic value of the company, there are various guidelines provided by Benjamin Graham to calculate the intrinsic values which are as follows:
- Benjamin Graham told the investors that they should always purchase the stocks or the security at the time when the company is selling the securities below the price that it original sells in the open market. Those investors who do not concentrate on the valuation of the securities and pay prices above the intrinsic value of the securities even at the period when the company is selling the stock at the intrinsic value are left a net value of zero margin of safety. However it may be possible that the companies in which the investors have invested are doing well but still in that case as well investors get burned.
Main strategy which Benjamin Graham held was that he bought those businesses or those companies in the market which were going at a very disappointing situation and was about to be shut. He made his fortune by investing in those businesses. These companies in which he invested were sold at a price lesser than their working capital which is current asset minus current liabilities. Benjamin Graham developed a model known as Net Current Asset Value model in order to see whether the companies are worth buying or how much they are deviated from their market price. (Whitman, 1999)
Net Current Asset Value model subtracts all the values of the liabilities like preferred stocks, short term debt, etc. These values of the liabilities were subtracted from net current asset of the company. After this model he successfully concluded that all the stocks that were trade above the value of Net Current Asset Value should not be purchased by the investors and buying securities which were trading below NCAV will help the customers or the investors to live to the future development.
Opting for bigger companies having strong sales
Benjamin Graham always said that for an investor it would be really beneficial to invest in the companies which have a very strong sale particularly the big companies. He gave a very strong reason behind this suggestion that larger firms in the market has very much less risk associated with them. Benjamin Graham mainly concluded in his approach to value investment that small companies are always in risk because of regular economic downturn in the market, hence it is very much beneficial for the investors to invest in the bigger companies rather than investing in the smaller one's.
His theory was something no understandable for the general population. At the time of Great Depression, Benjamin Graham was a very active investor which was absolutely a shocking thing to notice. He did this because he saw number of firms which were small in their industrial size was moving down. With this observation he made a very useful conclusion in the theory of value investment that in case of situations like Great Depression, companies which have diversified work and diversified customers will stay in the market and all else will be destroyed. Hence he concluded that large companies have a better chance of surviving in situations of economic down turns.
Selection of the companies paying dividends
Benjamin Graham was always very excited about investing in the companies which pay dividend. He recommended the investors that the investor should always invest in those companies which are paying dividends for almost more than 20 years in the past in a consecutive manner. He said that his main basis behind this theory was that dividends are paid from the profits of the company and if the company is showing dividend in the past years in a consecutive manner, this means that company is running under profit and this will be right sign for the customers to invest in the company. Another reason was that these companies which are providing dividend to the customers will provide returns to the investors even in the situation when the stocks of the company are not performing well in the market.
Company's Financial Shape is another observation
Benjamin Graham was always in seek of the companies which have good liquidly with them. He was always in the search of the companies whose current assets are always more than the sum of the long term debt and current debt. According to Graham, companies which have large amount of cash in their hand are not that much exposed to risk because these can pay back their liabilities if required. These companies having large amount of liquid assets which means cash are much safer than those companies which have low cash and are in huge debt in the market. Hence, he recommended the customers or the investors that a person should only invest in those companies which have large amount of cash access that is which have a good level of liquidity with them.
Sustainable Earning Growth of the company should also be observed
According to Benjamin Graham, investors always observe for those companies which have a rising trend in their earnings. Earning of such companies should either be study or rising in any case. According to him, if the company is having a steady earning or an increased earning their share price performance of the company will be improved. This is an important indicator of value investment for any investor (Value approach to investing in funds: value and large cap funds offer a conservative approach to long-term investing, 1999)
According to the Approach to Value Investment by Benjamin Graham, it is important for nay investor to have a look over the price multiples of the companies in which he or she wants to invest. In order to do this, he searched various companies and sought them according to their price per earning ratios as compared to their values in the history. He also looked at the price per book values of these companies. There was a proper commitment by Benjamin Graham in this context; he would only purchase the stock if the value of the stock is approximately 12 times lesser than their book values per share.
For explanation to the investors he explained that if a company has an Asset of 1 billion $ and the company has a liability of 700 Million $, then the book value of the shares of the company is $ 300 Million. If the company has outstanding shares of total number 10 Million, then book value of the company per stock would be $ 300 Million / 10 Million which is equal to $ 30 of Book Value of the company per share. Hence, Benjamin Graham concluded that in this case an investor should not pay $ 36 per share at any cost which is 1.2 times the book value of the share.
Synthesis of Information
The above analysis showed that there are some mixtures or the combinations of analysis done by the value investment approach. Such a combined analysis id derived as follows:
- He analyzed fundamental differences between investment and speculation. In his analysis he gave a very clear definition of investment which was absolutely different from speculation. According to him, Investment is an operation which after given a proper analysis gives security of return to the investors whereas in case of speculation no such kinds of securities are provided.
- Graham said that owner of the equity stocks of any company should always consider themselves as the first and the foremost owners of the company or the business. In value investment approach he explained that an investor must have such a feel in mind, then only the owner of the stock will not be that much worried about the fluctuations in the stocks because in case of the short term investments, this stock market acts like a voting machine but incase of long term investments, according to value investment approach, stock markets are like weighing machines. Hence according to this approach true value of the stock prices will be obse3rved in case of long run.
- In the analysis of value investment, Graham explained the differences between the active investors and the passive investors. According to him, he called passive investors as the defensive investors who believe in the investment but very carefully and prefer long term rather than short term investment but incase of active investors, they give a lot of time in the investment and prefer going for short term investment rather than long term investment. (Lowe, 1997)
- In value investment approach of Benjamin Graham, his favorite metaphor was Mr. Market. According to him Mr. Market is a person who every day goes doors to doors to sell and buy stock at different prices. Price which is quoted by Mr. Market is reasonable but it is vague. It is completely up to the investor to know his price and trade with him at that price or ignore his deals. There is no affect of such an act on Mr. Market and he will come back to the same investor next day with updated quotes. The point which Benjamin Graham was trying to explain in the approach to value investment that investors should not regard the impulses of Mr. Market in order to determine the values of the stock or the share prices of the companies. It is necessary for the investors to get huge profit from the market and do not participate in the value preposition of the market.
Depth of the Research
Support of Value Investment Approach
Support to the approach of value investment was vast. One of the very popular personalities, Warren Buffett supported this approach with a very minute change in the approach. There were many other people or the economists, who supported this approach and appreciated the method for recommending the investors about investing in the companies.
Still, in the present era, investors follow the same approach for investing in the companies and are benefitted.
Criticism of Value Investment Approach
There was a very serious issue with the approach to the value investment by Benjamin Graham that despite of the fact that the prices are undervalue at one point of time, there is a possibility that prices will again drop with the market. This was an issue with buying share in the bear market.
In the case when shares are not bought in the bull market, despite the prices are appeared overvalued at one point of time, there is a possibility that price may rise with the market.
There was an issue with the approach of value investment in case of the calculation of intrinsic value that two investors may have the same information about the stock may reach to different conclusion about the intrinsic value of the company. There should be a systematic method which should be made a standard method for calculating the values of stock.
We can conclude from our study that value investment approach developed by Benjamin Graham was a great success in the history and was a great evolution in the field of management and accounting. All the suggestions given by the value investment approach was in some situations are used still in the present comparison of the stocks of different companies but there are some loop holes in the approach as well like the approach was not perfect for the situation in which intangible assets are to be analyzed for any company. This was not at a small problem because in any case a company would be having both kinds of assets, intangible and tangible; hence calculation of intrinsic value was not up to the mark as per this approach. Another problem associated with this approach was that it was not made for the situations under rapid technological change in the market which is the present situation. Hence in all the value investment approach is not fit for the present era as far as value calculation is concerned.
As a recommendation to the use of value approach given by Benjamin Graham, it should be noted that value investment approach was a significant in case of investment because it takes the book value as its main concern but the problem with the value investment approach is that it is useful for the assets which are tangible in nature. In case of intangible assets like patents, brand value, good will and software it is very much difficult to quantify the same as in case of the tangible approach. In this case there might be possibility that it becomes difficult for the company to survive the break up. Hence it is recommended that when a fast technological advancement is there in the company, in order to valuate the value of the asset, investor should not use the calculation for intrinsic value because of the fact that in certain situations power of production of any asset may reduce up to a certain level due to some problem in the competitive innovation and because of this value approach may have a permanent damage. Hence in case of fast technological changes, this approach should not be used.
Hence another approach which is recommended for the calculation of the value of stock is discounted cash flow method in which value of the assets is summation of cash flow of the future which is discounted back to the present.
- Benjamin Graham: The Father of Value Investing. (n.d.). Retrieved on March 6, 2010 from http://web.streetauthority.com/benjamin_graham.asp
- Whitman, Martin J. (1999). Value Investing: A Balanced Approach. Published by Wiley. ISBN 978-0-471-16292-6.
- Value approach to investing in funds: value and large cap funds offer a conservative approach to long-term investing. (1999). Retrieved on March 6, 2010 from http://findarticles.com/p/articles/mi_m0JQR/is_10_14/ai_30548855/
- Lowe, Janet. (1997). Value Investing Made Easy: Benjamin Graham's Classic Investment Strategy Explained for Everyone. Published by McGraw-Hill Professional. ISBN 0070388644, 9780070388642