Grahamian Investing

My post on Value was inspired by Aswath Damodaran’s three posts on Value Investing.

Like many, I am a regular reader of Professor Damodaran’s blog. I find his posts interesting, sharp and thought-provoking. So were the Value Investing posts. I thought, however, they were marred by some degree of confusion, which I would like to address.

The first post sets the stage with the following picture, which Damodaran puts forward as a general approach that encompasses his other classifications of Value Investing:

Value Investing is defined as the search for bargains that arise when the market undervalues a company’s existing assets. This is contrasted with Growth Investing, defined as the search for bargains that arise when the market undervalues a company’s growth assets, i.e. assets that are currently not in place but are expected to be generated by future investments.

As I said in my post, I think this is a false dichotomy. As Damodaran himself puts it: ‘the contrast between value and growth investing is not that one cares about value and the other does not’. Investors who care about value are all Grahamians: they invest in stocks where they see a significant gap between true values and market prices, irrespective of whether such values derive from current or future assets.

Grahamians believe that Mr Market can be carried away by sentiment – excess pessimism that drives market prices below true values and excess optimism that drives them above. Depending on the company, true values can be mostly embedded in existing assets or mostly condensed in future assets – or a varying combination of the two. The difference is that assets in place are, to an extent, observable and quantifiable, whereas assets-to-be are not. But Mr Market can misjudge both, and in both directions. It can undervalue current assets, thus presenting a bargain to a Grahamian who can properly quantify them; or it can undervalue future assets, thus providing an investment opportunity to a Grahamian who is able to anticipate the value creation to be brought about by future investments. The first is a more common image of a Value Investor. But the second is as much a Value Investor as the first, and to call him a Growth Investor is a persistent source of confusion. Likewise, Mr Market can overvalue current assets as well as future assets, thus prompting a Grahamian who can see the mistake to stay away from them or, if so inclined, short them. Here the common image is that of a Value Investor shunning the sentimentalism of Pindaric flights of fantasy that exalt future growth opportunities while neglecting gravitational threats. But avoiding investment in overvalued current assets is as much a trait of an accomplished Grahamian.

The observability of current assets explains why Grahamians are more comfortable dealing with them rather than with the inherent impalpability of growth assets. The value of current assets can be measured – Book Value being its coarsest approximation – while growth assets can’t. But, as we know, ‘Not everything that can be counted counts, and not everything that counts can be counted.’ Valuing growth opportunities is more difficult, rife with uncertainties and therefore more prone to error. But serious Grahamians accept the challenge – indeed that’s what Damodaran does regularly and expertly, in his blog and elsewhere. He himself is the proof that value versus growth is a false dichotomy!

Hence it is puzzling to see him sticking to it in his second post, where he embarks in an historical evaluation of their relative performance, based on the flawed classification: low P/BV=value stocks, high P/BV=growth stocks. Damodaran recognises that P/BV is just a proxy for value, and that ‘low PE and low P/BV stocks would not be considered true value investing, by most of its adherents’. Indeed, in his first post he defines low multiples investing as ‘Lazy Value Investing’ – a term I borrowed in my post – as opposed to ‘Cerebral Value Investing’, where screening for low multiples may be the starting point but final choices depend on a host of other criteria. But then in the second post he uses SPIVA data to show that most mutual fund managers who claim to adhere to Value Investing fail to beat their assigned value index. That is: most Cerebral Value Investors underperform Lazy Value Investing. Notice that, with equivalent Bogleheaded simplicity, one can use the same SPIVA database to show that most mutual fund managers who claim to adhere to Growth Investing fail to beat their own assigned index. That is: Cerebral Growth Investors underperform Lazy Growth Investors (or Crazy Growth Investors, as one should call investors who purposely buy high multiples stocks).

An erudite Grahamian like Professor Damodaran should not be drawn into these fruitless comparisons. There is no Value versus Growth Investing, no Value versus Growth performance or Value/Growth cycle. Value does not ‘work’ according to whether low multiples stocks outperform high multiples stocks. Value always works: it is the central concept to a Grahamian investor who believes that it can and often does differ from market prices. Whether a company’s value resides more in its current assets or in its growth assets depends on the company, not on the investor.

Indeed, this is the focal point of Damodaran’s third post, where he calls for a ‘Reinvention’ of Value Investing. It seems to me, however, that what he proposes as ‘A New Paradigm for Value Investing’ is nothing more than what serious Value Investing has been all along, once one looks at it without the distorting lens of the spurious value/growth opposition. In fact, one can take Damodaran’s picture at the top of this post and label it ‘Value Investing’ rather than ‘Value versus Growth Investing’. Or – in the name of Reinvention – name it Grahamian Investing, in homage to its chief architect, who, with a touch of condescension, preferred to call it Intelligent Investing.

Grahamian Investing is a great deal more complicated than what careless academics – who have no qualms calling low multiples stocks ‘value stocks’ and concocting a ‘factor’ out of them – purport it to be. They should go back (or go) and read Chapter 1 of Security Analysis: ‘It is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price’. Grahamians are aware that value is an elusive concept, impervious to exact appraisal: ‘There is no such thing as the “proper value” of any given common stock’, and therefore there is no readily quantifiable value parameter – despite academics, index providers and performance analysts pretending otherwise.

That is why Grahamians place as much significance on the concept of Margin of Safety. They don’t need to know the exact value of an asset, but they want to make sure – as much as they can – that such value is considerably higher than the market price, i.e. that there is a comfortably ample gap between value and price. Equivalently, they want to minimise the probability that the market price is right.

Grahamians regard the Margin of Safety as the most appropriate measure of investment risk. The wider it is, the lower is the probability of a permanent loss of capital. In this respect, Damodaran rightly observes that ‘the margin of safety comes into play only after you have valued a company, and to value a company, you need a measure of risk’. But it should be obvious to a Grahamian that none of the common measures of risk – standard deviation, beta and all their CAPM-derived ratios – are of any use. These are proper measures of risk only in a Boglehead world, where values coincide with prices, markets are efficient and higher returns are ‘explained’ by higher risk. In a Grahamian world there are many risks, but they have to do with real things like business conditions, competitive threats, accounting accuracy, balance sheet integrity, management skills, and many others, none of which are accurately quantifiable. That is why the Margin of Safety needs to be wide enough to accommodate them.

The Margin of Safety determines the real risk/reward trade-off facing a Grahamian investor. If he sets it too narrow, he increases the risk of buying a dud – a value trap or a ‘growth’ trap – thus losing capital, time or both. If he sets it too wide, he increases the risk of holding too much cash and performing poorly. The trade-off is depicted in the following picture on Damodaran’s third post:

It is essentially the same picture I presented (almost nine years ago – scary) in my Pearls and pebbles post. A Grahamian’s primary concern is to avoid a Type I error – a False Positive. It is Warren Buffett’s Rule No. 1: Never Lose Money or, as I called it, the Blackstone Principle of Intelligent Investing. But that needs to be balanced with a secondary concern: to avoid a Type II Error – a False Negative. We can call it Rule No. 2: No pain, no gain.

In order to avoid a Type I error, the Margin of Safety needs to be wide enough. As Warren Buffett put it: better ten strikes than one wrong swing. But to avoid a Type II error the Margin of Safety cannot be too wide: no swing, no return. The first is an error of commission – make an investment that turns out to be wrong. The second is an error of omission – decline an investment that turns out to be right. A Grahamian investor needs to find the right balance between the two – a much more meaningful decision than the sterile and potentially dangerous return/volatility trade-off prescribed by the CAPM’s ‘efficient’ frontier.

This is only one of many dimensions in which Grahamian investors – which are often wrongly depicted as a homogeneous bunch – differ from one another. In fact, we come in many shapes and forms: different focus, interests, temperament, risk attitude, portfolio construction rules and, of course, experience, track records and success. But one thing unites us: we place great significance in the concept of value, as distinct from the notion of price. This sets us apart from Cynics, who believe there are only prices, and Bogleheads, who believe there is no difference between the two. I believe that this tripartite classification fills the space of mutually exclusive ‘investment philosophies’. All other finer distinctions can be traced back to one of these three groups.

One last point, where I thoroughly agree with Professor Damodaran. While I naturally sympathise with the Value Investing community, I share his view that it has a tendency to become rigid, ritualistic and righteous.

1. Rigid. These are what we have called ‘lazy value investors’, stuck to simplistic and restrictive rules based on current accounting measures, impervious to venturing into any consideration of future growth assets, and thus worthy of the disparaging caricature that academics, Cynics and Bogleheads make of them.
2. Ritualistic. Like Damodaran, I have made the pilgrimage to Omaha only once, to satisfy my curiosity. I have enormous admiration and respect for Warren Buffett but much less for his devotees, who hang on his every word and are incapable of any criticism, even when the oracle is evidently wrong.
3. Righteous. As embarrassingly obvious as it is, some investors need to be reminded that calling oneself a value investor is not enough to be a successful one. ‘Value always works’ does not mean that every value investor is able and, even less, entitled to make it work.

So here is my proposal to reinvent and reinvigorate Value Investing: let’s call it Grahamian Investing.