Continuing with last weeks discussion of Value Investing, today I’ve finished taking notes on Chapter 1: Value Investing Definitions, Distinctions, Results, Risks, and Principles. Greenwald starts this chapter by discussing how Graham and Dodd define value investing as a function of the following three concepts:
- Mr. Market is subject to erratic mood swings that affect prices significantly.
- Intrinsic Value: Despite large price swings in the stock market, the companies that underlie those stocks have fundamental economic values that are relatively stable and can be measured.
- Margin of Safety: Buying stocks only when their market prices are significantly below their calculated intrinsic value will produce superior returns over the long run.
The key difference between Graham and Dodd value investing and other fundamentalist approaches is the incorporation of an identifiable margin of safety.
Greenwald provides the following evidence that value investing works:
- “Low market-to-book portfolios have outperformed the market by 3 to 5 percent a year or more, since the 1920s, and low price-to-earnings portfolios have had similar success.”
- “Seventy percent of active professional money managers underperform the market.”
- Value investing has been adopted by Openheimer Capital and Tweedy, Browne and Company. Their superior returns have been comparable to the mechanical P/B studies.
- The “superinvestors of Graham and Doddsville” as described by Warren Buffett have substantially outperformed the market over the long run.
The academic world has argued that higher returns only come from taking higher risks. However, the standard measures of risk have not shown this to be true of value portfolios. Value portfolios perform better than high PE portfolios during recessions and the worst market downturns. Just because the price of a company goes down dramatically when Mr. Market is in a bad mood does not mean that purchase has become more risky. Risk and price volatility are two separate things according to Greenwald.
The key demands of value investing are as follows:
- Be aware of what you know and what you don’t know.
- Be patient and wait for bargains.
- While you wait you can put funds in money market accounts or other secure investments. You can even consider using a broad index fund.