While Quantitative Strategies for Achieving Alpha would obviously appeal to so called “quants”, I also think it is a book that value investors should not overlook. Tortoriello introduces the book by stating, “This book was written with qualitative investors in mind, particularly those who wish to “understand” the stock market from a quantitative (empirical) point of view and who desire to integrate quantitative screens, tests, or models into their investment process—or simply into their thinking.” While quantitative approaches often tend to focus on technical analysis, this book will appeal more to value investors given that it examines the theory of why each fundamental factor works and it relegates technical analysis to just one chapter on price momentum.

From page 39 of The Science of Hitting.

As I read through each chapter and flipped through the extensive results tables in the appendix, I started imagining Ted Williams’ strike zone graphic in The Science of Hitting. Could I use Tortoriello’s process and analysis to start building my own strike zone chart of where to find the fattest pitches in the stock market? By the time I made it through the second chapter, I was pretty excited with the idea of using Tortoriello’s method myself. With access to Portfolio123 data and this method, I might just be able to build myself a map of when and where to swing for the fat pitches.

Before I get too far ahead of myself, let me discuss why I like this book so much. Unlike Joel Greenblatt’s The Little Book That Beats the Market, Tortoriello’s Quantitative Stategies for Achieving Alpha provides all the details necessary for replicating his work. The method is clearly and fully described in a 26-page methodology chapter. There are no secret or ambiguous steps to his stock screens. I was never able to replicate Greenblatt’s Magic Formula (and I haven’t seen anyone else replicate his backtest results), but I feel confident that I can replicate Tortoriello’s work.  In fact, I’ve already started and will start sharing those results soon.

The method Tortoriello lays out begins with investment basics, building bocks, and finally mosaics.  An investment basic in this context is a grouping of investment strategies that generally work. The basics listed by Tortoriello are as follows:

• Profitability
• Valuation
• Cash Flow
• Growth
• Capital Allocation
• Price Momentum
• Red Flags

A chapter is dedicated to each of these investment basics in Quantitative Strategies. Each of these basics are then composed of building blocks.  Tortoriello states, “A building block is a specific strategy that has investment value and works for a clearly understandable, nonstatistical reason.” Finally, these building blocks can then be pieced together to form a mosaic. The mosaics take the form of two factor screens, multi-factor models, and integrated investment strategies that combine quantitative results with qualitative vetting and risk management.

Each of the building blocks tested in this book are sorted by the value of the factor being tested and then divided into five equal sized portfolios. Each of these quintiles are backtested with 12-month holding periods from 1987 to 2006.  The portfolios are rebalanced every 12-months and compounded annually to more realistically replicate what an individual investor might be expected to do to avoid higher short-term capital gains tax and trading costs. To help ensure that the test is not impacted by seasonal or statistical effects, the backtest is also started at four different points during the calendar year.  The results of the quarterly tests are used to calculate the average excess returns for each quintile.  The test results for the Enterprise Value to EBITDA ratio are provide below as an example of the many result summaries presented in this book.

When two factor tests are constructed, both factors are not weighted equally by Tortoriello. Instead, he first forms a set of stocks based on the first factor and then from that set he selects stocks based on the second factor. Not much rationale is provided for why this method was preferred, except to say that the first factor ends up being weighted more heavily and that the portfolio sizes end up consistent. This is a bit different from the way Greenblatt equally weighted both factors in his Magic Formula.

As you saw in the backtest example, many statistics are provided for each of the quintiles.  These include your typical compound annual growth rate, average excess returns, and the percent of periods outperforming.  In addition, the author includes some more academic statistics such as Sharpe Ratio, Beta, and Alpha. The author gets points with value investors for disparaging Beta as a measure of risk and its use in calculating Alpha. However, he still provides these statistics with every summary, I guess to cater to some quants that expect to see those stats. In addition to these statistics, many of the basic building blocks are also tested by industry sector.

Tortoriello uses a fairly intuitive and and basic set of criteria to evaluate each of the strategies tested in this book.  He write, “Our criteria for a strategy that works are (1) the top quintile outperforms the market by a significant margin; (2) the bottom quintile significantly underperforms; (3) outperformance and/or underperformance have been consistent over the years; and (4) there is some linearity in the performance of the quintiles, indicating a strong relationship between the strategy and excess returns.”  In addition, he also mentions that he prefers strategies with low volatility and low maximum loss for the top quintile and high volatility and high maximum loss for the bottom quintile.  Most importantly, Tortoriello doesn’t forget to emphasize that a strategy that worked well in the past may not work as well in the future.

The book concludes with two chapters on pulling together the most successful building blocks.  These included, but are not limited to, the following factors: EV to EBITDA, Free Cash Flow to Price, ROIC, Cash ROIC, 52-Week Price Range, 7-Month Relative Strength, External Financing, 1-Yr Reduction in Shares, EPS Score, and FCF Per Share Score. Several two-factor, three factor, and a complex multi-factor model built using Monte Carlo simulation to optimize weightings are presented. The use of Monte Carlo simulation makes me a bit uncomfortable with the potential for data mining and model overfitting, but at least it introduced me to another approach.

While the analysis in Quantitative Strategies for Achieving Alpha is valuable, this book is not an easy read. I would not recommend taking this book to the beach. Instead, I found it ideal to read this book over short intervals in a quiet study or during the quiet morning subway ride I take to work. I found myself referring back to the methods section and some individual building block backtest results several times. This is one of those books you’ll want to own and markup versus borrowing it from the library.

This book has inspired me to test out many of the stock fundamentals that are popular with value investors. Within the next few days, I’ll provide my own backtest of the Enterprise Value to EBITDA ratio from 2001 to 2011 using StockScreen123. What other fundamentals would you like to see tested?

The book currently includes over 70 businesses.  These include the following:

• Acme Brick Company, assigned to Adam Ward, UNO-CBA.
• American Express Co. (AXP), Dr. Maulik Suthar, Gujarat, India.
• Applied Underwriters, assigned to Adam Ward, UNO-CBA.
• Ben Bridge Jeweler, assigned to Beryl Chavez Li, University of Manchester, UK.
• Benjamin Moore & Co., assigned to Mr. Jack Wang CPA, Lexico Advisory.
• Berkshire Hathaway Group
• Berkshire Hathaway Homestate Companies, assigned to Beryl Chavez Li, University of Manchester, UK.
• BoatU.S., assigned to Peter Chen, Singapore.
• Borsheims Fine Jewelry, assigned to Tariq Khan, UNO-CBA.
• Buffalo NEWS, Buffalo NY,
• Burlington Northern Santa Fe Corp. assigned to David Leoy.
• Business Wire, assigned to Larry Harmych.
• BYD, assigned to Kevin Walsh, UNO-CBA.
• Central States Indemnity Company, assigned to Azalia Khousnoutdinova, UNO-CBA
• Clayton Homes, assigned to Erin Sestak, UNO-CBA.
• Coca Cola (KO) assigned to Sebastian Jung, UNO-CBA
• ConocoPhillips (COP), assigned to Adam D. Studts, PE, UNO-CBA.
• CORT Business Services, assigned to Erin Sestak, UNO-CBA.
• Costco Wholesale (COST), assigned to Jubin Jacob, AUC-SOM.
• CTB Inc., assigned to Todd Sullivan.
• Fechheimer Brothers Company, assigned to Ben Albaitis.
• FlightSafety, assigned to Mark Murillo, Memorial High School
• Forest River, assigned to Richard Konrad, CFA, Value Architects Asset Management.
• Fruit of the Loom®, Dr. Maulik Suthar, Gujarat, India.
• Garan Incorporated, assigned to Dr. Edwin Fuentes
• Gateway Underwriters Agency, assigned Daniel Rudewicz, CFA of Furlong Financial, LLC.
• GEICO Auto Insurance assigned to Florian Beil, UNO-CBA
• General Re, assigned to Raghu Dasari, UNO-CBA.
• H.H. Brown Shoe Group, assigned to Mervyn H. Teo (Singapore)
• Helzberg Diamonds, assigned to Natalja Callahan, UNO-CBA
• HomeServices of America, assigned to Sebastian Jung, UNO-CBA
• IBM
• International Dairy Queen, Inc., assigned to Tariq Khan, UNO-CBA
• Iscar Metalworking Companies, assigned to Kevin Walsh, UNO-CBA.
• Johns Manville, assigned to Manpreet Singh Saran.
• Johnson & Johnson (JNJ), Beryl Chavez Li. & Jubin Jacob.
• Jordan’s Furniture, assigned to Zehao Sun.
• Justin Brands, Dr. Maulik Suthar, Gujarat, India.
• Kraft Foods (KFT), assigned to Andrea Tagart, UNO-CBA.
• Larson-Juhl, assigned to David Arthur Dawes
• Lubrizol, with Scott Thompson, MBA.
• M&T Bank Corp (MTB), Cliff Orr, Kellogg-Northwestern.
• Marmon Holdings, Inc., assigned to Robert Williams.
• McLane Company, Dr. Maulik Suthar, Gujarat, India.
• Medical Protective, assigned to Michael Murillo, KCUMB
• MidAmerican Energy Holdings Company, assigned to Dr. Maulik Suthar, Gujarat, India.
• MiTek Inc., assigned to Mr. Jack Wang CPA, Lexico Advisory.
• Moody’s (MCO), assigned to Raghu Dasari, UNO-CBA.
• National Indemnity Company, assigned to Jen Iwanski, UNO-CBA.
• Nebraska Furniture Mart, assigned to Julie Rosenbaugh, UNO-CBA.
• NetJets®, assigned to Christian Labitan.
• PacifiCorp., assigned to Beryl Chavez Li, University of Manchester, UK
• Precision Steel Warehouse, Inc., assigned to Adam D. Studts, PE, UNO-CBA.
• Procter & Gamble (PG), assigned to Beryl Chavez Li, University of Manchester, UK
• RC Willey Home Furnishings, assigned to Azalia Khousnoutdinova, UNO-CBA.
• Richline Group, Daniel Doyon, Purdue University.
• Scott Fetzer Companies, Cliff Orr, Kellogg-Northwestern.
• See’s Candies, assigned to Jen Iwanski, UNO-CBA.
• Shaw Industries, Richard Konrad, CFA, Value Architects Asset Management
• Star Furniture, assigned to Pamela A. Quintero.
• The Pampered Chef® assigned to Julie Rosenbaugh, UNO-CBA.
• TTI, Inc., assigned to Peter Chen, Singapore.
• United States Liability Insurance Group, assigned to Stephen Chan, University of Manchester, UK.
• US Bancorp (USB), assigned to Richard Konrad, CFA, Value Architects Asset Management.
• USG Corp (USG),
• Wal-Mart (WMT) with Florian Beil, UNO-CBA.
• Washington Post (WPO), assigned to Andrea Tagart, UNO-CBA.
• Wells Fargo (WFC), assigned to Natalja Callahan, UNO-CBA.
• Wesco Financial Corporation, assigned to Stephen Chan, University of Manchester, UK.
• XTRA Corporation, assigned to Ryan M Shuck, UNO-CBA

This sixth edition of Security Analysis features a preface written by Warren Buffett. In it, he reveals that he has read the 1940 masterwork at least four times. This sixth edition is based on the 1940 edition. In addition to the preface by Mr. Buffett, the sixth edition also features an additional 200 pages of commentary from some of today’s leading value investors. The contributor list includes:

• Seth A. Klarman, president of The Baupost Group, L.L.C. and author of Margin of Safety.
• James Grant, founder of Grant’s Interest Rate Observer, general partner of Nippon Partners.
• Jeffrey M. Laderman, twenty-five year veteran of BusinessWeek.
• Roger Lowenstein, author of Buffett: The Making of an American Capitalist and When America Aged and Outside Director, Sequoia Fund.
• Howard S. Marks, CFA, Chairman and Co-Founder, Oaktree Capital Management L.P..
• J. Ezra Merkin, Managing Partner, Gabriel Capital Group ..
• Bruce Berkowitz, Founder, Fairholme Capital Management..
• Glenn H. Greenberg, Co-Founder and Managing Director, Chieftain Capital Management.
• Bruce Greenwald, Robert Heilbrunn Professor of Finance and Asset Management, Columbia Business School.
• David Abrams, Managing Member, Abrams Capital

I wouldn’t be surprised if this limited edition version of Security Analysis becomes a collector’s item in the future. This would be especially true if you could one or more of the commentators to sign your copy. If this ultimate gift does not quite work for you, consider my previous value investor gift ideas.

Using a 40 backtest of S&P Compustat’s, O’Shaughnessy’s found that all stocks as a group returned an average annualized return of 12.45% from 1954-1994. However, he found that if you only invest in stocks with a price to sales ratio less than 1 and rebalancing annually that annualized average returns increased to 18.14%. The P/S ratio might be have been better than using the P/E ratio, because earnings are often manipulated, but sales numbers are harder to fudge.

However, Computer Associates (CA) found a way to fudge both of these value ratios. The company manipulated its software sales numbers by recording part of it as license fees and part as maintenance fees. There was a huge gap between revenues booked and cash received.

Pabrai asks the following questions when looking at companies:

1. What are its revenues and market cap?
2. What is its expected future free cash flows?

Computer Associates’ 10-Ks and 10-Qs gave Pabrai a headache when he tried to understand them. As you might remember from “On Avoiding Enron-itis!” not being able to understand a financial statement is a serious red flag.

On its face, CA had a simple and effective business model. It bought up software companies, removed expensive senior management, and then milked the software maintenance fees. This is a vulture business model and it can be effective.

It is extremely hard for large companies to change vendors quickly, so many were locked into the maintenance fees. After a while, a Fortune 500 company figured out a way to prevent getting caught in the CA maintenance trap by requiring all software purchases to include a clause that would require the reimbursement of all investment in the software if the vendor ever gets acquired by CA.

I’m a bit surprised that Pabrai likes the price to sales ratio.  I’ve read several studies that indicate that the price to sales ratio is that that effective anymore since O’Shaughnessy’s book was written. I found this to be one of the weaker chapters of Mosaic. I recommend reading many of the earlier chapters however. You can read most of them for free online by visiting my collection of links called Poor Man’s Mosaic.

On Punting (taking a high risk, high return bet)

“Rule No. 1: Never Lose Money. Rule No. 2: Never Forget Rule No. 1.”

“We’re perfectly willing to trade a big payoff for a certain payoff.”

On When to Invest

“Be Fearful when the World is Greedy and Be Greedy when the World is Fearful.”

“We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.”

On Sticking to One’s Circle of Competence in Investing

“It’s not important how big one’s circle of competence is; knowing its boundaries, however, is critical.”

“I don’t try to jump over 7-foot hurdles: I look around for 1-foot bars that I can step over.”

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

On Capital Allocation

“[We] can take our capital and move it into businesses that make sense.”

“I am a better investor because I am a businessman and I am a better businessman because I am an investor.”

On the Importance of Investing in Good Businesses

“When a management team with a reputation for brilliance joins a business with poor fundamental economics, it is the reputation of the business that remains intact.”

On the Efficient Market Theory

“I’d be a bum on the Street with a tin cup if the market were always efficient.”

On Being (In)active in the Management of Acquired Businesses

“If they need my help to manage the enterprise, we’re probably both in trouble.”

On Investment Bankers and other Middle Men

“My idea of a group decision is looking in the mirror.”

“Never ask your barber if you need a haircut.”

These are all nuggets of Mr. Buffett’s wisdom that can help us all become better investors. Thank you Mr. Pabrai for sharing this cheat sheet with us. What else would you add to this list?

1. Obtuse financial statements
2. Consistency of business performance
3. “Restructuring” charges
4. Earnings guidance
5. Related party transactions, compensation and stock options
6. The nature of management

Obtuse Financial Statements: “The only reason that one may not understand a financial statement is because the writer does not want you to understand it.” – Warren E. Buffett

Consistency of Business Performances: In order to maximize stock price, some executives resort to manipulating accounting to show consistent earnings.  If earnings are going up in a highly consistent manner over several years, this may be a red flag except for subscription type businesses with recurring revenues.

“Restructuring” Charges: Beware of companies that routinely report onetime, non-recurring charges. Also, be extremely skeptical of large “restructuring” charges that “clean house” every few years.

Earnings Guidance: From Warren Buffett’s 2000 Letter to Shareholders of Berkshire Hathaway:

“Over the years, Charlie and I have observed many instances in which CEOs engage in uneconomic maneuvers so that they could meet earnings targets they had previously announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a variety of accounting games to “make the numbers.” These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more “heroic.” These can turn fudging into fraud. More money, it must be noted, has been stolen at the point of a pen than at the point of a gun.”

Related Party Transactions, Compensation and Stock Options: Be sure to examine the “Related Party Transactions” of 10-Ks and 10-Qs. Related party transactions of any kind are often a problem and indicate low ethics standards at a company. When studying compensation, consider option grants, bonuses and base salaries in relation to business and management performance.

The Nature of Management: The business description of a company in its 10-K should be understandable. Then move on to listening to the latest conference call to determine if you feel good about “partnering” with the management team.

Mohnish Pabrai did a great job with this chapter on identifying red flags that might indicate problems with management. Are there any items you would add to his list?

Part of Bill Millers mental latticework comes from his education in history and philosophy. His bookshelf features the following books:

• Lives of the Poets
• At Home in the Universe
• The Eudemonic Pie
• Percentage Baseball
• Swarm Intelligence
• The Metaphysical Club
• Nature of the Greeks
• Information Rules

I’m not much of a fan of Bill Miller, but some of these books look interesting. I think I’ll add Swarm Intelligence to my reading list soon. It covers a topic I’m particularly interested in, which is how individual behavior can appear random, but collectively have order. It might even help me improve how Value Investing News works.

The article then goes on to talk about Bill Miller’s interest in The Santa Fe Institute.  The goal of this organization is to encourage collaborative work between traditional disciplines, share ideas, and encourage practical applications.

Charlie Munger is very into to the development of his own investing latticework. This includes the creation of his own “law of economic selection” based on Charles Darwin’s work. One of Darwin’s observations was that people have a tendancy to ignore evidence that conflicts with their proconceived theories or the vast majority of other observed evidence. Understanding this bias, carefully observing things that don’t fit or agree with current theories, and then asking why are key to making discoveries. Pabrai recommends reading Darwin’s own words to understand how this scientist could see what others couldn’t.

The development of a latticework mental models requires continual learning. Pabrai notes, “[Investing] is one of the broadest of all disciplines where all knowledge has a cumulative effect and essentially nothing is wasted.” It’s good to know that generalists still have a use in this society, which seems to encourage and promote specialization. I’ve always been very interdisciplinary in nature, so I’m glad that this nature aligns with my interest in investing. Pabrai concludes this article by referencing and recommending The Man Who Beat the S&P by Janet Lowe.

Check out the previous chapter, Latticework I, or continue with chapter 14, Blue Chip Blues. If you are interested in reading about the other chapters of Mosaic, visit my Poor Man’s Mosaic.

Searching online, we found links to 20 of the 26 chapters of the book online. I then posted a collection of all these links in the Value Investing News Forum under the thread, Poor Man’s Mosaic. I called the post Poor Man’s Mosaic, because copies of the Pabrai’s first book are hard to find and sell for several hundred dollars in the used book market (though it appears the price has come down a bit this year, probably as a result of some recent blowups in Pabrai’s portfolio). Given the cheapskate nature of value investors, my Poor Man’s Mosaic has been a very popular page on Value Investing News. Now that I’ve finally tracked down a copy of Mosaic, I want to fill you in on the six missing chapters.

The first of these missing chapters is Chapter 11: Dhando! I believe Dhando! became the inspiration for Pabrai’s more recent book The Dhandho Investor. In this chapter, Pabrai discusses the Patel family and their motel businesses. Pabrai’s college roommate, Ajay Desai, would end each story about how his uncle would aquire businesses and lower their operating costs with the word, “Dhando!” Dhando literally means “business” in Gujarati, but in this context it referred to “awesome cash-generating machines” according to Pabrai. Pabrai goes into a lot more detail about the concept of Dhando and the Patel family history in The Dhandho Investor, which I recommend you read.

The concept of Dhando is very similar to Warren Buffett’s concept of wide moat and Michael Porter’s “sustainable competitive advantage.” Pabrai quotes Buffett’s response to a question on the topic of moats and Michael Porter at the 2001 Berkshire Hathaway annual meeting:

“To the extent I’ve read or understand what Porter’s written, we basically think alike in terms of businesses. We call it a moat and he makes it into a book… We don’t give a lot of instruction to our managers. We don’t have budgets. And we don’t have reporting systems or anything else. But we do tell them to try and not only protect, but enlarge the moat. And if you enlarge the moat, everything else follows.”

The Patels gained their competitive advantage in the motel industry by imposing costs structure that are much lower than their competitors, and thus gaining the low cost advantage. Without this type of advantage, the Patel motels would have faced much more competition and much lower profitability.

According to Pabrai, investing can be distilled into some fairly simple criteria. First, Pabrai encourages us to “stick to looking at simple businesses.” I’m guessing Pabrai wishes he stuck to this recommendation before investing in now collapsed Delta Financial. I remember passing on Delta Financial when I couldn’t determine its future cash flows. I believe Pabrai is right on when he notes that you’d likely pass on the Enrons and WorldComs of the world if you fixate on free cash flows. After you identify a simple business, you should clearly determine how that business generates cash today, how likely the business is going to generate cash into the future, and how much you are willing to pay for that future cash flow. Finally, think about the moat around that company’s cash generating capabilities and on how the “knight” in charge of the castle is maintaining the moat. If a business passes these criteria, then Pabrai recommend you invest in it. I generally agree with this method, but I think Pabrai makes it sound simpler than it really is and I don’t think Pabrai sufficiently emphasizes the importance of buying at a price that provides a significant margin of safety in this particular chapter.

I’ll be next looking at Chapter 13 of Mosaic titled, Latticework – II. Mr. Pabrai had lunch with Warren Buffett yesterday, so I’ll also be looking for reports on how that lunch went.

At the end of the interview, you will be able to ask Tom Au questions in the forum at Value Investing News. Tom has agreed to field questions from the audience live right after the interview, so come prepared with any questions you may have about his book or value investing in general. Be sure to login or register during the interview, so you can post your questions. In addition, members of Value Investing News even have the chance to win a copy of A Modern Approach to Graham & Dodd Investing as part of the June Members Contest sponsored by John Wiley & Sons and Tom Au.

As significant as the refinement of the microscope by Antonie van Leeuwenhoek, Labitan believes that Warren Buffett and Charlie Munger invented an investing formula that is underappreciated by the business and academic communities. In his view, the Four Filters developed by Warren E. Buffett and Charles T. Munger is an amazing intellectual achievement in both practical and behavioral finance. He thinks it will have a major future impact in the way business, management, and behavioral finance thinkers shape new methods of combining qualitative and quantitative valuation. After all, the Four Filters are an important set of steps used by the world’s greatest investors. While Mr. Buffett does not endorse this book, he did give Dr. Labitan permission to use his quotes from the annual letters to shareholders. Labitan weaves the material into the story of successful “framing” and the “filtering out” suboptimal investment choices.

Bud’s book is available for order via the secure Google Checkout system at Bud’s website, www.frips.com. The Four Filters is being released in two formats, a spiral bound book for $39.95 and $29.95 for an audio cd generated from text to speech technology read at a rate of 150 words per minute. Bud was planning to publish with a major publisher and he had a contract offer. However, they had wanted to change the book and drop Charlie Munger and Four Filters from the title. This along with plans to expand and dilute the prose was too much for this first time author to bear. Therefore, Bud Labitan decided to self publish his book so that his work could be shared the way he intended, lean and valuable, the new standard in “intelligent investing.”

CHAPTER FIVE OF FIVE: SUMMARY

As significant as the refinement of the microscope by Antonie van Leeuwenhoek, I believe that Warren Buffett and Charlie Munger invented an investing formula that is underappreciated by the business and academic communities. In my view, the Four Filters developed by Warren E. Buffett and Charles T. Munger is an amazing intellectual achievement in both practical and Behavioral Finance. The Four Filters are a remarkable and important set of steps used by the world’s greatest investors. The Four Filters function as an effective time-tested focusing formula for investing success. They serve as a very useful guide for assessing intrinsic value and sensible price.

Behavioral Finance and Common Sense have shown us that we all have human tendencies to frame ideas that are affected by our emotions. Ideally, we would use the best of our emotional and intellectual energies in the right way. In my view, the Four Filters reduce the risk of investment failure by helping us steer a better path to a quality bargain.

Charlie Munger has spoken about the merits of having a “pilot’s checklist.” This is something I did not appreciate until I studied the Four Filters. These days, Warren Buffett mentions the Four Filters this way: “Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.” These Four Filters can enhance the probability of our investment success. I think they will help you in your search for intrinsic value and sensible investment.

In the 1985 Chairman’s letter to Shareholders, Warren Buffett wrote that his advantage was attitude. The 2007 annual letter shows Buffett in top form, buying quality bargains. He learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. Along the way, he and Charlie Munger got better at picking stocks and whole companies for investment. Their experience and an expanded knowledge base helped them look for understandable first-class businesses with enduring competitive advantages. Philip Fisher and others have influenced their views on evaluating first-class managements and evaluating a business’s growth potential.

Note however, that growth is only one component in assessing value. Through the conscientious process of Elaboration and Elimination, the Four Filters illuminate the most important factors for business and investing success. The Four Filters highlight and reveal the good prospects and eliminate the bad prospects for investment. They encompass four clusters that are vitally important to investing success: 1. Products 2. Customers 3. Management 4. Margin of Safety. In each of the four clusters, I can imagine the influence of Ben Graham, Philip Fisher, Charles Munger, and John Burr Williams. Business students can also imagine the ideas of Porter and Greenwald in these filters. In my view, the development of this Four Filters Formula has been an evolutionary process. And, by 1977, the Four Filters were being used like a “checklist” by our pilots, Warren Buffett and Charlie Munger. You can read about many of these influences in Andy Kilpatrick’s big comprehensive book, “Of Permanent Value: The Story of Warren Buffett.”

If Buffett and Munger had focused solely on the fourth filter, “Margin of Safety” from bargain prices, they would have still done well. However, used as a sequential set of filters, the Four Filters Formula is remarkably effective. It is an elegant algorithm that combines the use of important qualitative and quantitative decision steps. Warren Buffett has also phrased the Four Filter check points in this way: “When buying companies or common stocks, we look for understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements, available at a bargain price.”

From a historical point of view, the record at Berkshire Hathaway under Warren Buffett’s tenure speaks for itself. Over the last 43 years, Berkshire Hathaway’s book value has grown from $19 to $78,008, a rate of 21.1% compounded annually. Berkshire Hathaway A share is selling at around $140,000 at the time of this writing (March,2008). It’s intrinsic value per share is much higher. And, it’s future earning prospects look bright. Future investment managers will do well to practice owner-oriented business principles. I hope Future investment managers understand the effectiveness of this “Four Filter” Formula. If I was privileged to serve on this team, I would practice the Four Filters.

From a mathematical point of view, think of each stop along the Four Filters as a mutually exclusive and additive event. If a company passes a couple of filters, it is, by the process of elimination, farther to the right on a normal distribution curve. Of course, this filtering is from an “investment prospect” point of view. If this were a field of racing horses, movement along each step of the Four Filters path, the prospect enters a subset of “better than average” horse. In my view, practicing these steps will make you a better investment thinker.

From a practical point of view, business is about taking good care of your customer and arriving at an agreeable trade. Finding the company that has enduring competitive advantage means that you are finding a company that has been tested by time and its customers. Products, Customers, Good Management, and Financial Safety given by a bargain purchase are always important.

Working together, Buffett and Munger have produced a remarkable and effective Behavioral Finance formula. Within that Fourth Filter, Bargain Price, we see Ben Graham’s three most important words in investing, “Margin of Safety.” “Investing Safety” is practically insured by purchasing at a bargain price.

Pricing Bubbles, Market excesses, and Government excesses will come and go. Warren Buffett wrote that a different set of major shocks is sure to occur in the future and that he will not try to predict these nor to profit from them. However, if he can identify businesses similar to those he has purchased in the past, external surprises will have little effect on long-term results. Buffett said: “We will stick with the approach that got us here and try not to relax our standards.” In my own work, I will continue to use the Four Filters. In talking with students, Warren Buffett often uses this baseball analogy using the story of Ted Williams and his book: “The Story of My Life.” Buffett explained: “My argument is, to be a good hitter, you’ve got to get a good ball to hit. It’s the first rule in the book. If I have to bite at stuff that is out of my happy zone, I’m not a .344 hitter. I might only be a .250 hitter.” Charlie and I agree and (we) will try to wait for opportunities that are well within our own “happy zone.”"

The Four Filters Formula helps to impose a greater prudence in our investment decision making. As significant as the refinement of the microscope, I believe that Warren Buffett and Charlie Munger invented an investing formula that has worked effectively over the last 31 years. The Four Filters will help you get closer to your own “happy zone.” It has helped me greatly in my own investment decision thinking and my own investment decision making. And, I hope it helps you as much as I think it will.

My first impression of this book is that it holds a lot of promise. I’ve never really looked at Buffett’s investment criteria as filters, but Bud’s take makes sense to me. I look forward to reading the whole book in the near future. Hopefully, it will be published soon. What are your thoughts on this future book?

You can republish this poll widget on your own website or blog to help us get a more more participants in this fascinating poll. I’m very interested to see which books make it into the top ten. It is pretty likely that I’ve read most of the top value investing books out there, but if any make it to the top ten that I haven’t read yet I will likely add them to my wish list. Please feel free to share your reasoning for you book rankings in the comments section below.

George: Vitaliy N. Katsenelson, CFA, has been involved with the investment industry since 1994. He is a portfolio manager with Investment Management Associates, where he comanages institutional and personal assets utilizing fundamental analysis.

He is also an adjunct faculty member at the University of Colorado at Denver, Graduate School of Business where he teaches a Practical Equity Analysis and Portfolio Management class. Finally, he is owns a blog called Vitaliy’s Contrarian Edge.

Vitaliy, welcome to our forum, and thank you for taking time out of your schedule to answer some of our questions.

George: I’ve read that you have studied finance since you first started college. When did you discover that you were a value investor?

Vitaliy: I don’t think I can pinpoint a specific moment; it was a gradual process as I started out as a GARP (Growth at Reasonable Price) investor. Stocks I owned were high quality companies. They were growing earnings, most paid dividends, but they were fairly valued and thus earnings growth and dividends were the main source of the return. What I discovered over time was that the growth is a lot more elusive than I realized. Also, if the growth was very predictable you had to pay-up for it.

For high quality companies, the ones that had a strong sustainable competitive advantage, maintaining high return on capital (on existing projects) usually is not an issue, but finding new, incremental projects that have high return on capital became more difficult over time – they already have high market share, the industry growth slows down with time and the law of large numbers kicks in.

I realized that in the long-run to generate superior returns earnings growth and dividends should be supplemented by the P/E expansion.

George: What motivated you to write Active Value Investing: Making Money In Range-Bound Markets? 

Vitaliy: As most key things in my life, including the birth of my kids, writing AVI was an accident. An instigator was an initial chapter that I wrote for a book that was compiled by an acquaintance. However, by the time I was done with that “chapter” it had the length of five chapters.

I compare my brain to a Caesar salad where ideas are like croutons mixed together with a lot of lettuce. Writing forces me fish out those croutons (insights) and organize them. This is in part why I like writing, often I don’t know how the article (or in this case the book) would look at the end. Over the preceding years I accumulated plenty of interesting insights through research, writing hundreds of articles and teaching. After the idea of the book was born, I was really excited to systematize, pull all my knowledge into a framework.

George: What were some of your biggest challenges in writing Active Value Investing?

Vitaliy: The first one was logistical. Writing a book is like writing a couple hundred articles that are logically interconnected. Keeping the connection going was a bit hard, as two months into the writing I could not remember if I already mentioned something or not. Also, while writing a first draft I was concerned that I would not have enough material for the whole book thus I was very liberal with words – the first draft was dripping with verbal fat and repetition. In hindsight, it was a good problem to have as cutting is easier than writing. All I had to do was create a fairly detailed outline and do a lot of cutting and pasting.

The second issue was the prediction dilemma. In the first part of the book I make a prediction that over next dozen years or so we’ll be in a stagnating market that goes nowhere. I did not want to use “it happened in the past, thus it will happen in the future” argument; on its own it is fairly weak. I knew if somebody made that argument to me, I would not buy it – it is too simplistic. As I said in the book: “history is prolific about the past but is mute about the future.” However, after looking a great deal into 100 years worth of detailed data I realized that there is a very good reason why range-bound markets take place.

Finally, I realized that even the future will play tricks on us, and a very high probability event – the range-bound market – may not take place (i.e. long-term market trend will be bull or bear). The strategy I describe in the book should still do well or better than other strategies. It has the lowest cost of being wrong!

George: From my experience, I know I often learn a lot by writing. What did you learn as a result of writing your book?

Vitaliy: Writing forces you to synthesize. Writing AVI forced me to learn from the good decisions, but more importantly from the bad ones. In fact, learning from the bad decisions is harder as revisiting these decisions brings plenty of pain.

George: Do the market’s current actions confirm to your thesis that we are in a range-bound market?

Vitaliy: This is a very important question. In the past secular range-bound market of 1966-1982, we have five small bull markets, five small bear markets and one small range-bound market. At the end all these markets cancelled out each other and the slope of overall market was fairly flat. In other words, if you bought a market index in 1966 (though at the time I don’t think they had an index fund yet), you would go through a very exciting rollercoaster ride, you’d collect stock dividends but at the end of 1982 your stock portfolio would be at roughly the same level as it was in 1966.

Today’s stock market action confirms my thesis; currently we are in a cyclical bull market. How long will it last? Will the next leg be cyclical bear or range-bound? I don’t know. I am not attempting to time the short-term cycle of the market, as I say in the book, ‘time (price) individual stocks’. Buy stocks when they are undervalued and sell them when they are fairly valued. And repeat this over and over again. Keep an eye on the (stock) ball, not the bowling alley (stock market).

George: Please describe a typical day in your life as a professional value investor.

Vitaliy: I don’t really watch much TV, CNBC is usually muted in the background. Though lately I’ve been watching Fox Business channel. I try to read as much as possible. I find that I get easily distracted when I listen to conference calls, plus I am easily annoyed by analysts questions that focus on trees but don’t see the forest, thus I read conference call transcripts. This way I read it on my own terms (while listening to music) and I skim over analysts absurd questions.

I actively trying to avoid distraction, though that doesn’t always work (but I am trying). I build models, read newspapers, annual reports, and corporate filings. Talk on the phone or by instant messenger to my circle of trust. I usually take work home, read more after I put the kids to sleep. I always try to measure my emotional state, if I feel overconfident I look on the wall where I have an annual report of a company I lost a boat load of money on framed (no, it is not Enron or Worldcom).

George: What advice would you provide someone interested in becoming a professional value investor?

Vitaliy: I cannot say it better than I said in this article which I wrote for Financial Times, and which is in the book as well. It is about the process. Look at your decisions in the context of the process. Of course it is also about controlling your emotions, not following the crowd – but you knew that.

George: In Active Value Investing, you describe an absolute PE valuation model you developed. Would you mind walking through an example of how you value stocks using your absolute PE model?

Vitaliy: It is very straight forward. I forecast earnings growth rate over the next five years, using the reverse growth pyramid that I described in the growth chapter. I forecast the company’s dividend yield and based on a lot of fundamental analysis determine its business and financial risk factors and earnings visibility. Pulling this analysis together, I determine the company’s fair value P/E, required margin of safety which leads me to buy P/E. I adjust fair value P/E by a fundamental return (earnings growth and dividend) and get a sell P/E. All this supplemented with DCF and relative valuation analysis.

George: As you know from my review, I found Chapter 12: Sell Process – Make Darwin Proud to be one of the key chapters in Active Value Investing. In this chapter, you describe several methods for Darwinian style stock selling. Which of the techniques are you specifically using currently in your stock selling decisions?

I am using all the techniques I mentioned in that chapter. I set a target sell valuation at the time I buy a stock. I have a buy, hold and sell valuation for every stock in our portfolios. I don’t delegate sell decisions to someone else, but when my partner at my firm thinks we should sell a stock I recommended he has a super vote (for the stocks he recommended I have a super vote). I am a proactive seller; I try to sell before problems escalate. I sell stocks when they reach predetermined valuation target, in fact over the last several months we sold a handful of stocks and only bought one stock.

I believe the Sell chapter rivals importance with the Valuation chapter. I called the book Active Value Investing to emphasize the importance of sell discipline. In the secular bull market not to sell decisions were rewarded, as valuations were pushed into irrational extremes. Secular bull markets program us to be buy and (not sell) hold investors. However, during range-bound markets we need to actively think about selling.

George: We are all about finding and reading financial news here at Value Investing News. What news reading and tracking tips do you have for other members of the VIN community?

Vitaliy: Read VIN!

George: You just made me blush. Thank you for the vote of confidence on Value Investing News. It’s good to know that the site is useful for both individual and professional value investors.

George: Do you have any plans to write another book in the future?

Vitaliy: I downloaded all the knowledge I accumulated over last 12 years into this book. As of today, I don’t envision writing another book for a long time. I spent evenings and weekends working on it, while keeping a day job and teaching a graduate finance class. To be honest I missed my kids. I don’t want to miss them growing up. I’ll write articles from time to time but that is far as I think my writing will go for now.

George: Thank you for your responses to my questions. Now we will open it up for questions from other members of Value Investing News.

We received several great questions from the members of Value Investing News.  You can visit the Value Investing News Forum to read Vitaliy’s responses to the questions. If you have any further questions for Vitaliy, send them to me and I’ll forward them to Vitaliy. If he shares a response with me, I’ll post it here.

Who is Vitaliy Katsenelson?

Vitaliy is a CFA charter holder and a portfolio manager with Investment Management Associates. (You can review IMA’s performance record here.) He has been involved with the investment industry since 1994.  Vitaliy is also a fellow value investing blogger at the site, Vitaliy’s Contrarian Edge. I give authors more credibility when they are willing to expose themselves to public comments and debate by having a blog.

In addition to his portfolio management work and writing, Vitaliy also teaches at the University of Colorado at Denver. He teaches an interesting sounding class called Practical Equity Analysis and Portfolio Management. You can tell that Vitaliy has teaching experience from his clear writing style and good use of examples in Active Value Investing.

Vitaliy’s life is another example of the American dream come true. He grew up in the Russian city of Murmansk during the Cold War, overcame his bias against the United States, immigrated with his family to the U.S., earned bachelor’s and master’s degrees from the University of Colorado at Denver, and now has a successful financial career. It is a very impressive story that I’m sure gives Vitaliy a unique perspective on life. I enjoyed reading Vitaliy’s story in the Acknowledgements section of Active Value Investing.  It’s at the last few pages of the book, so be sure not to miss it.

Why you should read this book?

First off, Vitaliy is keenly aware of the audience for his book. Value investors are a skeptical lot, and Vitaliy immediately sets about mentally disarming this tough audience. I chuckled when I read the imagined Q&A session with the “Skeptical Reader”. I was more than willing to step into the role of the skeptical reader. The Q&A session did a good job of answering my questions about what is active investing, what is a range-bound market, and what I can do to address this market challenge. After this short section, I was motivated to read more.

Are we in a “range-bound” market?

Part I of Active Value Investing examines whether we are in a “range-bound” market.  Vitaliy starts this section with a warning, “Fasten your seat belts and lower your expectations,” and sure enough my expectations did drop a bit. Not to worry though, my expectations rose again after page 72 of this 282 page book and it definitely became a worthwile read.

The first 72 pages of the book takes you through a detailed statistical history of the market to support Vitaliy’s thesis that we are in a range bound market. Like many other recent pieces on historical market performance, this part of the book relies heavily on Yale University professor, Robert Shiller’s data. I must admit that I’m not much of a fan of historical market analysis and I’ve seen similar research elsewhere, so it was hard for this section to keep my interest. However, the paragraphs on the Japanese bear market (pg. 27-29) did pique my interest, and this discussion helped explain the difference to me between bear and range-bound markets.

Even though I struggled a bit to get through this part of the book, I definitely came away believing that there is a lot of evidence to support the possibility that we are in a range-bound market. My problem might have been that I was convinced too quickly. If you are anything like me, I recommend that you skim through this Part I of Active Value Investing once you are convinced that we are in a range-bound market.

How do I become an active value investor?

Part II of Active Value Investing was much more to my liking. It sets out to teach you how to be an “active” value investor. Vitaliy does this by detailing his quality, valuation, and growth framework. I found this to be an excellent approach to analyzing stocks.

In Chapter 5 on quality, I was especially excited to see a section on competitive advantage. I found it interesting that Vitaliy focuses on the importance of sustainable competitive advantage similar to the way I do, and uses the same term for it that I use. I know that Buffett uses the term “durable competitive advantage”, and I’ve seen a few other variations elsewhere, but I prefer focusing on “sustainable” competitive advantage. To further illustrate what sustainable competitive advantage is, Vitaliy provides a great discussion on brands using several good examples to make his point. I had a similar discussion on brands back in October of 2005 in a post about brands versus franchises.

I also found the discussion on debt to be very enlightening. Vitaliy notes how stock buybacks distort the apprearance of the balance sheet and can result in debt-to-asset or debt-to-equity ratios that are misleading. I had never thought about this issue before, and I have been primarily using debt-to-equity ratios in my analysis, so I found this discussion to be extremely valuable. Instead of using the debt-to-equity ratio, Active Value Investing recommends we utilize the debt/EBITDA, debt/operating cash flows, EBITDA/interest expense, and operating cash flows/interest expense.  I’ll be definitely relying on some of these other ratios a bit more in the future. Vitaliy followed up this discussion on debt with an illustrative case study of Colgate-Palmolive’s capital structure.  This is one of the strong points of Active Value Investing, the book includes many good examples to help the reader understand what a concept really means. Vitaliy fully explains how sustainable competitive advantage, high-quality management, predictable earnings, significant free cash flows, strong balance sheet, and high returns on capital are some of the main elements that help determine quality. 

Growth is also an important element of active value investing.  Vitaliy uses a flipped growth pyramid to explain the drivers of growth. He lays out the primary strategies companies use to grow revenue and then goes on to talk about growth from margin improvements from operating efficiency, economies of scale, and stock buybacks. Vitaliy includes a good case study of Westwood One’s share buyback, which illustrates how share buybacks can destroy shareholder value if done improperly. This section on growth concludes with the topic of dividends and their relative importance in a range-bound market.

Valuation is at the hear of active value investing. Vitaliy does an excellent job explaining the concept of discounted cash flow analysis using the story of Tevye the Milkman. Tevye’s cow, Golde, and her various cash flows are cleverly illustrated. I know I will be using this graphic in the future when I’m asked to explain discounted cash flow analysis.  One unique concept introduced, was the absolute P/E model. The absolute P/E valuation method uses a schedule of expected EPS growth rates and, dividend yields to adjust a base P/E value level.  This multifactor P/E model seems practical but relatively untested in my mind.  I’d be interested in talking to Vitaliy in ten years to see if he still uses it. Regardless, it still might be interesting to compare the results you get with more traditional discounted cash flow models with this absolute P/E method of valuation to see how close your results come out.

I highly recommend that you read Chapter 12: Sell Process – Make Darwin Proud, if you read anything in this book.  This chapter was a wake-up call to me.  I don’t have a really good sell process and the one Vitaliy presents is very logical and seems to be the key to acheiving good investment performance in a range-bound market.  Vitaliy recommends setting a P/E target level right away to determine when to sell a stock.  He even suggests using a stop-loss strategy after a stock reaches its fair valuation.  I’ve started using this particular strategy.

Finally, I also recommend reading chapter 13 on risk.  If you are new to the topic of risk and randomness, this chapter will be a great introduction for you on the topic. He breaks the concept of randomness into two components: the level of uncertainty and the significance of impact. I am a big fan of Steve Irwin, the Crocodile Hunter, and I think Vitaliy did a great job discussing the role of randomness on Steve Irwin’s life.

In summary, I think there is a lot of substance to Active Value Investing.  The first few chapters might turn off some (market history buffs might love it), but the second half of the book is a real gem.  If you are new to the concept of value investing, you will learn a tremendous amount from the clear and instructive writing.  Even if you are a seasoned value investor, you will find several unique concepts and new ways of looking at value investing.

“I’m interested in learning about quantitative analysis. I was wondering if you
might be able to suggest a good book to start with. I’ve read Rule  1# investing and been using it for a little bit. I’m interested getting into finance as a career though. My background is in Computer Science and software development, so I’ve had exposure to Calculus etc… I appreciate any recommendations you might have.”

Hello JT!  I’m glad to hear that you are interested in learning more about quantitative analysis.  I can think of two books you might want to check out.

The first book is Value Investing by Bruce Greenwald et al.  It covers the basics of different types of stock valuation.

The second book is Investment Valuation: Tools and Techniques for Determining the Value of Any Asset by Aswath Damodaran. This is a comprehensive, more mathematical, text book on valuation.  I learned a lot from it. Damodaran has a website with a lot of material,
lectures, and even manuscripts of some of his books.

By the way, you don’t need calculus for valuation.  Heck, it will likely only get you in
trouble.  I guess it could help in learning some of the mathematical theory of why
certain things work, but that’s about it.

Does anyone else have any suggestions?

I have read many financial planning books, but I have never really read about wealth management. I found the topic to be very interesting and potentially very important for me and my family as we grow our assets and start dealing with the (very modest) wealth of our parents. I must admit that I was a bit put off at first by the discussions family offices and the management of massive family fortunes for income production over multiple generations.  However, I discovered many of the wealth management discussions in this book are relevant to my modest family wealth today and could become very important in the future as my family continues to accumulate assets.  I want to share with you some of my observations from this unique book.

First, Stuart Lucas, the author of Wealth, definitely has the credentials to write this book on wealth management.  He is the fourth-generation heir of E. A. Stuart’s Carnation Company fortune. He has a Harvard MBA and is a Chartered Financial Analyst. He manages his family’s wealth and has run their family office.  His career has included several wealth management positions.  Stuart Lucas today is the Chairman of Wealth Strategist Network LLC, an independent provider of strategic wealth management educational services to individuals, families and financial institutions. It really looks like Stuart Lucas has practiced what he is preaching in his book.

I immediately like the fact that Lucas challenges the classic approach to wealth management. As with most traditional financial advice, the classic approach to wealth management is incomplete and geared more towards the interests of managers. Stuart Lucas introduces a more holistic approach that he dubs the “Strategic Wealth Management Framework”.  This framework is guided by eight principles of strategic wealth management that act guideposts. These strategic wealth management principles listed in Wealth are as follows:

1. Take charge and do it early.
2. Align family and business interests around wealth-building goals and strategies.
3. Create a culture of accountability.
4. Capitalize on your family’s combined resources.
5. Delegate, empower, and respect independence.
6. Diversify but focus.
7. Err on the side of simplicity where possible.
8. Develop future family leaders with strong wealth management skills.

These principles can then help guide and direct your family’s values, resources and communication.  Out of this core, your family can then set financial objectives, select advisers, and plan for the type of legacy you want to leave.  I really like the way this fully integrated framework is built on the core of your family’s values and resources so that it can meet your unique objectives.

Some of my favorite parts of this book include the list of issues to discuss with your family at the end of each chapter.  I also like the way Lucas divided up the wealth management industry into three categories, “The Capital Kibbutz”, “The Secret Society”, and the “Enchanted Forest”.  The Capital Kibbutz is the safe world of index funds and term life insurance.  The Secret Society is the domain of investors that have figured out how to make returns in excess of the risks they assume and includes the realm of hedge funds, private equity funds and actively managed investments.  The Enchanted Forest is where everyone else ends up getting lost in the glitz and glamour of investing. I also found Stuart Lucas’ discussion of tax planning both refreshing and very reasonable.  He does not encourage the use of exotic tax shelters (used in an unethical manner by some wealthy families) and actually acknowledges that you should consider thinking of the federal government as investment partners and not adversaries.  He points out the obvious tax savings from saving early and being a long-term investor.  You can’t argue with that sound advice. Finally, be sure to read the appendix on learning the language of wealth management, which I actually found to be rather funny and entertaining.

I hope someday to be able to put some of the more advanced topics discussed in this book, such as philanthropy and multigenerational planning, to work but for now I am more focused on wealth accumulation versus management.  I believe, however, that like with most things in life it is always best to be prepared (it’s probably the Boy Scout in me) so I encourage you to take a look at Wealth. 

Greenwald notes some common variables relating the price of the shares to some fundamental company information, including:

• share price to earnings (P/E)
• share price to cash flow (P/CF)
• share price to book value (P/B)
• share price to sales (P/S)
• share price to dividends (yield)

Those with low prices relative to each of these variables often outperform glamour stocks. In addition, stocks of small companies have outperformed the shares of large companies even when their price-to-book ratios are similar.

Greenwald points out several sources of bias that can lead to value opportunities. There is a systematic bias to cause people to pay too much for winners and too little for losers. There are also institutional biases. Many institutional investment funds are prevented from owning certain kinds of stocks (i.e. social responsibility). Unless there are just as many irresponsible funds as socially responsible funds, shares of the “dirty companies” may be permanently undervalued.

There is also size bias. Many funds cannot invest in small companies, either because their internal rules won’t allow it or they have too much money to manage and small companies can’t absorb enough of it to make it worthwhile. This size bias can have a big impact, especially since small companies have better opportunities to grow faster. Comparing small cap PE stocks to large cap can help you determine the relative value of each of these categories. Spin-offs are often small and dumped by funds that end up owning them. They are worth watching, because they can provide good value opportunities.

Human biases can also create opportunities. Herd mentality can play a large role here. The safest path for fund managers is to look like everyone else. Window dressing by fund managers at the end of the year to make there fund look like everyone else’s creates value opportunities.

Other human psychological biases to look for include the following:

1. People remember the recent past better than the distant future. We often predict by extrapolation and do not consider reversion to the mean.
2. We dislike risk and losing money. Most importantly, we don’t notice when losers improve.

Greenwald also notes that obscure, small, and boring stocks are great sources of value. In addition, undesirable companies (i.e. financial distress/bankruptcy, companies of industries with overcapacity, industries with import surges, negative legislative or regulatory hits, lawsuits, or long periods of underperformance) are also likely to lead to value opportunities.

Related Posts:

• Current Reading: Value Investing – From Graham to Buffett and Beyond
• Value Investing Chapter 1: Value Investing Definitions, Distinctions, Results, Risks, and Principles

1. Mr. Market is subject to erratic mood swings that affect prices significantly.
2. 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.
3. 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:

1. “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.”
2. “Seventy percent of active professional money managers underperform the market.”
3. 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.
4. 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:

1. Be aware of what you know and what you don’t know.
2. Be patient and wait for bargains.
3. While you wait you can put funds in money market accounts or other secure investments. You can even consider using a broad index fund.

This book looks very promising, and I plan on sharing my notes with you as I go through the book. Let me start with the Preface.

Greenwald discusses how Benjamin Graham’s Security Analysis and Intelligent Investor established the discipline of security analysis and value investing. Benjamin Graham’s course at Columbia University started many famous investors careers such as Warren Buffett. Eventually the course was taught by Roger Murray and then more recently by Mario Gabelli. Mr. Greenwald attended Gabelli’s lectures, and then later convinced Gabelli to teach a revised version of the course with him. This is Greenwald’s connection to the investors of Graham and Doddsville.

It is generally agreed that the value of a company is the present value of the sum of its cash flows to its investors over the life of the company. However, this approach requires forecasting cash flows far into the future, but value investors like Graham prefer to look at currently known values versus future projections. Therefore, value investors prefer to estimate the intrinsic value of a company by looking first at assets and then at current earnings power. The only time growth is worth something is when it produces returns that exceed the costs of additional capital that is necessary to fund the growth. This usually only occurs in companies where there are barriers to the entry of competitors. Therefore, it is critical that investors assess the strategic position of a company as part of the process of determining its value.

Graham loved “net-nets“, stocks trading substantially less than the current assets of the company minus all its liabilities. However, net-nets are very rare now and require us to move beyond this basic reliable asset value approach.

The next chapter is Chapter 1: Value Investing Definitions, Distinctions, Results, Risks, and Principles.