Value Investing

December 7, 2006 by  


By Bob Wood

If you ever wonder what you must do to invest successfully in the stock markets, the best thing I can advise is to spend a lot of time reading. The wealth of information made available to us daily offers the opportunity to produce satisfactory investment returns. I am sure, though, that too few individual investors put enough emphasis on this chore.

Yes, reading is time-consuming, and few enjoy the more mundane tasks that are routine for professional investors. Most find it much easier to get information from the television or take hot stock tips from friends. But if you are going to invest on your own, the burden is on you to know what you are doing — and why.

One of my regularly scheduled stops each Monday morning is at the excellent website, www.hussmanfunds.com, provided by John Hussman, Ph.D., who manages a hedged mutual fund, the Hussman Strategic Growth Fund. Dr. Hussman invests in domestic markets, which is one area where we definitely disagree. But he is also free by mandate to hedge these positions with hedges, short positions in over-priced stocks, or buy “buying puts” on the major indices that correlate to his long-side positions.

If you have already checked the performance of his fund over the past few years, you’ve seen that his returns have not been too strong. But since he follows an “absolute return” mandate for his investors, he is concerned with how his fund preserves investments during bear market cycles, and this makes it an “all-weather” fund. Hussman’s long-term record is much better than recent performance shows.

What I appreciate most when reading Hussman is his adherence to the value of fundamental analysis. He believes what you pay for a stock matters over time, whereas, in today’s market environment, valuation seems to mean little.

Of course, value investing was not an original idea with Hussman. But in a recent online message, free to anyone checking his web site, he quotes liberally from Benjamin Graham, one of the men credited with teaching the concepts of value investing to none other than the greatest investor of our time, Warren Buffett.

Graham’s book, The Intelligent Investor, is considered an investment classic. Buffett himself calls this book ‘’by far the best book on investing ever written.’’ And Hussman seems to believe that if Graham were alive today, he would be doing little buying of stocks at today’s prices. And that concept may have some relation to how much cash his famous student Buffett now continues to hold patiently.

One concept still taught academically to students of the markets is that they are efficiently priced. That is that stocks always sell for what all available information judges them to be worth — or to be worth at some point in the future. And, yet, for that reason, an investor trying to beat the market will seldom, if ever, succeed. In fact, Buffett has been quoted as saying that if that concept were true, he never would have become a successful investor and may have wound up selling pencils on the street corner — or something to that effect.

In the following, taken from his website, Hussman writes:

In 1984, Warren Buffett gave a talk at the Columbia Business School in honor of his mentor, Ben Graham. He began by relating the academic argument that investors having long-term records of outperforming the market really owe their success to randomness. Buffett responded by describing a hypothetical coin-flipping contest, where each participant flips a coin each day for 20 days, and those who come up with all heads are declared winners.

Buffett continued, “if (a) you had taken 225 million orangutans distributed roughly as the U.S. population is; (b) 215 winners were left after 20 days, and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were onto something. So you would probably go out and ask the zookeeper about what he’s feeding them, whether they had special exercises, what books they read, and who knows what else. That is, if you found any really extraordinary concentrations of success, you might want to see if you could identify concentrations of unusual characteristics that might be causal factors…”

“I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville. While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock.”

Buffett concluded his talk by explaining why he had no fear of diluting the performance of value investing by winning more converts to it – “I can only tell you that the secret has been out for 50 years… yet I have seen no trend toward value investing in the 35 years that I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It’s likely to continue that way. Ships will sail around the world but the Flat Earth society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”

Graham and Buffett both appear to believe that most investors truly do “under-perform” the stock market over time. Ignoring the basic tenets of value investing and relying upon speculation are the most likely causes for their beliefs.

Hussman shares these excerpts from Graham’s book:

“Nothing will appear more logical and natural to this audience than the idea that a common stock should be valued and priced primarily on the basis of the company’s expected future performance. Yet this simple-appearing concept carries with it a number of paradoxes and pitfalls. For one thing, it obliterates a good part of the older, well-established distinctions between investment and speculation.”

“I should greatly welcome an effort by security analysts to deal intelligently with speculative operations. To my mind the prerequisite here is for the quantitative approach, which is based on the calculation of the probabilities in each case, and a conclusion that the odds are strongly in favor of the operation’s success. It is not necessary that this calculation be completely dependable in each instance, and certainly not mathematically precise, but only that it be made with a fair degree of knowledge and skill. The law of averages will take care of minor errors and of the many individual disappointments which are inherent in speculation by its very definition.”

“……but there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.”

Continuing his own commentary, Hussman offers his interpretation of Graham:

That distinction between investment and speculation has been a frequent topic in these weekly market comments over the years. In my view, stocks are claims on the stream of cash that will be delivered to business owners, either in the near-term through liquidation, or over time, as the result of ongoing business activities. When you can buy stocks at prices that can be reasonably expected, on conservative assumptions, to produce a satisfactory long-term return, the purchase meets the definition of an “investment.” When you buy stocks on the expectation that they’ll increase in price, based on factors other than a discount to existing assets or conservatively discounted future cash flows, the purchase is a “speculation.”

Of course, accepting the idea that stocks are sometimes neither good investments nor reliable speculations can make one vulnerable of missing certain market advances, particularly when they appear in overvalued conditions (such as those that we’ve observed in recent months). Graham wrote “it is a cliché that in a roaring bull market knowledge is superfluous and experience a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss.”

Graham’s approach to risk management involved buying stocks when they appeared cheap and selling them when they became richly valued. “That sounds like timing,” he wrote, “but when you consider it you will see that it is not really timing at all but rather the purchase and sale of securities by the method of valuation. Essentially, it requires no opinion as to the future of the market; because if you buy securities cheap enough, your position is sound, even if the market should go down. And if you sell the securities at a fairly high price you have done the smart thing, even if the market should continue to go up.”

“If you believe – as I have always believed – that the value approach is inherently sound, workable, and profitable, then devote yourself to that principle. Stick to it, and don’t be led astray by Wall Street’s fashions, illusions, and its constant chase after the fast dollar. Let me emphasize that it does not take a genius or even a superior talent to be successful as a value analyst. What it needs is, first, a reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.”

As I see it, Hussman, Buffett and Graham all agree on the basic concepts of value investing. And none, including Graham if he were still alive, are at all comfortable with today’s investing environment. So many seem to chase the latest fads — like Google, airline stocks or whatever the financial media touts — without doing any real, fundamental analysis.

Following one simple metric could prevent your becoming the type of investor bound to experience what Graham referred to as a ‘’temporary profit and ultimate loss.’’ Buying stocks that sell for 18 to 22 times earnings qualifies to most value investors as speculating, which is a form of gambling. When the major markets like the Dow or S&P 500 sell at those levels, little true value investing — and way too much speculation — is going on.

Be sure to look the world over for markets and stocks that offer better valuations. And there are not many in today’s domestic market that do!

Have a great week,
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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