A Review of Value Investing: From Graham to Buffett and Beyond
By Ankur H Shah
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Anyone who has studied value investing has most likely read The Intelligent Investor and Security Analysis, which is now in its 6th edition. Although less known, Bruce Greenwald's Value Investing: From Graham to Buffett and Beyond, is no less important than the seminal books written by Benjamin Graham. Greenwald systematically lays out the methodology that can best be described as modern value investing. Although the basic principles of value investing haven't changed, Greenwald has done an excellent job of identifying the key components of a value oriented stock analysis and how a company should be valued using a modern Graham and Dodd approach. In my personal experience, following the correct methodology and sticking with it is probably more important for long-term investment success than even superior intelligence. Greenwald clearly lays out the three criteria that are important for investment success: 1) a screening methodology, 2) valuation methodology and 3) sticking with your process through market cycles. Unfortunately, Greenwald doesn't provide much detail on screening techniques and the bulk of the book deals with his approach to value investing.
Chapter 1 begins with an overview of value investing. He discusses various studies that show how mechanistically constructed value portfolios such as low P/B stocks have outperformed the general market indices. He also addresses the main criticism of efficient market theorists, who believe that value portfolios provide outsized returns due to outsized risks. However, he provides a devastating critique by explaining that based on standard risk criteria such as Beta or annual return variability and in my view the more relevant measures of risk such as maximum loss realized or stock reactions to bad news, value based portfolios have outperformed. I'm going to go on a slight tangent here but I want to emphasize that Beta (i.e. historical volatility) is a poor measure of risk. Knowing that you have a low beta portfolio is going to provide you with little solace watching your stock portfolio tank in a bear market. In bear markets stock returns become highly correlated and Beta goes to 1 for everything. Thus, acknowledging the existence of an intrinsic value of a stock and being able to measure it accurately will provide you with the confidence to hold on to your investments even in a bear market. In fact, as any good value investor you'll have the confidence to start going bargain hunting as Mr. market provides you with numerous opportunities to purchase businesses below their intrinsic value.
The book does a good job of outlining how to value a stock but provides limited details on the places to look for undervalued stocks. Greenwald identifies areas such as small cap stocks, downtrodden stocks and spin-offs as areas where to look for undervalued gems. Although these are all good places to start, Greenwald doesn't provide enough additional detail about the criteria he would use to identify interesting long candidates. For example, what factors should an investor focus on to avoid investing in a value trap? In my view, Joel Greenblatt does a better job of explaining where to look for interesting investing opportunities in his book You Can Be a Stock Market Genius. I'll be doing a review of Greenblatt's book as well, but for now we'll get back to Greenwald's book.
The core of the book deals with the three main components of his valuation methodology which are net asset value (NAV), earnings power value (EPV) and growth value (GV). Modern value investing can be seen as a continuum where intrinsic value is first determined by the asset value of the company. Net asset value is the most conservative measure of a stock's value as it is based on the reported assets of a firm based on the latest balance sheet. However, there are a number of adjustments that are made which can be quite subjective. Essentially, Greenwald's NAV analysis attempts to determine how much it would cost for a competitor to recreate a company's balance sheet. Although the analysis is based on the balance sheet there is a great deal of subjectivity as we move from current assets to longer dated assets. The area of greatest subjectivity is how to measure goodwill, which from a reproduction balance sheet perspective measures everything from the value of a brand, customer loyalty and distribution networks. Clearly these components of a company all have significant value but the measurement of these intangible assets is extremely difficult. I think this is the area that needs the most work in terms of developing a better framework under the modern Graham and Dodd approach. In my view, Warren Buffett has been so successful because he's been able to determine the value of these intangible assets with higher degree of accuracy relative to peers. After doing a few NAV analyses, I now understand the difficulty in accurately measuring the value of intangible assets. EPV analysis is similar to DCF analysis but is more conservative because it assumes no growth. Essentially, the firms latest adjusted annualized cash flows are assumed to be sustainable for the indefinite future. EPV is the second most reliable measure of a firm's intrinsic value after NAV as its based on historical and observed values of distributable cash flow. Greenwald does an excellent job of providing relevant valuation examples and case studies using real companies, which helps bridge the gap between theory and practical application. The final and most subjective valuation tool in the modern Graham and Dodd approach is the Growth Value methodology. Greenwald emphasizes that growth valuation should only be utilized when it's clear that a company has a franchise value due to significant and defensible competitive advantages. In the language of Warren Buffett, growth value multiples should only be applied to companies with a wide and deep moat.
The second half of the book provides detailed profiles of eight modern value investors, many of whom are considered legends. The profiles are interesting because the reader is exposed to a practitioner level view of modern value investing. I'm not going to provide a summary of all eight profiles, but I will highlight some of the important lessons that I gleaned from the profile on Warren Buffett. Greenwald states, "while Buffett in the Berkshire years still speaks with reverence about Graham, he looks for companies that have impregnable franchises even though they sell for multiples of book value." It's interesting to see how Buffett has continued to shift and expand the boundaries of what constitutes a value investment. I think his shift from following a strict Graham based approach has been a key factor in his success.
Overall, this book should be read by all students of value investing. Greenwald, a Columbia Business School professor, has expanded and deepened Graham's original work by clearly defining the practice of modern value investing. My main criticisms would be that not enough time was spent on the process of screening. I think the next version of the book should focus more on the screening criteria and the development of a more detailed framework for measuring intangible assets. For those readers who are currently Columbia Business School students, I would recommend taking every course that Professor Greenwald offers. For the rest of us, he actually teaches an executive education course twice a year. At some point I would like to attend and will provide a detailed course review at the Value Investing India Report.
Chapter 1 begins with an overview of value investing. He discusses various studies that show how mechanistically constructed value portfolios such as low P/B stocks have outperformed the general market indices. He also addresses the main criticism of efficient market theorists, who believe that value portfolios provide outsized returns due to outsized risks. However, he provides a devastating critique by explaining that based on standard risk criteria such as Beta or annual return variability and in my view the more relevant measures of risk such as maximum loss realized or stock reactions to bad news, value based portfolios have outperformed. I'm going to go on a slight tangent here but I want to emphasize that Beta (i.e. historical volatility) is a poor measure of risk. Knowing that you have a low beta portfolio is going to provide you with little solace watching your stock portfolio tank in a bear market. In bear markets stock returns become highly correlated and Beta goes to 1 for everything. Thus, acknowledging the existence of an intrinsic value of a stock and being able to measure it accurately will provide you with the confidence to hold on to your investments even in a bear market. In fact, as any good value investor you'll have the confidence to start going bargain hunting as Mr. market provides you with numerous opportunities to purchase businesses below their intrinsic value.
The book does a good job of outlining how to value a stock but provides limited details on the places to look for undervalued stocks. Greenwald identifies areas such as small cap stocks, downtrodden stocks and spin-offs as areas where to look for undervalued gems. Although these are all good places to start, Greenwald doesn't provide enough additional detail about the criteria he would use to identify interesting long candidates. For example, what factors should an investor focus on to avoid investing in a value trap? In my view, Joel Greenblatt does a better job of explaining where to look for interesting investing opportunities in his book You Can Be a Stock Market Genius. I'll be doing a review of Greenblatt's book as well, but for now we'll get back to Greenwald's book.
The core of the book deals with the three main components of his valuation methodology which are net asset value (NAV), earnings power value (EPV) and growth value (GV). Modern value investing can be seen as a continuum where intrinsic value is first determined by the asset value of the company. Net asset value is the most conservative measure of a stock's value as it is based on the reported assets of a firm based on the latest balance sheet. However, there are a number of adjustments that are made which can be quite subjective. Essentially, Greenwald's NAV analysis attempts to determine how much it would cost for a competitor to recreate a company's balance sheet. Although the analysis is based on the balance sheet there is a great deal of subjectivity as we move from current assets to longer dated assets. The area of greatest subjectivity is how to measure goodwill, which from a reproduction balance sheet perspective measures everything from the value of a brand, customer loyalty and distribution networks. Clearly these components of a company all have significant value but the measurement of these intangible assets is extremely difficult. I think this is the area that needs the most work in terms of developing a better framework under the modern Graham and Dodd approach. In my view, Warren Buffett has been so successful because he's been able to determine the value of these intangible assets with higher degree of accuracy relative to peers. After doing a few NAV analyses, I now understand the difficulty in accurately measuring the value of intangible assets. EPV analysis is similar to DCF analysis but is more conservative because it assumes no growth. Essentially, the firms latest adjusted annualized cash flows are assumed to be sustainable for the indefinite future. EPV is the second most reliable measure of a firm's intrinsic value after NAV as its based on historical and observed values of distributable cash flow. Greenwald does an excellent job of providing relevant valuation examples and case studies using real companies, which helps bridge the gap between theory and practical application. The final and most subjective valuation tool in the modern Graham and Dodd approach is the Growth Value methodology. Greenwald emphasizes that growth valuation should only be utilized when it's clear that a company has a franchise value due to significant and defensible competitive advantages. In the language of Warren Buffett, growth value multiples should only be applied to companies with a wide and deep moat.
The second half of the book provides detailed profiles of eight modern value investors, many of whom are considered legends. The profiles are interesting because the reader is exposed to a practitioner level view of modern value investing. I'm not going to provide a summary of all eight profiles, but I will highlight some of the important lessons that I gleaned from the profile on Warren Buffett. Greenwald states, "while Buffett in the Berkshire years still speaks with reverence about Graham, he looks for companies that have impregnable franchises even though they sell for multiples of book value." It's interesting to see how Buffett has continued to shift and expand the boundaries of what constitutes a value investment. I think his shift from following a strict Graham based approach has been a key factor in his success.
Overall, this book should be read by all students of value investing. Greenwald, a Columbia Business School professor, has expanded and deepened Graham's original work by clearly defining the practice of modern value investing. My main criticisms would be that not enough time was spent on the process of screening. I think the next version of the book should focus more on the screening criteria and the development of a more detailed framework for measuring intangible assets. For those readers who are currently Columbia Business School students, I would recommend taking every course that Professor Greenwald offers. For the rest of us, he actually teaches an executive education course twice a year. At some point I would like to attend and will provide a detailed course review at the Value Investing India Report.
I'm the author of the Value Investing India Report and am an experienced global investor.
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