by elmads

Introduction

Value investing became a well known investment strategy all thanks to the two of the best investors of this generation, Warren Buffett and Charlie Munger. It’s due to their investing prowess, their years of experience and success in this field, that both greenhorns and experienced investors look into this once unknown investment strategy.

Its method and definition have evolved over time but initially its approach is summarized to: purchasing shares of a company below its intrinsic value, then selling it once the stock price reaches the assumed value.

While this method and definition still somehow holds true to this day, the principles and philosophies have change already through out the years. It branched out into different forms such as growth investing and growth at a reasonable price investing.

Nevertheless, some forget that these strategies are derived and based from its roots. Some investors thought these strategies are constant, where in fact its roots – value investing – is dynamic, where “Value” encompasses other fundamental investing strategies.

Value is not a strategy by itself, it is reflective of the fundamentals and assumed future of the business.

As like what Charlie Munger has said:

Its principles and philosophies have been evolving since it was coined and practiced since the early 20^th century.

Value Investing and Its Roots

For us to understand what is this investment approach, we need to rewind back time where it said it all started. In the decade of the roaring 1920s in the USA.

This was a time where the USA had a wonderful decade of economic expansion. People had good income flow, companies were growing, new businesses were popping every corner in the US mega cities, money in the economic system was flowing, the stock market was booming, people had disposable incomes to spend on things they needed and wanted, in short it was indeed a great era to live. But then, good times -more of exuberant economic state – don’t usually last forever, the roaring 1920s ended into – what is know in history as – the great depression which started in1929.

A year before the dawn of the great economic depression of 1929, there were two economists, investors and educators who started teaching in Columbia Business school, about value investing. The said individuals were Benjamin Graham and David Dodd. Benjamin Graham is known as the Father of Value Investing and Warren Buffet’s mentor.

Benjamin Graham all through out his experience in the market, noticed that most market participants solely focus on the price action of the marketable securities, which comes by as market speculation, because no one knows with consistent accuracy what will happen with the stock market prices in the future. He also noted that the common stock price of companies tend to massively fluctuate, even though the underlying financials and operations of the business have not substantially changed at all in a year, a month, a week or even a day.

He started as a bond investor and he mastered bond analysis. He then took some of the principles of bond analyzation to the equities market, and did a common stock analysis. This is where he looked into the liquidation asset value of a company. This means that, if ever the company goes into liquidation bankruptcy, how much of the Current Assets & Equity of the company could be returned to its common stock investors.

A company who undergoes liquidation bankruptcy will first and foremost pay their creditors, secondly their preferred share investors, and lastly the common stock shareholders. If the company has enough Current Assets amount after paying their, 1^st creditors, and 2^nd preferred shareholders, then the rest will be given back to company’s common stockholders.

If the Common Stockholders invested less than the said Liquidation value of the company, then they would still have generated returns in the said investment despite the bankruptcy (In theory). That’s the simple gist about it. Then again, not all companies will undergo liquidation bankruptcy, this just was the worst case scenario thinking for a liquidation value investing strategy of Benjamin Graham.

His main train of though here was this, if the speculative market participants continuously buy and sell securities, which could push market prices at both extremes (exuberant and depressive). Then, there will come a time where the market price of a company could go way below its liquidation value of its underlying business. Once the stock price reached the depressive levels, then eventually the common stock price would return to its mean (but not most of the time), in this case the value of the business. This finding and strategy of Benjamin Graham helped him to maximize investment returns even during the decade long economic and market depression of the USA.

In summary, buy very very low than the computed liquidation value of the company (like 30%-50% below it), then sell high once it reverts back to its mean, which is the business’ liquidation value.

In the value investing space, this is what’s called, Benjamin Graham’s Net-Net Value Investing or also known as the Net Current Asset Value per Share (NCAVPS).

Below is the simple and known formula to arrive into the NCAVPS of a business:

NCAVPS = (Current Assets – (Total Liabilities + Preferred Stock)) ÷ Shares Outstanding

From Cigar Butt to Long-Term Competitive Advantage

The Father of Value Investing, Benjamin Graham became a great investor due to his investing prowess and strategy that did not base from market speculations, but from the underlying business of a common stock. This gave somehow, a basis of certainty and approach to follow in an area of very high risky and very unpredictable equity markets. Because of this, there were people who wanted to learn what was discovered and practiced by Benjamin Graham.

Enter Warren Buffet.

One of Graham’s students in Columbia University is the well renowned investor of this generation Warren Buffet.

Warren learned value investing under Benjamin Graham in 1949. Where he upon finishing his Master’s degree in Economics in the said school, worked with Ben Graham’s investment fund named Graham-Newman Corporation, up until Ben Graham retired.

Like his mentor, Warren Buffett also did the Net-Net Investing. But, his investment focus was a bit different from Graham’s, he called this approach as the “Cigar Butt Investing”.

A person who does not have any money would go around picking discarded cigars on the street to enjoy a few puffs which would cost him nothing. Cigar butt investing too runs along the same lines. In Warren Buffett’s words “Cigar Butt approach to investing is where you try and find a really kind of pathetic company but it sells so cheap that you think there is one good puff left in it”.” Though the stub might be ugly and soggy”, the bargain purchase would make “the puff all free”. He’s been doing this method since he opened his own business partnership.

As the years passed for Warren Buffett, he continued to build his investment firm where he only bought not just common stocks but also operating businesses. Through out his journey he got to meet Charlie Munger, and eventually the both of them partnered in 1978.

Enter Charlie Munger.

Both Warren and Charlie built Berkshire Hathaway to the empire that most people know of today. Though Warren had a rough start because Berkshire Hathaway was initially a failing textile company who he bought in 1965. (Warren Buffett did not build Berkshire Hathaway from scratch, he just acquired the whole business.)

This is one of his popular failures in purchasing a business. Even though it was a failed investment, he turned it around into an overwhelming success. Over the years, he learned that Cigar Butt investing is not always the best investment approach, and he realized that it is very hard to scale it once you reach a certain amount of money to invest. The partners eventually changed the operations of the business from textile to conglomerate that we all know of.

Charlie has been credited by almost everyone in the investing world as the person who changed the investing strategy of Warren Buffett from Cigar Butt Investing to buying companies with great management and with long-term durable competitive advantage.

This strategy is simply put by Warren Buffet himself as “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.

It’s better if we let Warren Buffett and Charlie Munger explain it themselves, is it not? below is the video transcript where they talk about Warren Buffett’s transition from Cigar Butt Investing to Buying wonderful companies at a fair price. This transcript was taken from Berkshire Hathaway 2003 Annual Shareholder’s meeting.

https://www.yapss.com/post/collection-warren-buffett-274-why-did-warren-buffett-move-on-from-cigar-butt-investing – Transcript

https://buffett.cnbc.com/2003-berkshire-hathaway-annual-meeting/ – The Whole 2003 Berkshire Hathaway video.

In a nutshell:

• Know the intrinsic value of the company based on the projected and probable free cash flow in the future, then buy the common stock below its underlying intrinsic value of the business.
• Make sure that the business has a long-term durable competitive advantage (MOAT), and a management who is trust worthy, honest and with integrity.
• Invest in businesses you would own for more than a decade and just let both your invested money and those wonderful businesses grow.
• In Charlie Munger’s own words “Investing is where you find a few great companies and then sit on your ass”.

To Sum It Up

• Value investing strategy started with Benjamin Graham, who bought companies at 30%-50% below its liquidation value and sold once the common stock price reaches the perceived value. The downside of this are, not all companies who are within this criteria will do well, and it’s not about being a business owner but a person who buys and sells businesses to arbitrage the misprices of the market.

• Warren Buffett is the student of Benjamin Graham who also did liquidation value investing, which he called the Cigar Butt investing.

• Charlie Munger is the partner of Warren Buffet, both of them became one of the best duos in the business and investing world through Berkshire Hathaway. Charlie influenced Warren to transition from Cigar Butt investing to investing in companies with long-term competitive advantage at compelling valuations.

• Value Investing encompasses all other fundamental investing strategies (Growth, Growth at a Reasonable Price, Net-Net Investing and Dividend Investing).

• “Long Ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying QUALITY merchandise when it is MARKED DOWN” – Warren Buffett
  
  Source: https://www.berkshirehathaway.com/letters/2008ltr.pdf (Page 4, 4^th paragraph from the top of the said page.)

Below are the books that Warren Buffett said had influenced him greatly to start to invest early and take the path of value investing. Also, I’ll add Benjamin Graham’s well known written textbooks.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.