For the longest time in my investing experience, I felt like a bit of a fraud, when calling myself a “value investor”, the phrase so prominently visible on the header of this site. Here’s why.
The definition of value investing, as introduced by the oft-quoted Ben Graham is quite simple:
The strategy of selecting stocks that trade for less than their intrinsic values.
Sounds simple enough. List all stocks along with their market prices (A). Add intrinsic value (B) as a column. Compute difference B minus A and voila! The stocks with the largest differences are your value stocks. Buy. Wait for rest of market to come to its senses so A = B. Sell. Repeat until rich.
Now for the confession, I don’t believe I have ever bought a stock that was trading at less than it’s intrinsic value in the Indian stock market. And going further down the rabbit hole, I don’t believe, I could ever really tell, with any confidence, that elusive number, called the intrinsic value of a stock.
Don’t get me wrong, I tried. Painstakingly teasing out the various heads from financial statements, making the right adjustments, honoring the tenet that only Free Cash Flow mattered. Applying conservative estimates of growth of that free cash flow into the future before applying an “appropriate” discount rate to arrive at a fair value for the stock. Flushed with a sense of accomplishment, I would look at the stock price and sure enough, the intrinsic value I had meticulously calculated would be a fraction of the market price. And this happened for stock after stock that I did this with.
I was torn. Either I declare the Indian stock markets as being hopelessly overvalued and forget about equity investing until 70-80% corrections happened or find another way to think about my investing.
That’s when I chanced upon this book called “More than you know” by Michael Mauboussin. The book is a collection of essays he wrote over the years, while in his role at the time of Chief Investment Strategist at Legg Mason Capital Management. (Not to be confused with Long-Term Capital Management (LTCM) – the hedge fund run by Nobel prize winners that lost $4.4B in one year)
Circumstances over Attributes to find value
Traditional investing theories are attribute-based. Growth investors buy companies showing rapid sales and earnings growth without being concerned about valuation. Value investors load up on “cheap” stocks and consider earnings growth a bonus.
Mauboussin says “a sound theory helps predict how actions or events lead to specific outcomes across a broad range of circumstances.” The problem, he says, is that much of investment theory is unsound because of poor categorization and is attribute-based.
A shift from attribute to circumstance-based thinking can be of great help to investors and managers. Such thinking tells you what to do in different situations.
This means while buying low P-E stocks is not a bad idea, expecting that approach to generate superior returns irrespective of context is incorrect. This explains why the investment strategies of the world’s successful investors is often described as eclectic. Mauboussin says, their strategies are more circumstance-based, not attribute-based and often get criticized for straying from that attribute-based mindset.
Why Warren Buffet is not the world’s greatest value investor – Forbes (2013) link
He ends his essay by saying
All investors use theory, wittingly or unwittingly. The lesson from the process of theory building is that sound theories reflect context. Too many investors cling to attribute-based approaches and wring their hands when the market doesn’t conform to what they think it should do.
So, instead of obsessing over why the market didn’t stick to my “model”, I developed a broader checklist based approach to identify companies and focused on reducing the time it took to zero in on potential investments . Also to not stop there and to keep revisiting how things worked or did not work, to keep refining the process. And that, I reckon qualifies as value investing.