There is a remarkable similarity between today's investment climate and the 1934 post-Great Dep...
There is a remarkable similarity between today's investment climate and the 1934 post-Great Depression investment environment that inspired Benjamin Graham and David Dodd's Security Analysis, which laid down the principles of value investing. It is unsurprising, therefore, that there is renewed relevance and interest in value investing.
Value investing involves the purchase of a security at a discount to its fundamental value. On a daily basis Mr Market, as Graham termed the aggregation of all players in the public markets, gives investors opportunities to buy or sell securities at particular prices. Value investing involves finding a process that is founded in the fundamental analysis of a company's intrinsic value, or earnings power and franchise worth, and then taking appropriate positions when presented with them by Mr Market.
It is more difficult today, however, to practice and reap the rewards of value investing than it was in the time of Graham and Dodd. Information flows have never been greater causing markets to become more efficient, more people than ever are chasing the same bargains, and reaction times are rapidly approaching real-time. Graham could afford to focus on basic 'net-nets' (companies trading at or below their tangible asset value) and tended not to worry about management teams or impending changes to a company's industry or regulatory environment. He believed that if you stayed within your areas of core competence, bought truly deep value and 'ran in the opposite direction of the crowds', one could succeed by practicing patience, selectivity, strict profit taking and diversification. The key to Graham's approach was the significant margin of safety inherent in his positions through the purchase of such inexpensive companies.
Today's value investors are forced to become more creative in their methodologies. Mario Gabelli, chairman and founder of Gabelli Asset Management is one such investor ' credited with developing the 'Private Market Value (PMV) with a Catalyst' approach to value investing. Gabelli's style of value investing is founded upon the ideas of Graham & Dodd and also borrows from the writings of Warren Buffett, in particular, his focus on franchise businesses (businesses with significant barriers to entry) and his willingness to take significant stakes.
The objective of PMV with a Catalyst is to identify large differences between the valuation estimate of PMV and the public market price. The approach then strives to identify a catalyst, or event, which will help realise the return inherent in the spread with minimal influence from the overall direction of the stock market.
The process is founded in research. International analysts follow industries on a global basis and narrow the universe of potential investment candidates to a shortlist of the most attractive companies. All publicly available materials are reviewed, including annual reports, quarterly reports and proxy statements. Each analyst develops an operational understanding of their industry and is expected to become an expert in it by continually visiting companies and their managements, and by talking to competitors, suppliers and customers. They also develop and maintain government and trade sources to derive an overall understanding of their industry.
The valuation process employs a three-dimensional approach: (i) earnings per share; (ii) free cash flow; and (iii) private market value. The first step is to analyse the income statement and cash flow. Free cash flow is viewed as the best barometer of a businesses' financial health and often foreshadows earnings trends.
The second step is to examine the balance sheet. PMV forces investors to approach minority investing as potential buyers of a company and thus focus on what they are actually buying: cash and marketable securities; on-and-off balance sheet assets and liabilities, working capital intricacies; hidden assets and land, for example. The corporate balance sheet is thus recast, assessing the real world values of inventories, property, plant and equipment and stated book value.
Finally, PMV strives to assess what a company would be worth to someone attempting to create or purchase a business with similar characteristics. Once this complete valuation estimate is assembled, it is then compared to the price currently available in the public markets. If the margin of safety is sufficient (usually a potential 50% return over a two-year period), a valuation opportunity has been identified.
The identification of a mispriced situation does not necessarily guarantee a rewarding investment. The next step in the process is to determine events that will narrow the spread between the stock's public market value and its PMV. These events or catalysts can include industry fundamentals, changes in the regulatory environment, management of a company, financial engineering or an improving balance sheet, merger and acquisition activity, spin-offs and sales of divisions.
This approach also believes that while earnings trends are by no means unimportant, there is too much accounting noise between free cash flow and earnings per share and thus prefers to avoid trading a stock on management's ability to hit a particular earnings figure.
Instead, returns are realised when a company's stock price approaches its PMV as fundamental catalysts materialise. Mergers and acquisitions are common examples of such events. As a result, a focus on smaller companies with strategic characteristics that make them attractive to larger industry players increases the likelihood of finding potential takeout candidates. This allows the investor to capture the control premium, the last component of PMV.
Has run Cautious Managed fund since 2011
What’s right – not what sells
Richards fires back at committee report
Available on Investcentre platform
Invested from 2006-2011