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Value Investing Redux

by Tom Delic

Having been in consistent print since its first publication in 1949, Benjamin Graham’s ‘Intelligent Investor’ has, along with ‘Security Analysis’, provided the philosophical foundation to thousands of successful investment practitioners over the decades.  However, as Mark Twain said, “A classic is something that everybody wants to have read, and nobody wants to read”.  Open almost any page of those two texts however, and your mind will be enriched with the ideas and thoughts of Graham, and like most literature that has survived the test of time, you will soon realise why.

The concepts laid down by Graham over 70 years ago sets an investor up with a sound, rational, mental framework to deal with the vicissitudes of a hyper-active stock market, that swings between the emotions of a broken-hearted teenager and a toddler’s first taste of chocolate.  But what does Graham not say?  Is the consensus view of value investing in line with the thinking of Graham or has time distorted and twisted the interpretation?

Leaning on the work of Eugene Fama and Kenneth French, investing is often reduced to nothing more than quantitative pigeonholing.  A fund manager strategy or a point-in-time valuation ratio of a listed equity can then be boxed neatly into categories, pitted against one another in an endless race where investors are pressured to pick a side.  Today, the consensus is “value” investing is losing the race, with “growth” investing in an unassailable lead.  Perhaps though, there are no “style” sides and instead a footrace exists between investment and speculation, which can often feel like a marathon.  This takes us back to Graham.

Graham’s core tenets seek to teach us how to act like investors rather than speculators.  The margin of safety concept sits at the heart of this approach and simply advises that the investor should only purchase securities where a gap exists between their conservative estimate of intrinsic value, and the price at which the security is being offered.  In Graham’s words, “the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future”.   

The example of Microsoft provides an illustrative example of Graham’s concept in practice.  From 1999 to 2012, Microsoft’s free cash flow yield increased from 1.6% to 13.1%[1], with equity holders of the company suffering a -42% total return over the period[2].  The speculative era of 1999 had faded away and in 2012, an opportunity for a conservative investor was available. 

Value investing today is assumed to be a blind investment in the optically cheap but in ‘Security Analysis’, Graham emphasises that an investment operation is one that can be justified on both qualitative and quantitative grounds”.  A cursory glance at the data in 2012 would have shown you that despite the share price halving since 1999, the business was fundamentally strong, with consistent revenue and cash flow growth over the period[3] and Microsoft Windows remaining the dominant operating system in an ever-increasing world of computer usage.

[1,2,3] Bloomberg Finance L.P.

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