Quantitative Value Investing

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Value investing as a philosophy of investing started its evolution at the beginning of the twentieth century when Benjamin Graham started teaching this investing strategy in Columbia Business School in 1927. Later, in 1934, one of his students, David Dodd, published Graham’s lectures as Security Analysis that is considered to be a bible for value investors (Gray and Carlisle 104). Today, any investor who is keeping to this strategy may be referred to as Graham-and-Dodd investor. This philosophy has one attractive advantage – one does not need to be a finance genius to become a successful value investor; all he needs is money to invest, patience and time and desire to read some books and do some accounting. It gained popularity because of success of one of its most famous followers, Warren Buffett, who once said about it:

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought. (Buffett par. 65)

There are a lot of interpretations of the concept of value investing but they all derive from the basic definition according to which value investing is a strategy of buying the stocks at less than their intrinsic value. That means that the value investors are inclined to believe that the market’s reaction to bad or good news is very often inadequate, thus it results in the decrease of stocks price that is contrary to the company’s long-term objectives and it is a perfect time to buy them so they may benefit when a price returns to its normal level. Generally speaking, the core of value investing is buying stocks while their price is undervaluated and waiting till it reaches its true value. So, this approach is:

A broad church, encompassing investors who take positions in liquidations, special situations, undervalued assets, and undervalued businesses, using a variety of valuation methods, from simple price ratios, to detailed discounted cash flow analyses, and intricate sum-of-the-parts valuations that seek current market values for long-term and fixed assets. (Gray and Carlisle 246)

Value investing as such is based on three primary features of the financial markets. First of all, the prices of stocks are in a continuous movement depending on the developments in the financial market and state as the whole. Should it be of positive or negative impact, these developments are always close to unpredictable. Second, no matter what the developments mentioned above are, they always have a stable economic background. That means that every company has its intrinsic value that does not change; what changes is the price of trading. Third, buying stocks at the lowest possible price always brings maximum revenues in the long run that is why there should always be a gap between that price and the price of future selling the stock (Greenwald et al. 3-4). These characteristics of the financial markets not only help understand value investing better but also serve as the background for establishing certain golden rules and principles of behavior that are to be kept if one wants to become a successful value investor.

There are several golden rules of becoming a successful value investor. First of all, they know that every company has its intrinsic value, and the only question is about finding it to buy the company’s stocks at the lowest price possible, so that gives an opportunity to make maximum profits. Second, there should always be a margin of safety. That means that it is desirable to buy the stocks when the investor is sure that their value has reached its minimum level, and there will be no further decline so that he is secured against financial losses and can sell them making some profit in case his initial plan does not work out. Third, value investors do not believe that the stock prices are at their efficient market price and reflect all information about the company and know that they are over- or undervaluated. Fourth, those who want to become successful value investors do not follow the trends on the market. That means that they think outside the box and do not buy what is popular of do not sell what is not, they listen to their gut and common sense and follow their strategy and keep to their philosophy. Fifth, the successful value investors always listen to ideas of the people they respect but make final decisions by themselves based on their intuition. And finally, they are patient and realize that success as well as response to actions on the market requires time (Schloss 1).

Together with the rules mentioned above, there are also some principles that a successful value investor should follow. First of all, it is of significant importance to know the business. That means that the investor should understand the risks and know how to minimize them effectively. Second, no one but investor himself should be allowed to run his business or control his money unless he can supervise them or has extremely strong reasons for being confident in that people. Third, the investor should make all his decisions based on his knowledge and understanding of the market and once the decision is made he should stick to it (Graham 523). What is more, he should realize the limits of his abilities and that there is always the possibility of failure though he should try to do his best to keep it to a minimum.

It is not enough to identify and buy undervaluated stocks to become a successful value investor. Successful value investors need to do more, they need to form a portfolio of combined stocks bought at the lowest intrinsic prices, so that they keep the possibility of failure and the level of risk as low as possible. The more securities there are in a portfolio, the lower is the risk of losing revenues, so nothing can be done to escape diversification (Greenwald et al. 148). Value investors are aware of the risks of market’s volatility and the risk of failure because of only one asset in a portfolio. That is why they choose to diversify their portfolio to the maximum extent, but they do it buying only those securities that they understand and can fully evaluate. What is more, they choose only companies with the history of sustainable earnings, stable position on the market, financially successful, and those that can be reliably evaluated.

There are two approaches to value investing, qualitative and quantitative. Under qualitative approach, all that investor is interested in is the quality of a company he plans to invest in, i.e. its products and services, competitors, management, etc. while according to quantitative approach, the decision to buy stocks is made upon quantitative characteristics of the company such as balance sheets, income, cash flow and so on. Quantitative value investing is also known as systemic because it refers to analyzing the fundamental statistical data of a company mentioned above. The benefit of this approach is that it is “easy to emulate and, therefore, easily commoditized” (Mihaljevic 187). That means that it is based on the total understanding of stocks, investor’s intuition, and common sense. The quantitative approach to value investing is what was mentioned above when speaking of reducing risks and diversification.

What is more, there are different strategies of value investing. The first one that is the most evident consists in buying low and selling high. That means that the investors buys stocks at the lowest price possible and sells at the highest. The second strategy is known as the general trading and according to this strategy the investor reacts to overall developments in the market and buys stocks of companies that operate in different sectors. Unlike the second strategy, the third one, selective trading, supposes that the investor is interested in particular sectors of the market and believes that non-diversification is the best tactics for conducting business. According to the fourth strategy, known as long-pull selection, the investor analyzes the market and chooses the companies that will prosper in the long run. That means that he is more interested either in steadily successful companies or ambitious start-ups. One more strategy of value investing is referred to as bargain purchases and it very closely related to the first strategy because according to it the investor seeks the opportunities to buy the stocks below the marker price, i.e. that are undervaluated so that he can make maximum revenues (Kennon par. 4). It should be borne in mind, that there is no need to stick to only one of the strategies mentioned above. It can be of more economic reasonability to combine them or use them interchangeably depending on the level of investor’s knowledge, experience, and resources.

Together with the strategies, there is also a technique to successful value investment known as a magic formula of investing. This technique is basically a set of rules for choosing a company to invest in. First of all, the investor should choose the company with a high level of market capitalization. That means that he will choose the one that is financially successful and has a history of sustainable earnings and has stable positions on the market. After the investor has finished the first step, he moves on to the second one and excludes financial stocks and utility. By doing so, he focuses only on the earnings of the company and its current financial performance. Next, the investor should leave out foreign companies that would help him in controlling his resources and undoubtedly benefit the domestic economy. Fourth, the investor should define the desirable level of earnings yield and return on capital. This step helps to choose a financially successful company because it is preferable to invest in the companies with the highest levels of return on capital and earnings yield. The next step is investing in 20 to 30 companies with the highest ranks chosen based on the previous steps during a period of 12 months so that the investor can evaluate whether he has chosen the right companies. What is of significant importance is that every once in a while, for example once a year, the investor should examine his portfolio and rebalance it by selling the stocks that brought the least revenues and buying more stocks with the highest level of revenue (Greenblatt 140-141). Keeping to the magic formula mentioned above and repeating its steps for many years is a key to investing success in the long run.

One can better understand the principles and rules of value investing by studying example of successful value investors. The brightest and the most well-known story of success in value investing is the story of Warren Buffett. Among other examples of success, one can recall such names as Max Heyne, Charles Royce, Joel Greenblatt, Martin Whitman, William Ruane and many others. Their live values and principles that led them to success is what will be described below.

The first and the brightest story of success is the life path of Warren Buffett, the president of Berkshire Hathaway that is the fifth largest company on the globe and own a variety of businesses from confectionery and jewelry to manufacture and gas and electric utilities. The company established and kept to a set of particular rules and principles to reach its current position. First of all, Berkshire Hathaway sees itself as a conduit. That means that nevertheless it is a corporation, it thinks of itself as of partnership and considers that all its shareholders are owner-partners thus showing that it is an open system willing to accept more new partners. Second, consisting of a wide range of different businesses it uses the products of one of the businesses to produce the goods in the other thus adding up to the intrinsic value of the company. As of value investing strategy, it is characterized by aiming at maximizing the intrinsic value of the company as mentioned above, owning parts of different businesses and by doing so diversify its portfolio and minimize the risks, and keeping to its philosophy, i.e. not changing its investment strategy every year but sticking to it for a long time (Greenland et al. 163-166).

Next story of success in value investing is that of Max Heine. He started his business, Mutual Shares Corporation, in 1949, and over consequent decades added different funds to it. The area of business activity of his funds is various management services. Moreover, his Mutual Shares Corporation can be mentioned among the first known open-ended mutual funds in history. He was a value investor in the classical sense because the core of his investment strategy was to buy the stocks that were undervaluated. His primary target in investment was to receive 15 percent of annual return from the stocks no matter what were market fluctuations (“Max Heine: Background & Bio” par. 3-5).

One more story worth being mentioned is the story of Joel Greenblatt, founder of Gotham Capital and a bestselling author of books on value investing such as The Little Book that Beats the Market revealing a magic formula investing, You Can Be a Stock Market Genius about special situation investment, and The Big Secret for the Small Investor (“Joel Greenblatt” par. 3). Like Max Heine, he is a traditional value investor, and his views are based on the teaching of Graham and Dodd, but he went a little further and invented what is known as the magical formula investment that was mentioned above. So the base of his investment strategy is his magic formula.

Another similar example of prosperity is the walk of life of Charles Royce, who is the President of The Royce Funds and a portfolio manager of many different companies all over the world. What is noteworthy about his investment strategy is that he always starts investing from the risk analysis and prefers buying stocks of the financially successful and stable companies. That means that he is interested in the long-term perspective and safety and not in short-term earnings. Together with that he believes that once he buys stocks, he should keep them forever and selling the can be justified only in the case of changing business strategy (“Charles Royce: Background & Bio” par. 1, 5, 7).

Martin Whitman, the founder of the Third Avenue Funds, is also a value investor whose story should be mentioned. He saw himself as an opportunistic investor and always preferred buying stocks at the lowest possible price thus also being a traditional value investor. Together with the low stock prices, his investing strategy is based on investing money in safe companies, i.e. in companies with rich resources available and promising growth perspectives (“Martin Whitman: Background & Bio” par. 1, 14, 21-22).

And finally, the last but not the least, example of success is the life journey of William Ruane, a co-founder of Ruane-Cunniff investment fund and Sequoia Fund. All his life he was occupied in investment management and always followed his investment rules strictly. One of such rules was always buying businesses with the high level of return on capital and financially stable. Second, he believed in buying stocks of the companies with little competition and pricing flexibility as well as at moderate prices, i.e. at a discount from them intrinsic value. Moreover, William Ruane preferred buying companies with cash earnings instead of reported ones so that he knew that he invested in a financially stable and profitable company (Motiwala par. 7-10).

So, value investing is indeed an effective tool for becoming successful in investment, and it has proven to be so during the long years of effective use. Keeping to all of its principles and golden rules together with studying the technique known as the magic formula investing, one can become a reach the heights of the investment business. What is more, looking closely at the stories of value investing success of different people around the world and the companies they founded, one can learn that no matter what age he or she is or what resources he or she has at their disposal, prosperity is easy to reach by studying, allocating available resources effectively, thinking outside the box, and being patient and persistent.

References

Buffett, Warren. Shareholder Letter. 1992. Web.

Charles Royce: Background & Bio.n.d. Web.

Graham, Benjamin. The Intelligent Investor: A Book of Practical Counsel, New York, NY: Harper Business. 2006. Print.

Gray, Wesley R. and Tobias Carlisle. Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, Hoboken, NJ: John Wiley & Sons, 2013. Print.

Greenblat, Joel. The Little Book That Beats the Market, Hoboken, NJ: John Wiley & Sons, 2010. Print.

Greenwald, Bruce C. N., Judd Kahn, Paul D. Sonkin and Michael van Biema. Value Investing: From Graham to Buffett and Beyond, Hoboken, NJ: John Wiley & Sons, 2001. Print.

Joel Greenblatt. n.d. Web.

Kennon, Joshua. The 5 Major Stock Investing Strategies for Value Investors. n.d. Web.

Martin Whitman: Background & Bio.n.d. Web.

Max Heine: Background & Bio.n.d. Web.

Mihaljevic, John. The Manual of Ideas: The Proven Framework for Finding the Best Value Investments, Hoboken, NJ: John Wiley & Sons, 2013. Print.

Motiwala, Adib. Investing Rules of William Ruane. 2011. Web.

Schloss, Walter. 16 Golden Rules of Investing. 1994. Web.

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Quantitative Value Investing

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