The Art of Value Investing

How the World's Best Investors Beat the Market

John Heins, Whitney Tilson

• Publisher: Wiley
• Year: 2013
• Print ISBN: 9780470479773
• eBook ISBN: 9781118233962
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Says Bill Ackman of Pershing Square Capital Management about The Art of Value Investing:

"I learned the investment business largely from the work and thinking of other investors. The Art of Value Investing is a thoughtfully organized compilation of some of the best investment insights I have ever read. Read this book with care. It will be one of the highest-return investments you will ever make."

Based on interviews with the world's most-successful value investors, The Art of Value Investing offers a comprehensive set of answers to the questions every equity money manager should have thought through clearly before holding himself or herself out as a worthy steward of other people's money. What market inefficiencies will I try to exploit? How will I generate ideas? What will be my geographic focus? What analytical edge will I hope to have? What valuation methodologies will I use? What time horizon will I typically employ? How many stocks will I own? How specifically will I decide to buy or sell? Will I hedge, and how? How will I keep my emotions from getting the best of me?

Who should read The Art of Value Investing? It is as vital a resource for the just starting out investor as for the sophisticated professional one. The former will find a comprehensive guidebook for defining a sound investment strategy from A-to-Z; the latter will find all aspects of his or her existing practice challenged or reconfirmed by the provocative thinking of their most-successful peers. It also is a must read for any investor – institutional or individual – charged with choosing the best managers for the money they are allocating to equities. Choosing the right managers requires knowing all the right questions to ask as well as the answers worthy of respect and attention – both of which are delivered in The Art of Value Investing.

CHAPTER 1

“All Sensible Investing Is Value Investing”

A walk down any supermarket aisle makes it clear we live in a world of increasing product specialization. To break into a new market or grab more of an existing one, companies launch a dizzying array of new products in ever-more-specific categories. Want your soda with more caffeine or less? You've got it. More sugar? Less sugar? Six ounces, 10 ounces, 20 ounces? Whatever you like.

This trend has not been lost on marketers of investment vehicles. Specialized mutual funds and exchange-traded funds exist for almost every imaginable combination of manager style, geographic reach, industry sector, and company market capitalization size. If you're looking for a mid-cap growth fund focused on the commodity sector in so-called BRIC countries (Brazil, Russia, India and China), you're likely to find it.

We understand the marketing reality of specialization, but we argue that the most important factor in judging an investor's prospective gains or losses is his or her underlying philosophy. As you might guess from the fact that we co-founded a newsletter called Value Investor Insight, we agree 100 percent with Berkshire Hathaway's Vice Chairman Charlie Munger, who says simply that “all sensible investing is value investing.”

But what exactly does it mean to be a value investor? At its most basic level it means seeking out stocks that you believe are worth considerably more than you have to pay for them. But all investors try to do that. Value investing to us is both a mindset as well as a rigorous discipline, the fundamental characteristics of which we've distilled down to a baker's dozen.

Value investors typically:

• Focus on intrinsic value—what a company is really worth—buying when convinced there is a substantial margin of safety between the company's share price and its intrinsic value and selling when the margin of safety is gone. This means not trying to guess where the herd will send the stock price next.
• Have a clearly defined sense of where they'll prospect for ideas, based on their competence and the perceived opportunity set rather than artificial style-box limitations.
• Pride themselves on conducting in-depth, proprietary, and fundamental research and analysis rather than relying on tips or paying attention to vacuous, minute-to-minute, cable-news-style analysis.
• Spend far more time analyzing and understanding micro factors, such as a company's competitive advantages and its growth prospects, instead of trying to make macro calls on things like interest rates, oil prices, and the economy.
• Understand and profit from the concept that business cycles and company performance often revert to the mean, rather than assuming that the immediate past best informs the indefinite future.
• Act only when able to draw conclusions at variance to conventional wisdom, resulting in buying stocks that are out-of-favor rather than popular.
• Conduct their analysis and invest with a multiyear time horizon rather than focusing on the month or quarter ahead.
• Consider truly great investment ideas to be rare, often resulting in portfolios with fewer, but larger, positions than is the norm.
• Understand that beating the market requires assembling a portfolio that looks quite different from the market, not one that hides behind the safety of closet indexing.
• Focus on avoiding permanent losses rather than minimizing the risk of stock-price volatility.
• Focus on absolute returns, not on relative performance versus a benchmark.
• Consider stock investing to be a marathon, with winners and losers among its practitioners best identified over periods of several years, not months.
• Admit their mistakes and actively seek to learn from them, rather than taking credit only for successes and attributing failures to bad luck.

WHAT IT MEANS TO BE A VALUE INVESTOR

Elaborating in detail on all aspects of the bare-bones list above is essentially what this book is about. We begin by turning to the uniquely successful investors we've profiled over the years as co-editors of Value Investor Insight to examine what they consider to be the key components of a value-investing philosophy, from general fundamental principles to the overarching mindset needed to make it work.

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Our entire process is rooted in Ben Graham's simple philosophical framework for investing. He believed there were two values for every stock, the first being the current market price, and the second what the share would be worth if the entire company were acquired by a knowledgeable buyer or if the assets were liquidated, the liabilities paid off and the proceeds paid to stockholders. He called that the intrinsic value and argued that the time to buy was when there was a large spread between the current price and that value, and the time to sell was when that spread was narrow.

Over time we've developed different ways of applying that —by valuing income streams rather than just assets, by calculating private market values, by investing internationally—but the essence of what we do has remained consistent. Our work every day is essentially directed at valuing what businesses are worth.

—Will Browne, Tweedy, Browne Co.

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At the heart of being a value investor is having a contrarian bent. Beyond that, though, there are many different flavors of value investing. Tweedy Browne is a great deep-value investment firm. Chuck Royce at Royce Funds is a wonderful GARP [Growth At a Reasonable Price] practitioner—he's focused on value but definitely doesn't like to own bad companies. Mason Hawkins at Southeastern Asset Management and Marty Whitman of Third Avenue are oriented toward stocks trading at significant discounts to net asset value. Bill Miller is probably best described as an all-out contrarian. The fact that all these people have been successful proves that there's no single way to do it. What the market offers up as opportunity is constantly changing, so being able to deploy a variety of strategies as the situation warrants allows us great flexibility to go almost anywhere and never get shut out of the market. That's important because our investors don't ask us to move in and out of cash depending on how overvalued or undervalued we think the market is. And frankly, having an eclectic view makes investing a lot more interesting.

—Preston Athey, T. Rowe Price

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We've found that to earn repeatable, excellent returns over time with reasonable risk exposure requires being able to assign something approximating a fair value to a business, making conservative estimates. Then it's a question of looking at the price. If price is significantly below that fair value, you're likely to have a good outcome by investing in it. If the price is significantly above that fair value, you can make good money by shorting it.

—Zeke Ashton, Centaur Capital

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There's nothing particularly earth-shattering about what we try to do. We believe the market often misprices stocks due to neglect, emotion, misinterpretation or myopia, so our value-add comes from bottom-up stock selection. We're trying to buy at low prices relative to our current estimate of intrinsic value and we want to believe that intrinsic value will grow.

—Steve Morrow, NewSouth Capital

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When I got much more interested in individual securities analysis in the early 1990s I read as widely as I could and a light bulb just switched on when I read everything Marty Whitman wrote. I was thinking it was critical to understand the ins and outs of how the stock market really worked, but his basic message was to ignore the market, which was just the bazaar through which you had to make trades. He was all about valuing what a company was worth—independent of what the market was saying it was worth at the time—and buying when the market was giving you a big discount and selling when it was paying you a premium.

As obvious as that sounds, it was very liberating to come across such a straightforward approach. Using whatever analytical tools I want, whether it's valuing net assets, calculating private-market values or discounting future cash flows, I can arrive at a clear estimate of what a company is actually worth. From there, the actual buying and selling decisions aren't that hard.

—Jim Roumell, Roumell Asset Management

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I've heard it said many times that value investing is not as much about doing smart things as it is about not doing dumb things. Avoiding mistakes, resisting market fads, and focusing on allocating capital into ideas that are highly likely to produce satisfactory returns and that offer a margin of safety against permanent capital loss – these are the dominant themes of the value investing approach. Contrary to how it sounds, these elements don't make value investing easier than other approaches. In fact, cultivating the discipline to avoid unproductive decisions, refining the craft of valuing businesses and assessing risk, and developing the emotional and mental equilibrium required to think independently in a field in which there is tremendous pressure to conform requires constant diligence and effort.

—Zeke Ashton, Centaur Capital

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Long-term-oriented value investors have greater scope to produce superior risk-adjusted returns when the seas are rocky. The valid response when there's chop is to focus on the end destination—what value investors call intrinsic value—and not worry about whether the next wave is going to push the boat up or down. If you don't invest with a very clear notion of underlying value, how do you do it? Nothing else makes sense.

Your ability to maintain focus on the long term comes from experience. You go through a couple cycles where everybody else is screaming at you not to try to catch a falling knife, and then when you do so and make some money, it does wonders for you . . . and for your ability to do it next time.

—Howard Marks, Oaktree Capital

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We make no heroic assumptions in our analysis, hoping, instead, that by compounding multiple conservative assumptions, we will create such a substantial margin of safety that a lot can go wrong without impairing our capital much or even at all. We never invest just to invest and don't bet blindly on mean reversion or on historical relationships holding up. Our settings are permanently turned to “risk off.”

—Seth Klarman, The Baupost Group

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In traditional-value ideas we're looking for a large discount to our estimate of value based on a company's normal earnings power, where normal means that general business activity is not too hot and not too cold. These tend to be more average-quality businesses, which can get very cheap in the down part of a cycle or when dealing with a self-inflicted problem.

The priority in these ideas is on margin of safety, which we look at in two primary ways. The first is by making sure the potential downside is a small fraction of the upside. That means we avoid stocks that are cheap on an equity-value basis primarily because there's a mountain of debt. The ...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Introduction
• Chapter 1: “All Sensible Investing Is Value Investing”
• Part One: Field of Play
• Part Two: Building the Case
• Part Three: Active Management
• Part Four: Of Sound Mind
• The Final Word
• About the Authors
• Index