The History of Value Investing
May 15, 2018, 10:01 am
Value investing often conjures up images of mature, sometimes quite ordinary companies that sell for cheaper than the overall market. While it’s true that most value stocks have low metrics, there is a lot more to this strategy than numbers. It is a combination of art and science, and it begins with a mathematical principle taught in the first lesson of every Finance 101 course:
The value of an asset (i.e. business) is the present value of its future cash flows.
When it comes to value investing, I aim to scientifically value a company based on real numbers and realistic projections – the exact opposite of wild assumptions (hope) that a company will grow 20% forever. In other words, instead of jumping blindly into what’s “hot,” we’re using solid data and analysis to more accurately identify a company’s future value.
How do I do this? Believe it or not, up to the time of the Great Depression, there was no systematic method to analyze and determine a company’s value – even though the stock market had been around for decades! This lack of knowledge and discipline helped drive much of the speculation that occurred before the 1929 market crash that ushered in the depression.
Then in 1934, Benjamin Graham, the father of value investing, changed the game by publishing Security Analysis. For the first time, a scientific framework was laid out to analyze and value stocks. Security Analysis became the Bible of value investing (and remains so to this day for value investors), with the sixth and most recent edition published in 2008, nearly 30 years after Graham’s death.
The story doesn’t end there. Graham also taught his methods in a popular class at Columbia Business School, and one of his students was so impressed by what he learned that he offered to work at Graham’s investment partnership at no cost. He was turned down at first but would eventually work there for a few years until it was dissolved in 1958. That young student, by the name of Warren Buffett, then struck out on his own. He went on to be Graham’s intellectual successor and the greatest investor of our time. Graham was so influential in his life that Buffett eulogized him as a man who planted trees that other men could sit under.
Buffett refined Graham’s original methods and turned them into modern day value investing. This was necessary because Graham’s preferred method of investing – buying stocks that were selling for less than their liquidation value – became impractical. In the 1940s and 1950s, the stock market was still spooked by the crash, and there were plenty of opportunities to buy such companies. However, valuations rose as investors regained confidence in the market, and eventually there were only a handful trading at such a discount.
Buffett added qualitative methods to Graham’s quantitative approach, seeking the bulletproof franchises with large “moats” that dominate his current Berkshire Hathaway portfolio. Buffett believes – and I agree with him – that if a business is solid and keeps generating cash, the stock almost has to go up over time. Those are the kinds of businesses to invest in.