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Cape Town - For many investors, Benjamin Graham is the father of value investing. Well known Graham disciples, like Warren Buffett, has made their fortunes by applying the Value Investing philosophy.
This philosophy, which is based on buying companies below their intrinsic value, is believed to deliver a margin of safety against loss of capital. Those who have read Graham's Intelligent Investor, first published in 1949, will know he is an advocate of buying companies on low valuations which are unloved by the market. His “Mr. Market” analogy is one of the most sighted in the field of value investing.
According to Graham, when you own a share in a company you are also in business with Mr. Market. Mr. Market wants to buy your share of the company. Each day he will quote you a price for your part of the business.
The price will be high when he is feeling optimistic and low on days that he is feeling less so. It is hardly ever the same. Graham portrays Mr. Market as a man that is driven by emotion. When he is depressed he wants to buy your share for less than fair value and when he is optimistic he is willing to buy your share at a premium to fair value. Thus, Mr. Market’s quotes might not be a true reflection of a share's true value.
READ: BOOK REVIEW: How to invest on the JSE like Warren Buffett
Graham's analogy is one of the first lessons in behavioural finance in which Mr. Market portrays the human emotion present in financial markets.
The field of behavioural finance only attracted attention decades later as economists and analysts began to realise that their models, based on the assumption that all humans are purely rational thinkers, is not only unrealistic but also fail to predict future price movements.
Studies of behavioural finance show that the human brain is excellent at pattern recognition, making predictions open to emotional or confirmation bias with no real predictive power. Take the recent oil price as a case in point.
When oil first broke through $100/barrel (bbl) analysts predicted that it might break $90/bbl, possibly even touching the high $80/bbl range. When it reached $80/bbl they began to argue that it might reach $70/bbl. The guessing game continued through to $60 and $50, until oil reached $45/bbl. The oil example proves that predictions are influenced by human emotion and recent patterns or price movements.
Graham was a strong believer that the future can't be predicted with any meaningful accuracy and stated that: “The further one gets from Wall Street, the more scepticism one will find, we believe, as to the pretentions of stock-market forecasting or timing.”
Thus, true value investors apply their trade in an environment in which the future can't be predicted with any certainty. This makes timing the market a difficult task characterised by periods of long underperformance when Mr. Market is pessimistic and considerable outperformance when Mr. Market is feeling optimistic.
An example of a typical value investing play on the JSE was the Telkom Group [TKG]. At the beginning of 2011, the share price of Telkom was hammered by investors to a low of around R11 to R12 in May 2013. The pessimism of the market towards Telkom was high with a lot of bad press priced into Telkom's share price. Telkom was priced as if it would go out of business.
Once the share price began its downward spiral investors began to lose faith in the share, resulting in an even further decrease in share price.
Then, in May 2013, Mr. Market began to feel more optimistic. This optimism continued into the rest of 2013 and throughout 2014, driving Telkom's share price to over R80 a share. If you had held on to your shares and did not sell when the pessimism was at an all-time high, you would have beaten the JSE Top 40 over the period as indicated in the figure below.
The figure shows that if you bought Telkom shares in January 2011 you would have underperformed the JSE Top 40 for the first two years after which Telkom more than made up for the underperformance in the following two years. Over the four year period you would have outperformed the JSE Top 40 index.
Although value investing can be a very profitable investing style and philosophy, investors should be cognisant of the following value investing pitfalls:
• Buying cheap is not always buying value: When a share has fallen significantly in value, true value investors start to take note as the share might offer value. Unfortunately not all shares that showed a decline in price offers value. After all, there is a reason that the price of a share is trading at historical low levels. If the business environment is such that earnings are depressed and there is no certainty that earnings will recover, stay clear. Cash generating businesses should be on top of a value investor's shopping list.
• Do not rely on external factors: Investors often buy shares that are experiencing an earnings slump because of a slow-down in the business environment or economy. These investors buy these shares with a view about when the business cycle will change or the economy will recover. They believe that economies and business cycles revert back to their long run mean.
Unfortunately, as discussed earlier, the future cannot be predicted with any meaningful certainty and these investors cannot truly say if the changes in the business environment is structural or just temporary. Therefore, value investors should focus on companies which are able to adjust to structural changes in the economy. Ask yourself: If the current business conditions continue indefinitely, does the share at its current price offer value?
• Value investing’s rock-star status: Warren Buffett has given value investing a rock-star status. Many investors call themselves “value investors” simply because it has become popular to do so. Many asset managers call themselves value managers with each having a different way of measuring value. This leads to investors who refer to themselves as value investors without understanding the philosophy behind it.
• No standard view on fair value: With so many investors calling themselves value investors, all of them aiming to buy a share below its intrinsic value, views about the intrinsic value will be diverse. Some investors are better at calculating fair value than others and this leads to underperformance for those who aren’t as skilled.
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* Kirk Swart is an analyst at Overberg Asset Management (OAM), an Authorised Financial Services Provider (No. 783) which specialises in the private management of local and global discretionary portfolios as well as pension products.
Disclaimer: The above article does not constitute financial advice and is not a recommendation. Investors must always seek the advice of professionals and trade with caution. Under the ECT Act and to the fullest extent possible under the applicable law, Fin24 disclaims all responsibility or liability for any damages whatsoever resulting from the use of this site in any manner.
