Transcript
Welcome to Sunday Morning Coffee with Erik.
Today, I want to talk about value investing. I talk to a lot of people who tell me that they are value investors, and it seems to me that when talking about value investing, everyone thinks they’re talking about the same thing. In fact, I’ve realized that there are a couple different branches of value investing; it’s not just one big monolithic thing.
The godfather of Value Investing is of course Benjamin Graham. He wrote a long and very difficult book called Security Analysis and here on Amazon, it’s got over four stars out of five. I can’t help but thinking that not all the people who rated the book actually read the entire thing – it really is a hard slog to get through.
He wrote another book called the Intelligent Investor which is very close to the title of my favorite book: the Framework Investing.
The Intelligent Investor is a little bit easier to read and while Graham was Warren Buffett’s teacher, his style of Value Investing is actually different from Buffett’s, which will discuss in just a moment.
Benjamin Graham wrote these books and he was definitely a good fundamental analyst, but at the end he always kept coming back to creating some formulas. “Look at the book value, and multiply that by 2.2 and add that at the P/E ratio” or something.
He is essentially suggesting an investor screen stocks that have these characteristics as kind of a shortcut way of finding stocks. You can read more about the Benjamin Graham formula, which is actually not only one formula. There’s a couple different formulas, and he suggested different kinds of investors use different formulas to find different kinds of stocks in an almost mechanical way.
You look for a company and if it meets these Graham criteria, you can invest in the stock and be relatively certain that you are buying a stock for less than its intrinsic value.
The interesting thing about Graham was that he said that you should not invest in less than 30 stocks in a portfolio. I believe that this is because he was screening [for stocks rather than researching them], and since he didn’t know a lot about each of the stocks in his portfolio, he needed to keep the position size is small. Generally, this is what we recommend as well: if you don’t know much about the company, you manage your risk by not owning much.
This “flavor” of value investing, if you will, has given birth to quantitative value strategies; value quants are people who are screening for stocks defined by certain characteristics – price-to-free-cash-flow or something – and trying to build an optimal basket of stocks. It’s not an individual ownership model, but is kind of a mechanized model to build a basket.
You can see the people from AQR – a big hedge fund here in Chicago – have been doing a lot of work to create the best baskets by combining value criteria with quality criteria or value criteria with what they call “momentum” criteria to try to find a portfolio or a basket of stocks that over time will outperform the index.
Let’s contrast this style of value investing, which we’ll call “Quant Value” or “Graham Value” with the value investing of Warren Buffett. Buffett, of course, was one of Graham students are and he used the principles that were written in Graham’s book about fundamentally analyzing a company, but he didn’t necessarily follow Graham style.
Buffett thinks of himself as the owner of a business and tends to own a very few number of stocks. In one of the previous videos that I made for members. I put a quote up of his. That said, if you own more than six stocks in your portfolio. It’s ridiculous that you’ll never make as much money on your seventh best idea as you would make by putting more money in your first best idea.* This style really contrast a lot with Benjamin Graham who said you know you need to have at least 30 stocks in your portfolio.
I brought up the Berkshire Hathaway’s portfolio and there are a lot of stocks on this list, but you can see that most of them are really, very small stakes. If we look at the top six stocks, together their weight totals about 75% of the portfolio value.
In essence, what Buffett has done is put a lot of money into his high conviction bets. Of course, these are only the public companies that does include Geico, which he owns outright. But you get the idea that his best ideas he puts a lot of capital behind them and really understands how those businesses operate and has an expectation of how those businesses are going to grow and prosper in the future.
At IOI, we advocate kind of a combination of the two styles.
Benjamin Graham I think would’ve been really surprised in the ‘60s and ‘70s with the Efficient Market Hypothesis, one of the ideas of which is that you can’t beat the market.
Graham and Buffett have laughed at that idea, but the fact is that most professional investors cannot beat the market.
What we talk about at IOI is reserving most of our allocation for growth – which would normally be an investment in equities – to reserve that allocation for an investment in the index or in something like an index, which is very diversified.
Then with a smaller part of your portfolio, using the Buffett approach; really understanding the company that is underlying that stock price, and understanding what the value of that company is, and then putting a sizable investment into that company.
You can vary the size of those allocations – maybe most people would do 80% in an index allocation and the remaining 20% would be two or three stocks that they know well and understand. I think this is the kind of portfolio that really can beat a benchmark. Thanks for joining me for this edition of Sunday morning coffee!
* Quote
“If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea.”