Resurgent value investing has a whole new set of tools, but the fundamentals still apply.
By Laurie Kaplan Singh
September 2001
Institutional Investor Magazine
Buy stocks the way you buy your groceries, not the way you buy your perfume, Benjamin Graham once advised readers of a women’s magazine. Never forget to ask, “How much?”
The legendary Columbia University professor and father of value investing would be gratified to learn that his down-to-worth approach continues to be practiced by many of today’s most successful investors. But he might be surprised by the new analytical tools that modern investors are using to implement the concepts he and David Dodd set forth in Security Analysis, the groundbreaking 1934 book that many value investors still consider their bible.
“The fundamental principles of equity theory have not changed,” says Charles Lee, a finance professor at Cornell University’s Johnson Graduate School of Management and a leading equity valuation theorist. “But with the rapid pace of change in our economy, the task of forecasting a company’s future cash flows with any degree of certainty has become virtually impossible.” That complicates traditional valuation methods.
Explains Lee: A company that built a better mousetrap - or railroad or steel mill - in the 1950s or ‘60s could profit from it for a long time because would-be rivals would be hard-pressed to duplicate it. Graham’s method of assessing value largely relied on such tangible assets. But in today’s information-driven economy, earnings often derive from intangible assets, and barriers to entry are much lower. Thus, Lee says, “many Internet start-ups failed simply because they couldn’t protect the wealth-producing engines they created.”
In such an environment it can be impossible to pinpoint a company’s true value. Then again, says Lee, you don’t have to. He tells a story: Two fishermen are wading in a trout stream when a grizzly bear appears. One man strips off his waders and puts on running shoes. His companion asks: “What are you doing? No one can outrun a grizzly bear.” The first man responds, “I don’t have to outrun the bear, I just have to outrun you!”
This is the essence of modern value investing, according to Lee. “I don’t really care if a company is worth $150 a share or $170 a share,” he says. “I just have to get in a little earlier and out a little sooner than the guy before me.” He values companies against selected peers using multiple regression analysis. “I let the market determine the weight assigned to each of the key determinants of a stock’s overall multiple,” Lee says. “I’ve reduced the discounted cash flow model to a linear regression - I’m taking a short cut.”
Not all value managers would accept the notion that value is strictly relative. One who does is Basu Mullick, manager of Neuberger Berman’s $2.3 billion Partners Fund. He looks for stocks trading at historically low price-earnings ratios relative to the market multiple. For example, he bought Merck & Co. in early 2000 when its P/E was 75 percent of the market P/E - considerably below the stock’s historical range of 80 to 120 percent. When Merck’s P/E expanded to 125 percent of the market’s, Mullick reduced his position. In mid-July he was buying shares of Waters Corp., a supplier of liquid chromatography instruments, and Compu-
ter Sciences Corp., an information tech-
nology provider, both of which were trading at historical lows relative to the Standard & Poor’s 500 index.
Mullick screens stocks on the basis of their P/E compared with the market’s for most, but not all, industries. For example, when examining cable stocks, which may not have significant current earnings, he uses a multiple of enterprise-value-to-ebitda relative to the market’s. Once Mullick identifies a potential buy, he uses fundamental research to determine why the company has a low relative valuation and, if it appears to be temporary, what it will take to restore the multiple and turn the stock around.
Like Mullick, James Gipson, the longtime manager of the Beverly Hills, California-based Clipper Fund, is flexible in applying benchmarks. “A key distinction between Benjamin Graham’s valuation model and ours,” he says, “is that we have introduced the use of specialized valuation techniques for specific lines of business.” A value benchmark such as price-to-book may be meaningful in evaluating a bank or insurance company, Gipson says, but it is of little use in assessing a media company, for which price-to-cash-flow or dollars-per-subscriber are more appropriate yardsticks. In this sense, he says, “we have taken Graham’s concept of valuing a company as a private buyer one step further.” Whatever the method, it appears to work: For the ten years ended April 30, Clipper had an average annual return of 18.4 percent, compared with 15.2 percent for the S&P 500.
Research by Sanford C. Bernstein & Co., one of the premier value houses, demonstrates vividly how the effectiveness of different value measures varies with market conditions. Bernstein studied the top six value measures and found that trailing P/Es were the single best benchmark in 1951-'55, 1966-'70, 1981-'85 and 1996-'01; price-to-book was the most reliable in 1971-'75; and forward P/Es were the superior yardstick in 1991-'95 (“Bernstein Quantitative Handbook,” February).
Christopher Darnell, chief investment officer of the global quantitative group at Grantham, Mayo, Van Otterloo & Co., contends that the wider recognition of the value of intangible assets is a significant development in equity valuation. “The type of companies that are valuable are those that are able to capture market share through branding, research and development, technology distribution and global presence,” he says. That is to say, they have a franchise. (Warren Buffett and Mario Gabelli, among others, realized this early on.)
Grantham’s valuation model seeks to identify companies with strong franchises. “If a company is more profitable than its stated assets suggest, there’s probably a cash-generating asset that doesn’t appear on the balance sheet,” says Darnell.
Prompted by its model, Grantham took positions in Microsoft Corp. and Intel Corp. in the early 1990s. “At the time, they were viewed by most investors as cyclical, capital goods companies,” recalls Darnell. “But to our model they looked like franchise companies worth big premiums. People looked at us askance and asked if we were building a momentum or growth factor into our model. But we were simply focused on what we determined an astute buyer would be wil-
ling to pay for the franchise.” Grantham bought Microsoft in February 1992 at $5.15 and sold it in December 1998 at $70.88, locking in a 1,262 percent return. This summer Grantham’s model was pointing to Fannie Mae, Linear Technology Corp. and Reader’s Digest Association.
Bruce Greenwald, a professor of finance and asset management at Columbia Business School, incorporates franchise value in his method for appraising companies, described in Value Investing: From Graham to Buffett and Beyond (John Wiley & Sons), a book he recently co-authored. First, he uses a model to calculate what a company’s balance-sheet assets would be worth if they had to be replicated. Second, he tabulates the value of the company’s earnings power based on its current profits adjusted for its cost of capital. Last, he assesses whether the company’s franchise is sustainable. “To the extent that a company’s earnings-power value exceeds its asset value, it has franchise value and must enjoy high barriers to entry,” he says.
Even firms like Bernstein that remain committed to a more traditional value approach have recognized the need to refine their methodology. Over the years, Bernstein (now part of Alliance Capital Management) has added enhancements to its discounted cash flow model. “The new models allow us to better capture change and to avoid the classic value trap of buying cheap stocks that stay cheap,” says Marilyn Fedak, chief investment officer for U.S. value equities.
Bernstein’s valuation model now consists of four chief components: The discounted cash flow model that has been at the heart of the firm’s valuation process for more than 20 years and three additional models designed to gauge the timing of a turn in a stock’s price and to identify its risks. An earnings-revision model plots changes in Wall Street consensus earnings forecasts, a relative-price momentum model keeps track of stocks’ price movements over the previous 12 months, and a 19-factor risk model prevents clients from having too much exposure to similar stocks.
Bernstein combines the determinations of all four models into a risk-adjusted return estimate; it computes this for each of 700 large-cap stocks. “We take the internal rate of return for each company, compare it to the IRR on the market and, using proprietary techniques, translate the difference into an expectation of over- or underperformance,” Fedak explains. But the linchpin of this whole process remains fun-
damental research to ensure that inputs into the valuation model are accurate. “Our model isn’t a black box,” emphasizes Fedak.
No tool set or modeling technique alone can assure success. As Fedak says: “There are many different ways to skin a cat. Most approaches to valuing companies work if they are applied in a consistent and disciplined manner. If the past two years have taught us anything, it’s that the worst thing a value investor can do is capitulate to a short-term environment.” Or as Ben Graham put it, “The investor’s chief problem - and even his worst enemy - is likely to be himself.”
