The Road to Graham and Doddsville

I thought I was investing when I dabbled in the forex markets. Back then I based my trading decisions on technical charts and interest rate decisions. However, during a discussion with my friends on our investments, they posed me a question on how do I derive the intrinsic value of a currency? I had totally no idea what they meant. After playing in the forex markets for close to 4 years with no results to show, I decided to give it up and with the recommendation from my friend, I opened a securities trading account.

The first person that came to my mind when it comes to investing in the stock market is none other that Warren Buffet. He adapted Benjamin Graham’s early investment framework to apply to competitive modern investment markets. I came across his article, “The Superinvestors of Graham -and-Doddsville” and his philosophy in value investing made sense to me. Value investing has shown that it can survive the test of time with the ranks of superinvestors listed by Warren Buffet. Basing my principles from Benjamin Graham and the other Superinvestors, my journey into value investing begins. Over the course in time, I will be sharing my investment framework and its track record in this blog. 

What is “Value Investing”?

The value investor seeks to buy assets when they are priced at a discount to their intrinsic value, which means buying assets for less than they are worth. The principles of value investing can be summarized into 3 key points. They are:

1. Look at stocks as small pieces of business

2. Stock market volatility is your friend.

3. Always have a margin of safety

First and foremost, no disrespect to all the technical chartists out there. But part of my investment framework is to acknowledge that a share represents part ownership of a business. I don’t trade based on movement in price patterns of a security. 

Second, Benjamin Graham created the persona “Mr Market” as a metaphor to to explain market volatility. The price that Mr Market offers will vary according to his mood swings. Take advantage of the mood swings and not his instructions. 

Third, the purpose of having a margin of safety is to avoid costly mistakes. It also allows your investment to have room for appreciation. This gives you the confidence to hold through volatile markets. As Buffet said, “Price is what you pay, value is what you get”. 

Components of Total Value

With the 3 core values listed above, I developed my framework to derive intrinsic value. Do note that different value investors will have their own definition of intrinsic value. This is because there are many different components of the total value of a company and some investors will choose to pay more for different components than others. The level of components ranges from the most conservative to the least enterprising. The different levels of components of a company’s total value are explored below. 

For example, a deep value investor might only buy when the price is well below a company’s net current asset value. This is how Graham valued an investment. Another value investor might prefer to look at its earning power and the ability to produce much higher than average returns due to some sort of competitive advantage. This is the approach Warren Buffet has taken.

There first component is the ‘net net’ valuation method. This is the most conservative valuation approach. It attributes value only to the net current assets (current assets minus current liabilities) of the company and attributes zero value to to Property, Plant and Equipment (PPE) as well as other long term assets. 

The second component is the ‘liquidation value of the assets’. This values the worth of a company if it is no longer in operation and all of its assets were sold on the open market. Usually, assets will be liquidated at a fraction of their worth as buyers know that they are purchasing from a distressed seller. 

The third component is the ‘book value’ of the company, which determines the total assets less the total liabilities on the balance sheet. Although rare, there are some cases where some elements of hidden value are not reflected on the balance sheet due to accounting standards. An example would be a property where it has appreciated over time but the value of the land is recognized at historical or purchase price. Intangible assets such as brands or goodwill may also have a value materially different to what is stated on the balance sheet. Walter Schloss is a noted value invester who invest based on margin of safety discounted to asset values. 

The fourth component of value is the ‘reproduction  value of assets’. This measures the cost of reproducing the market position of a company. For example, the distribution network of a trading company which is not included in its balance sheet. The cost of building this network and running it would have been expensed long ago but there is an intangible value attached to this network. This also applies to valuations of brands, R&D and patents. 

The fifth component is the ‘valuation of earnings’. Also known as PE ratio, this valuation applies a multiple to what is considered to be sustainable future earnings of the business. For this valuation method, it veers off the classic Ben Graham investing strategy of buying assets selling at a price discount to its ‘net net’ value. 

The final component of a company’s total value is the ‘franchise value’. It refers to a business that has barriers to entry and sustainable competitive advantage. Some ways for competitive advantage are product differentiation, low cost due to economies of scale and locking out competitors. This value is the major source of any value that exceeds the asset reproduction value and it can be very difficult for investors to identify. Warren Buffet has the ability to identify the value inherent in the franchises of businesses such as Walt Disney, Coca Cola and Gillette and invested at times when the rest of the market did not. 

From the levels of components of total value, you can see the evolution and adaptation from Ben Graham’s principles to Warren Buffet’s recognizing of the business franchise value. 

Conclusion

It is important to note the foundation on which investment strategies are based. Value investors stayed true to the 3 principles of value investing; a stock is a piece of business, exploit rather than be exploited by Mr Market; and buy stocks with a margin of safety. From Buffet’s Superinvestors speech, we know that although generations of value investors have used different methods to quantify intrinsic value, Ben Graham’s 3 principles are common to all. 

As a value investor, you can choose to take your own path, but we all aim for the same destination of stock market out-performance called Graham-and-Doddsville. 

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