Secrets Of Success: Effort, not brains, key to value investing
Saturday 04 November 2006
If you are a value investor by temperament, you will (or should) find a lot that is persuasive in what Christopher Browne has to say about the craft of value investing in a delightful new book out this autumn. Browne is a partner in the New York firm of Tweedy Browne, which started out as a broker and made markets in obscure American stocks before branching out into money management.
The firm has two particularly striking distinctions. It was the brokerage firm that bought most of Warren Buffett's shares in Berkshire Hathaway 40 years ago, thereby setting in motion what was to become a great modern investment business. It was also the money management firm that more recently took a prominent lead in pursuing the newspaper magnate Conrad Black over his treatment of shareholders at the media company Hollinger.
The aforementioned Lord Black, whose business methods are brutally exposed in Tom Bower's new book on the subject, does not rate a mention in Browne's treatise on value investing, I am happy to say (you can have too much of a bad thing). Instead, he concentrates on the technical and temperamental skills that are needed to hunt down undervalued securities.
It is nicely written and utterly persuasive if long-term investment success is what you are after and your temperament is equipped to handle the psychological pressures of making non-consensus investments.
The case that Browne advances is that applying the principles adumbrated by Ben Graham, the so-called father of value investing, is the only surefire route to success in the stock market. The two principles that are central to the value investor's approach are intrinsic value (know the worth of what you are buying) and margin of safety (protect yourself against losing money).
This approach, which might be crudely summarised as cheapskate investing, will never shoot the lights out. Indeed, it may often leave its proponents trailing the market over two to three years at a time.
This is something that requires stamina and strong nerves to withstand, and is one reason why, in an age when relative performance is the chosen measure of success, so few professionals choose to pursue it.
But it has the advantage of standing up rigorously under analytical scrutiny. Scores of academic studies have demonstrated that a value approach, based on buying shares with low price-earnings ratios and a low price-to-book value, reliably produces superior long-term returns. This appears to be true in all countries where stock markets have a credible history.
But as Browne makes clear, you have to love doing your homework if you want to pass muster as a true value investor. Just as Warren Buffett started out by spending hours poring over stock manuals and calculating ratios in his search for undervalued shares, so, too, the modern value investor has to be sure that he understands the dynamics of the business in which to buy shares.
The meat in Browne's book consists of a long list of the questions that value investors should be asking. As most investors appear to want instant gratification, without much effort, this makes for a demanding check list.
"Value investing," he says, "requires more effort than brains, and a lot of patience. It is more grunt work than rocket science." In addition to analysing data, you ideally need a businessman's sense of what a company would be worth if it wasn't a traded security.
One of the problems that true believers in value investing face is that bargains on their original criteria are becoming harder to find. Markets, in general, are a lot more efficient than they were in the days when you could sometimes find shares trading for less than the amount of cash in their balance sheets, which is a classic model for the true Grahamite investor. Increasingly, they are being driven overseas in their hunt.
Browne describes his wonder at being able to find in Europe, from the 1980s onwards, the kind of undervalued stocks that were becoming increasingly difficult to find in the US, where most companies of any size are worked over by analysts in more detail than elsewhere. In Europe at that time, accounting standards were variable and poorly observed, and many companies indifferent to capital market pressures.
I liked the example he gives of Lindt & Sprüngli, the Swiss company that makes Lindt chocolate. When Browne found it, the company was selling at 10 times earnings. This already looked promising compared with the 20 times earnings that other chocolate makers had recently been sold for. L&S was cheap, he says, for two reasons. Inflation in Switzerland was rising, which was spooking investors. The second was that Herr Sprüngli had recently divorced his wife and remarried a Scientologist, prompting fears that the new Frau Sprüngli might have other ambitions for the company than shareholder value.
But further research revealed that the company's accounts were conservative in the extreme (score one for intrinsic value) and a call to a Swiss banker friend revealed that "the former Frau Sprüngli and her children had more stock in the company than her former husband, and she had told him that if he put his new wife on the board of directors, she would fire him." (Score two for the margin of safety, the value investor's second key criterion.) The shares turned out to be a big success.
Now that mainstream Europe has joined the ranks of equity market-conscious regions, such bargains, alas, are harder to find. Logic suggests that emerging markets are the place where valuation anomalies are more likely to be found. But Browne is not so sure. He displays the American's mistrust of far-off places and, on margin of safety grounds, prefers not to go looking in South America and countries with unstable politics. But somewhere like Eastern Europe, where in some countries the politics and economics are converging in the right direction, looks a more promising story for true believers.
'The Little Book of Value Investing' is published by John Wiley & Sons
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