The financial markets would appear to have gone mad. One third of all government bonds now trade with a negative yield, offering hapless investors a guaranteed way to lose money. The insanity isn’t limited to bonds. Cash interest rates are now negative throughout Denmark, Japan, Sweden, Switzerland and the eurozone — and the same may come to pass in the UK. Yet many stock markets remain close to all-time highs, pumped uneasily upwards on gusts of monetary stimulus from the world’s central banks. These are difficult times for investors seeking low-risk ways to grow their savings.
Difficult, but not impossible. To steer a safe passage through such treacherous conditions, we could do worse than follow the investment philosophy of Warren Buffett’s mentor, Benjamin Graham. Graham taught the principles of value investing at Columbia Business School, beginning in 1928. Buffett, the so-called Sage of Omaha and one of the world’s wealthiest self-made men, is the only student to whom Graham ever awarded an A-plus. How best to summarise value investing? It’s the search for dollar bills that cost you only 40 cents.
And it’s also the most successful fund-management strategy ever developed. Graham also taught Mario Gabelli, Glenn Greenberg, Charles Royce, Walter Schloss and John Shapiro. All of these alumni of his value-investment school would go on, as investors, to become multi-millionaires or billionaires.
To qualify as a genuine value investment, a listed company should have three specific characteristics. It should represent a high-quality business, with little or no debt, trading at a significant discount to its inherent worth. The combination of these three characteristics, and especially the last, gives such an investment what Ben Graham called ‘a margin of safety’. And with so many public companies trading at absurdly high multiples (Facebook, by way of example, has a price-earnings ratio of 88, meaning that today’s shareholders are paying $88 for just $1 of earnings), stocks offering a margin of safety are just about the only things in the investment world today that make any sense.
The Canadian insurance company Fairfax Financial Holdings (which I hold in my fund) is run by ‘Canada’s Warren Buffett’, the Indian expat Prem Watsa, and is a good example. For 30 years it has grown its compounded book value per share by an annualised 20 per cent. Its current price-to-book ratio stands at a lowly and very appealing 1.3 — well within Ben Graham buying territory.
Anybody seeking a primer in value investing could do worse than find a copy of Graham’s magnum opus The Intelligent Investor, first published in 1949. Warren Buffett called it ‘by far the best book on investing ever written’.
And although most western markets seem overpriced courtesy of seven long years of quantitative easing, the good news is that pockets of Ben Graham-style value can still be found today. The single most compelling valuation story of 2016 is Japan. Almost 40 per cent of the Japanese stock market trades on a price-to-book-value ratio of less than one. This means that a huge part of the market is available for sale at less than its replacement cost.
Sceptics might counter that Japan is full of so-called ‘value traps’: stocks that seem cheap but stay cheap. What has been lost in translation as those sceptics dismiss the economic prospects associated with ‘Abenomics’ — the series of corporate reforms enacted by prime minister Shinzo Abe — is the fact that Japanese companies, after a bruising two-decade deflation, now have the healthiest balance sheets in the world. Many Japanese companies are reporting record profits. But the stock market, and foreign investors in particular, have been slow to wake up to the trend.
If value investing has been such a successful strategy, why does it have so few practitioners? Warren Buffett addressed this puzzle in his appendix to The Intelligent Investor in 1984: ‘I can only tell you that the secret has been out for 50 years [since Graham first wrote on the topic], yet I have seen no trend toward value investing in the 35 years that I’ve practised it. There seems to be some perverse human characteristic that likes to make easy things difficult.’
The value manager Peter Cundill was even more candid. The most important attribute of a successful value investor? ‘Patience, patience and more patience. It’s a quality that most investors do not possess.’
With bond markets virtually uninvestible and deposit rates everywhere flirting with the ‘zero bound’, value investing is the logical and pragmatic response to absurd valuations everywhere else. It acknowledges the risk inherent in stock-market investing and seeks to limit it.
In practising it, Ben Graham was concerned primarily with capital preservation. As he wryly remarked: ‘An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.’ Many investors today have become speculators but don’t even realise it.
Tim Price is manager of the VT Price Value Portfolio.