What is Value Investing? From Old School to Modern Approaches

What is value investing? The first time you come across the term you’ll see it being defined as buying stocks with a low price-to-book or price-to-earnings ratio. Most likely you’ll also run into several articles that state the investment style isn’t working and has suffered bad returns in the past decade. This post will examine old school value investing and more modern approaches.

Low Multiples & Cigar Butts

In Ben Graham’s days, the aim of value investing was to buy companies for less than the value of the assets on the balance sheet. In layman’s terms, this means buying below net worth. If a company’s net worth is $10, you want to buy at $5. The idea was to buy companies below their liquidation value. Old school value investing also stresses to buy low p/e stocks. In short, no consideration is given to company quality, management or future earnings. Stocks are to be bought “as if they’re dead”.

Net-Net Stocks aka. Cigar Butts

One of the more significant value investing strategies developed by Graham is buying “net-net stocks”. What this means is buying stocks that are trading below their net current asset value. This number is computed by subtracting a company’s total liabilities from its current assets. If you buy a basket of net nets, chances are that on average you will do quite well due to the built in margin of safety. Some will fail, but as a group the stocks should give you a handsome profit.

Warren Buffett is famous for deploying this strategy almost exclusively until he befriended his future business partner Charlie Munger. Munger had a huge influence on Warren shifting his investment style from net-net “cigar butts” to more quality, compound-oriented enterprises.

“You’re walking around, and the ground is littered with cigarette butts. Every once in a while you’ll find a cigar, with one puff left. It may not be the nicest puff, but it’s all profit” – Warren Buffett.

Today, this “cigar butt” style of investing is practiced by some, but finding worthwhile targets has become very difficult. Most cigar butt inefficiencies are quickly arbitraged away and competition for them is fierce. Personally, I don’t recommend only sticking to a cigar butt style of value investing. Instead, it can be a part of your investing arsenal if the opportunity suddenly emerges. The opportunities to get a “free puff” are usually more prevalent during great crises, such as the crash of 08.

The “True” p/e Ratio

The price-to-earnings ratio is the most widely reported valuation metric. But buying solely on this metric is a huge mistake in my opinion.

Using p/e as a guide to buying is a mental shortcut in determining if a stock is cheap or expensive. It doesn’t give any indication to the quality of a company, or the debt it may carry. If a company is on its way to bankruptcy, buying at a low p/e will not help. The “P” in the ratio is just the price. Not indicative of value.

If you want a “true p/e” ratio, I recommend figuring out the metric known as: EV / EBIT. aka. Enterprise Value / Earnings Before Interest & Tax.

EV is the number on which theoretically the company could be bought (without consideration for future earnings). This is calculated as follows: (Market cap + debt) – cash. In other words, buying all outstanding stock, as well as debt. Then we subtract the cash, since it’s a non-operating asset and we want to get the net debt number (we assume the cash will be used to pay off liabilities). EV is the number used in corporate takeovers and acquisitions. The takeover price is usually some multiple of EV/EBIT.

Another word for EBIT is operating earnings. The reason why we use this number is because tax rates may vary, and net earnings can be dressed up via creative accounting.

To sum, look at p/e as a way to gauge Mr. Market’s mood. Here’s a rule of thumb: Below 10 = Pessimism. around 15 = Careful optimism. Over 20 = Optimistic. Over 30 = extremely optimistic.

As with all things, the above is not set in stone. All situations need to be gauged on an individual level. If a company is growing at a rapid rate and will continue to do so into the foreseeable future, a p/e of 20 may actually be considered cheap.

Contemporary Value Investing

So is value investing dead as headlines in the media say? It is true that as a group, low p/e and p/b stock returns have been underwhelming. Yet, the logic of buying stocks below their intrinsic value makes so much sense. How should you approach value investing today?

Focus on Free Cash Flow

The best way to estimate intrinsic value is to have an idea what the company’s future free cash flow will look like. We expect to put down money today, in order to receive a return in the future.

A common mantra you may hear is that in order to generate higher returns, you must take on more risk. As value investors, we’re looking to do the opposite: Generate a higher return with lower risk. And since the future is by definition unknowable, the only way to reduce risk is to pay a lower price. I believe the definition of risk is not knowing what you’re doing, and thus it’s difficult to quantify. Although if you consistently buy companies at high multiples, over time you’re definitely stacking the odds against you.

The public stock market is auctions driven; The price of a stock is the highest the buyer is wiling to pay, and the lowest amount the seller is willing to sell for.

In order to do better than average in the market, you must stick to mental models. Here’s some of Charlie Munger’s best advice:

Only deal in things you are capable of understanding
Buy a company with a durable competitive advantage
Prefer a management with a lot of integrity and talent
No matter how wonderful a company, it’s not worth an infinite price. The price needs to give a margin of safety, considering the natural vicissitudes of life.

“All intelligent investing is value investing” – Charlie Munger

-IGTSKasimir

Ignore The Street

Intelligent Investing Since 2019