A few years back, I wrote a post on how I stumbled into investing. After experimenting with a number of investment philosophies, the one that I settled on was value investing. In fact, value investing resonated with me so much that, I wondered why anyone would choose a different approach to investing. However, with more experience since that post, I am not certain anymore whether an investor chooses his/ her philosophy or whether the philosophy chooses the investor. It now seems to me that a philosophy that is not aligned with the mental make-up of an investor will not work for that investor, no matter how successful other people have been at applying that philosophy.

The recent sell off and volatility has been a good catalyst for me to revisit some of the basic tenets of value investing, which tend to get lost the longer markets continue in a singular direction. Before I get into some of my recent observations on investor behaviour (including my own), I thought it would be useful to start with a short introduction to value investing and discuss its history and evolution.

An introduction to value investing

Value investing is often described as the process of buying something for less than it’s worth or intrinsic value, as it is popularly know in value investing circles. This intrinsic value is the value that you derive for an asset based on its fundamentals¹, being cash flows, growth and risk.

At its core, value investing requires faith that:

• Every asset has an intrinsic value;
• This value can be estimated; and
• Given enough time, the price will adjust to value.

This is easy enough to understand but some of the reasons why value investing is not easy to practice include:

• An asset’s worth is based on what it will do in the future and therefore, requires us to make judgments about variables that are uncertain to begin with.
• Value also changes as future events unfold and new information is revealed about an asset.
• Value is impacted by an asset’s attractiveness or lack thereof relative to alternatives, not just alternatives in the same asset class but also among asset classes.

Nonetheless, there are investors who have been insanely successful at applying this this philosophy over the years, the most notable of them being Warren Buffett.

History, evolution and current state of value investing

Ben Graham is considered as the father of value investing, organising his investing beliefs in his famous work, Security Analysis (released in 1934).

While Security Analysis was dense and highly technical, Graham also wrote a more accessible version of his investing ideas in The Intelligent Investor, one of the most popular investing books even to this day. It was this book that inspired Warren Buffett to attend Graham’s classes at Columbia and paved his path to greatness.

To understand Graham’s idea of value, one has to understand the context of the world that shaped him. He was a product of the Great Depression, the most devastating economic event in living memory. To contextualise how severe the Depression was, it is helpful to compare it to the GFC (spanning 2007 to 2009), which is the worst recession we have had since the Depression. Real GDP during the Depression declined more than a third (-36%) from peak to trough over a 4-year period from 1929 to 1933 vs. only 5% in the GFC. Similarly, more than 1 in 4 people (25%) looking for employment couldn’t find one. By comparison, the maximum unemployment rate in the GFC touched 10% and that too very briefly. The unemployment situation is even worse in the Depression than the headline numbers suggest since it does not include those who had to transition from full time roles to working only part time and do a job that was well below their qualifications.

It is no surprise then that the Great Depression left enduring scars on Graham and defined his investing philosophy. That’s the reason Graham laid extraordinary emphasis on margin of safety, sometimes even at the cost of potential. And so, were born ideas such as investing in companies trading below net cash and “net-nets”. As so often happens, Graham’s ideas have been diluted to formulaic investing, even though it is quite likely that Graham himself evolved and refined his philosophy as the cloud of the Depression lifted with the passage of time.

To an extent, Warren Buffett followed this formulaic approach in the early part of his investing life. Over time, however, Buffett has shifted his focus to higher quality, stable businesses which he’s bought at reasonable prices as opposed to mediocre businesses at bargain basement prices. As part of this philosophy, Buffett has tended to hold companies for longer than in his earlier avatar. Like Graham, Buffett’s followers have also tended to dilute the true essence of his more refined and nuanced investment philosophy.

A world divided

From my vantage point, therefore, I see the value investing world today being divided into two camps:

• those that mimic Buffett’s early years and are rigid in their insistence of investing only in low PE, low PB companies based on arbitrary thresholds of what is “low”, irrespective of differences in quality; and
• those that follow the more contemporary Buffett, emphasizing only high quality businesses, often at the expense of price.

In my view, these need not be two mutually exclusive domains. True value investing can be practiced in businesses of every stripe – low or high growth, earning a low or a high return on capital, capital light or capital intensive.

So what are some of the specific mistakes that each group is likely to make?

By focusing purely on price and arbitrary valuation thresholds, the first group of investors end up self selecting for lower quality, higher risk companies. These are companies that usually earn a low return on capital and businesses that have no or fleeting competitive advantages.

The second group is likely to make the opposite mistake. By focusing mainly on quality, they tend to neglect the price, often paying prices that are inconsistent with a value philosophy. And even when they buy companies at reasonable prices, they tend to overstay their welcome, often holding these “high quality” companies at unjustified prices. The consequence of this is to turn those higher quality businesses into lousy investments.

In this post, I want to focus more on the latter group, not only because I feel this is the more prevalent view today among investors, but also because I myself tend to fall into this category. Perhaps, the long bull market has conditioned investors to behave this way.

Buy or hold (at any price) is not consistent with a value philosophy

Is this not a strawman argument, you might ask? After all, how often have you heard any sane investor say that they buy or hold their companies at any price? I agree that nobody ‘says’ this but, when you look at how people act (including me), they do this far more than they realise. They hold onto their winners, long after these companies have crossed their bounds of reasonable value. Maybe it’s the warm and fuzzy feeling that we get clinging onto companies that are doing well operationally. After all, it is human nature to enjoy the company of success. Socially, we try and associate ourselves with successful people and so, who’s to say this behavior does not translate into investment decision making. While I have no way of proving this, my hunch is that social media has only amplified this bias. As the popular saying goes,

“Success has many fathers, but failure is an orphan.”

Another possible reason why people tend to behave this way is that human beings are rationalising animals rather than rational animals. It’s amazing how the human mind can create compelling stories to justify ridiculous prices. And so, we end up holding onto companies long after it makes little sense to do so. Of course, the ridiculousness of those arguments is known only with the benefit of hindsight. One of my favourite sayings encapsulates this sentiment perfectly:

“Stock price performance creates its own narrative.”

The sell decision is harder

It might seem irrational that there should be different emotional responses to buy and sell decisions, but there just is. For whatever reason, the sell decision seems to be a lot harder than the buy decision. Maybe this is because it is easier to pass up opportunities and see them go up than to sell something that you already own and then see it shoot the lights out. There’s a certain level of commitment with a stock that you already own which just isn’t there with a potential buy, no matter how much time you’ve spent researching it.

The other aspect with selling is that the length of time of potential regret for selling out early is likely longer. This is because bull markets tend to last longer than bear markets and therefore, once you sell, the time that the stock runs higher than your sale price is likely to be much longer as well. As someone very rightly said,

“Markets take the escalator up and the elevator down.”

Despite these biases, I feel that staying true to a value philosophy requires the discipline to sell when things become overvalued. At times, this means that we will end up selling companies only to see them continue to go higher for long periods of time. If the analysis is right and the stock keeps going higher despite this, all you can do is wait. There are also situations where we end up selling things when we shouldn’t have because our “sell analysis” turns out to be wrong, i.e. what you thought was overvalued was not necessarily so. The obvious thing to do in this case is to acknowledge your mistake, update your analysis and then wait for the price to be right again. In my short experience (and the experience of others who I trust), no matter how far away from intrinsic value stocks go, they eventually do come back.

I’ve long struggled with the question of how do you deal with the regret of rightly selling a company based on valuation grounds only to watch it keep going higher. The most convincing answer that I’ve come across is from Prof. Aswath Damodaran. When asked whether he regrets having bought and sold Amazon shares rather than just holding them (and thus leaving money on the table), this is what Prof. Damodaran had to say:

“I believe if I value something and the value is much higher than the price, that if I buy it at a low price, over time the price will adjust to value. But if that’s my faith, then that faith requires me to also act when price goes above value… That’s why when people say I am a value investor, I buy when something is cheap but I buy and hold… How do you reconcile the contradiction in what you just told me. That doesn’t seem to be an internally consistent philosophy and my experience is that when you have a philosophy that has internal inconsistencies it eats into itself. Those internal inconsistencies come back and eat away at the core of your philosophy… Should I have held onto Amazon? With the benefit of hindsight, absolutely but, to me it’s a small price to pay for a consistent philosophy.”

The essence of value investing lies in its acknowledgment that there are limits to our knowledge and that investing is a game of probabilities. There are times when the outcome is bad even thought the process was right. All we can do is to make peace with our decisions, learn from them and move on, even if they cost us in hindsight.