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Understanding ‘Value Investing’ - August 2013



    Mr Graham distinguished the two as follows: “The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices.”

    In Mr Graham’s mind, investors are looking for value; they are the bargain-hunters. At its core, value investing is simply about buying good companies at a price less than their fundamental worth. Value investors believe markets overreact to news, be it good or bad, and that stock prices can move in a manner that does not accurately reflect a company’s quality. As such, they can underestimate its value.

    Mr Graham expounded his theory of value investing at Columbia Business School in the late 1920s and, with his colleague David Dodd, published the thesis in the book Security Analysis.

    The authors also created the Graham & Dodd price-to-earnings ratio.

    The price-to-earnings (P/E) ratio – a barometer of a share’s price relative to a company’s annual profit – is commonly used by equity investors to assess whether a company is cheap or expensive.

    The Graham & Dodd price-to-earnings ratio, however, is defined as price divided by the average of 10 years of earnings. The pair’s methodology asserted that analysing a firm’s earnings in the past five to 10 years gives a better long-term picture of a stock, as one-year earnings are too volatile to indicate a firm’s true potential.

    While the concept of value investing sounds simple enough, it can prove far more difficult in reality. Value managers are often buying stocks which are unloved and are likely to have underperformed. The risk is that performance could get worse before it gets better – or, indeed, that it might not get better at all.

    Value investing has its critics. Some argue that value stocks cannot outpace growth stocks, which was illustrated in the run-up to the tech boom in the 1990s.

    Patrick Connolly, financial planner at Chase de Vere, says: “Value investors often need to adopt a contrarian approach, be brave and have conviction and a long-term outlook, because stocks which are performing badly do not tend to recover overnight. All value managers are therefore likely to have periods when they underperform.”

    Mr Graham’s approach has been adopted by many investors, most notably Berkshire Hathaway’s multi-billionaire boss Warren Buffett.

    Mr Buffett, a student and protégé of Mr Graham, is famed for his success in value investing. He asserts that investors should approach buying a stock as if they are buying the company itself. Mr Buffett is known for buying household name companies, such as Coca-Cola and American Express, and holding them for indefinite periods. When Mr Buffett invests, his primary concern is not how the market might view the firm but how the firm can generate money as a business.

    Other disciples of Mr Graham are Seth Klarman, founder of Boston-based value-led hedge fund giant The Baupost Group, and the late Walter Schloss, who outpaced the S&P 500 index for nearly 50 years. When it comes to value-led fund managers, Adrian Lowcock, senior investment manager at Hargreaves Lansdown, highlights two: Aberdeen Asset Management and Franklin Templeton.

    Franklin Templeton was established when investment houses Franklin and Templeton joined forces. The latter firm was owned by the late Sir John Templeton, another well-known value investor.

    Mr Lowcock says: “Sir John Templeton’s rule of investing was buy value, not market trends or the economic outlook, [and] the firm’s philosophy has hardly changed since. The focus is on acting differently to the herd, believing that value in the long term outperforms, and being willing to take risks.

    “Aberdeen’s view is that, in the long term, share prices reflect underlying business fundamentals. It therefore identifies it’s best investment ideas but only invests at the right valuation.”

    Louise Kernohan, pan-European equities manager at Aberdeen Asset Management, says: “[We do not want to] overpay for a company, no matter how good we believe it is. L’Oréal, for example, is a company we always liked and had visited on a number of occasions, but we felt it was always too expensive to invest in. But in 2009, like many firms, its share price fell back, but nothing fundamentally had changed within the company. It was then we decided the price was right for investing. Since then, the stock has risen well.”

    Philip Scott is a freelance journalist

    In this special report


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    1. The Graham & Dodd price-to-earnings ratio is defined as a company’s price divided by how many years of average earnings?

    2. In what decade was value investing developed?

    3. Which company does Schroders’ Mr Kirrage cite when he says that managers can find “value hiding in plain sight”?

    4. Mr Vaight of M&G says that emerging markets are currently cheaper than developed markets on a price-to-book basis by how much?

    5. And at what level does Mr Podger of Fidelity say emerging markets are currently trading on a price-to-book basis?

    6. What return has the Investec UK Special Situations fund delivered over the past five years?

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