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D. Murali

FROM Benjamin Graham to Warren Buffett and beyond is the gamut of Value Investing, a book by Bruce C. N. Greenwald, Judd Kahn, Paul D. Sonkin and Michael van Biema, published by Wiley (www.wiley.com).

In chapter 1, you'd meet Mr Market, personifying "the impersonal forces that determine the price of securities at any moment." Know `him' as a strange fellow, "subject to all sorts of unpredictable mood swings that affect the price at which he is willing to do business."

As a value investor, you should estimate the fundamental value of a financial security and compare that value to the current price Mr Market is offering for it, explains the book. "If price is lower than value by a sufficient margin of safety, the value investor buys the security." The book calls this the master recipe of Graham and Dodd; there are variations, however, that differ in selecting securities, estimating fundamental values, calculating margin of safety and deciding when to sell.

There are two classes of fundamental investors — the macros and the micros. The former look at "broad economic factors that affect the universe of securities as a whole" such as inflation rate, interest, exchange rate and so on. It's to the micro group that most value investors belong; they take the current price as "the point of departure". Their focus, in contrast to value investors, is "on prior and anticipated changes in prices, not on the level of prices relative to underlying values." Thus, value investing is most frequently a microfundamentalist approach, explain the authors. But not all microfundamentalists are value investors.

In the vast `investment space' how do value investors keep from losing their way? They rely on a three-phase process: One, a search strategy "to locate potentially rich areas in which value investments may be located". Two, "an approach to valuation that is powerful and flexible enough to recognise value in different guises." And three, a strategy to construct an investment portfolio.

As a value investor, you may have to sit still at times. "That's doing nothing!" you'd protest. But the book recounts how Warren Buffett once sent the money he was managing back to the partners because the market was so highly priced that he could find no place to invest it. "Value investors have traditionally parked the funds temporarily in money market instruments or other secure investments. That has been the default strategy."

Searching for value is to fish where the fish are. Else, you'd be like Mulla Nasruddin searching for his lost ring under a lamppost not because he'd dropped it there but because there was light.

In a world of smart investment managers, you may still find anomalies in stock performance, where apparent `dogs' outrun what are anointed by analysts. How do you explain such errors, "strewn about randomly as ungainly blots on the smooth canvas of human reason"? Take a dose of behavioural finance, by importing cognitive psychology into economics. From such a study, the book highlights a few findings: One, we predict by extrapolation though "a more thorough examination of the correlation of past performance with future return would reveal just the opposite". Two, "we confuse past fiascos with future disappointments."

The book explains the three-element approach to valuation that considers assets, earnings power, and profitable growth. Info that is `solid and certain', with `more realism and less optimism', because, as Wittgenstein said: "Whereof one cannot speak, thereof one must be silent." Value assets at `reproduction costs', because "they are still used in an economically viable industry, and as they wear out, they will be reproduced at some cost."

Earnings power value (EPV) = adjusted earnings x 1/R, where R is the current cost of capital.

"The goal is to arrive at an accurate estimate of the current distributable cash flow of the company by starting with earnings data and refining them," note the authors, explaining EPV. "We assume that this level of cash flow can be sustained and that it is not growing." If EPV is greater than the reproduction cost of assets, inference is that the industry has `strong barriers to entry'. The difference is "the value of the franchise enjoyed by the company".

Growth (G) is tough to estimate, concede the authors. "Uncertainty regarding future growth is usually the main reason why value estimations based on present value calculations are so prone to error," they write, justifying the need to isolate `G' and keep it from "infecting the more reliable information incorporated into the asset and earnings power valuations."

When constructing your portfolio, keep in mind `risk, diversification and default strategies'. Bear in mind that value investors operate within the boundaries of their competence. For them, `margin of safety' helps reduce risk even when stocks are volatile.

Diversification is not achieved by increasing the number of industries in your portfolio. "Find assets whose returns are not strongly correlated with one another." For example, a portfolio "consisting of an umbrella maker and a sun-tan lotion manufacturer" is one for all seasons. A value read.

BookValue@TheHindu.co.in

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