First published at ValueWalk.com
What are the fundamental principles of value investing and how should you interpret them?
Joseph Calandro, Jr., a Managing Director of a global consulting firm, Fellow of the Gabelli Center for Global Security Analysis at Fordham University, author of Applied Value Investing, and a Contributing Editor of Strategy & Leadership, published a paper earlier this year that seeks to answer this question.
I should say now that this is only a brief summary of the paper and principles covered. It’s a highly recommended read for those interested. A link to the full paper (PDF) can be found at the bottom of this piece.
Value investing principles: Principle 1
Joseph Calandro starts by laying out the principles of contrarianism, which is also the first principle of value investing. Every value investor should be a contrarian, it’s an essential part of the school of thought. However, it’s often the case that investors fail to adopt correctly this strategy. Calandro quotes a paragraph from Liar’s Poker:
“Everyone wants to be [a contrarian], but no one is, for the sad reason that most investors are scared of looking foolish.”
Value investing principles: Principle 2
So, principle number one of value investing is to have a contrarian nature. Principle number two is the fact that value investing in itself is an opinion. Every value investor has an opinion as to whether or not a stock is undervalued at a particular level. The problem is, as Calandro writes, that everyone is confident in their own opinions when others agree with them.
Unfortunately, the value of everything is subjective:
“…the principle of value subjectivity can be operationalized; stated another way, because value is an opinion the assumptions behind a valuation should be thoroughly understood and validated.
Because value is subjective, all valuations are based on assumptions. What exactly is meant by the term assumption? A dictionary defines it as “the act of conceding or taking for granted.” The phrase “taking for granted” is a harsh one, but it is applicable to the art of valuation.” — Calandro, Joseph, Value Investing General Principles
After this statement, Calandro gives a quick run-down of the various subjective factors that usually form the basis of any value-orientated valuation technique. Even rigorous bottom-up analysis can have its downfalls and relies on key assumptions such as:
- Will costs remain at historic levels or increase faster than inflation?
- How will changes in the economic environment affect performance?
- Are historic costs based on current market values?
Value investing principles: Principle 3
Principle two blends into principle three; rigorous bottom-up case specific analysis is a characteristic of all professional value investors.
And it’s here that Calandro outlines a rather staggering fact. Most of the time, even professional investors don’t bother to read the financial documents associated with their investments. In most cases, simply reading SEC filings can give investors a huge edge over the rest of the market. However, while an in-depth study of the company and its financials can significantly improve an investor’s chance of getting things right, the subsequent forecasts produced still depend on a number of assumptions, which are based on an opinion. Like all opinions, these assumptions can be formed correctly or incorrectly.
Value investing principles: Principle 4
With assumptions being subject to opinion, it’s the job of the value investor to apply a rigorous and conservative approach to the estimation of all assumptions.
“A dictionary defines conservative as “cautiously moderate or purposefully low: a conservative estimate.” Accordingly to Benjamin Graham, “It is a basic rule of prudent investment that all estimates, when they differ from past performance, must err at least slightly on the side of understatement.” Value investor Seth Klarman explains why:
‘Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb. Virtually everything must go right, or losses may be sustained. Conservative forecasts can be more easily met or even exceeded. Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuation derived therefrom.’” — Calandro, Joseph, Value Investing General Principles
Another view on the matter, this time from value investor Wally Weitz, who told me earlier this year how he applies a conservative estimate to all of his valuation calculations:
“We build a model of how the income statement works. All too often this is based on estimates, which, hopefully, we are appropriately skeptical about…Then we do a discounted cash flow model using a 12% discount rate. And we get a number. That’s our — as I say we try and be appropriately skeptical about out inputs…we’ll make a high case for, if a few things go right, how good could it be. Then a low case based on if something goes wrong — hopefully we’ve already figured out what could go wrong — we try to figure out how bad things could be…”
Value investing principles: Principle 5
Principle five is based on the statistical concept of mean reversion. Specifically, market perceptions of value will fluctuate around some long-term mean. Fluctuations in pricing will frequently revert to some central tendency with a staggering level of predictability. Professional value investors seek to both identify assets (and liabilities) that are positioned to benefit from mean reversion and to identify ones that could be punished by it. For example:
“…during the depths of the financial crisis when many people were panicking, Mr. Buffett insightfully diagnosed the likelihood of mean reversion that led to a number of high profile and ultimately successful investments” — Calandro, Joseph, Value Investing General Principles
Value investing principles: Principle 6
Calandro notes that all of the above principles — one through five — are cumulative. They all build upon each other and lead to the final, and most important principle of value investing, the margin of safety. However, you cannot invest with a margin of safety unless you follow the five principles above. In order:
Principle one: Approach the market as a contrarian — if you think like everyone else you are going to value things like everyone else.
Principle two: Understand the risks and opportunities associated with value subjectivity.
Principle three: Approach valuation rigorously from the bottom up.
Principle four: Formulate conservative valuation assumptions.
Principle five: Understand how to put mean reversion to work for an investment instead of having it work against one.
Principle six: Invest with a margin of safety.