While Ben Graham is considered to be the father of value investing, Warren Buffett has popularized it and made it known to the wider public. But while as Mr. Buffett says "value investing is simple but not easy," there is still a lot of confusion in the public sphere about value investing. As far as I can tell there are at least two misconceptions about value investing.
The first is the belief that all value investors do is sort stocks by price-to-earnings (P/E) or price-to-book (P/B) and buy the stocks with the lowest multiples with a preference for small-cap stocks. But this is only partly true. Value investors do like stocks with low multiple values and small capitalization stocks, because they consider them potentially undervalued – that is, worth examining a bit closer but not yet worth buying. To determine whether such stocks are worth investing in, value investors proceed to value them in order to estimate their intrinsic value and they invest in them only if these stocks meet the margin of safety requirement, namely their price is at least one-third below their intrinsic value. These are the truly undervalued stocks and the stocks worth investing in.
But a strategy that focuses on low multiple, small-cap stocks seems to fly in the face of what Mr. Buffett and other well known value investors do, which is to prefer larger cap stocks without necessarily low multiples. And this gives rise to more public confusion about value investing.
So what is value investing and who are the true value investors – is it Mr. Buffett and his like-minded value investors, or the others who emphasize low P/E (or P/B) small-cap stocks? The truth is that both of them are value investors.
Value investing has evolved over time, not because anything has changed or that the rules of the game have changed, but mostly because the demographics and the size of assets under management of some of the key players have changed.
When people talk about value stocks in general, they refer to low P/E or low P/B small cap stocks. These are the obscure and undesirable stocks that tend to be associated with high likelihood of being undervalued. This is what Mr. Graham taught about at Columbia University. Mr. Buffett was a student of Mr. Graham and learned to invest in this kind of stocks early on in his career. But currently Mr. Buffett seems to use a different approach to choose stocks to invest in. He no longer invests in low P/E (P/B) small cap stocks, also known as "cigar-butt stocks." But early on, he did. These are catalyst driven investments that tend to be shorter term in nature. Value investors who follow this approach are more opportunistic.
Believe it or not, Mr. Buffett was opportunistic early on in his career; it's just he can no longer afford to be. Berkshire Hathaway has become too big to be able to easily invest in the low P/E (P/B) small and less liquid stocks. The Berkshire Hathaway CEO acknowledges this in his most recent letter to shareholders where he stated that "cigar butt strategies worked very well when I was managing small sums." And he went on to say that "[I]n 1951 when I bought Geico most of my gains came from investments in mediocre companies that traded at bargain prices. Ben had taught me that technique very well and it worked."
Mr. Buffett has evolved not because the rules changed, but because his assets under management skyrocketed. He now buys larger companies with higher than typical P/E (or P/B) multiples. These stocks are also value stocks, because they possess significant competitive advantages that are sustainable in the long run. As a result, while the early Mr. Buffett would buy and sell stocks opportunistically, the Oracle of Omaha now likes to hold his stocks for the long run. His holding period, as he has frequently said, is "forever." Why? Because if the stocks he buys have a significant degree of sustainable competitive advantage, chances are that their intrinsic value will be ahead of the stock price. If this is the case, then the recommendation will be not to sell, or by extension never to sell.
Value investing is not monochromatic, but comes in several variations, and so it is with those practising the craft of value investing. The cigar-butt approach to value investing of the younger Mr. Buffett offers many more profitable opportunities than the high quality, competitive-advantage-driven investing approach that he currently follows. That is why Mr. Buffett's returns have declined when compared with his returns early on in his career.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.
George Athanassakos