Value Investing: Bruce Greenwald Interview with the Financial Times

John Authers, the FT investment editor, did a two part interview with Bruce Greenwald of Columbia Business School and First Eagle Funds regarding value investing and the current market environment.  Greenwald is very well known within the value investment community and has written a great book detailing the value investment approach called, Value Investing: From Graham to Buffett and Beyond (Wiley Finance).

In the first part of the interview, Greenwald states that the theories on value investing that Benjamin Graham proposed nearly 75 years ago in his book Security Analysis have been more correct regarding financial market theory and the achievement of superior investment returns than any of the subsequently developed financial theories.  Basically, Graham’s theories were based on buying companies that were ugly, cheap, disappointing, and boring.  Underlying Graham’s focus on these companies was his understanding of the market’s psychology.  He believed that: (1) people loved lottery tickets, which are highly bid up  and ultimately underperformed; (2) people eschewed ugly companies, which usually outperform other investments; and (3) people apply much more certainty to their opinions than they should.  Graham’s analysis of a company began with the balance sheet.  Of all the factors to analyze, the balance sheet is what the company currently owns and owes and has the least amount of uncertainty.  Next, Graham would look at the company’s current earnings ability, these earnings are not  guaranteed to continue into the future, but allows one to get a better sense of the company’s profitability when properly analyzed.  Finally, Graham eschewed making growth projections.  He believed there was too much uncertainty in these projections for them to be relied on for an investment decision.  However, Warren Buffett, his star pupil, built on Graham’s theories and introduced the idea of franchise value, which looks at the company’s attributes and industry position to determine whether a company’s current earnings will likely continue into the future.

Authers points out in the interview that Buffett does not invest in dirt cheap and disappointing companies.  Greenwald counters by discussing Buffett’s initial purchase of Coca Cola.  At the time, Coca Cola appeared to many to be in bad shape and consequently its price took a large hit.  Buffett’s analysis revealed that this drop in price was an overreaction by the market, and that Coca Cola would probably manage through the tough times.

Since, this interview was only a few minutes it was impossible for Greenwald to cover all the details of value investing.  Below are a few additional thoughts that CB has decided to provide :

(1) Buffett invested in “dirt cheap” companies in the 1950s and 1960s.  However, he no longer invests in these companies for two reasons.  First, he is limited by the large amount of capital at his disposal.  As a result, he cannot take a meaningful position in a beat down company without pushing its price higher and thus making the investment unattractive.  Second, he has come to believe that investing in great companies at a fair price produces better long-term results than investing in bad companies at cheap prices.  Remember, most of the time a company is cheap for a reason.  When Graham was running his investment partnership, his staff would go through numerous companies before actually investing in one.  A good investor does not buy a stock only because it is cheap.

(2) Greenwald’s discussion on certainty is important and could be expanded upon in more detail than this post will allow.  To be brief, investors should always consider the possibility that their investments and expectations may not play out the way they envision.  Uncertainty must be considered during investment selection and portfolio management.  Regarding company investments, there will always be negative and positive events that happen to a company that were unforeseen by investors.  Companies are too complex for one person to fully understand every potential obstacle or boost companies will receive in the future.  As a result, many value investors use a margin of safety when investing in a company.  Basically, buying a company with a margin of safety implies purchasing the company at a price that appears much lower than its calculated value.  Thus, when events do not go the way the investor planned, then the company’s price may still appreciate, even if it doesn’t reach the investor’s originally calculated levels.  However, if the investor had purchased the company at a price equal to the company’s value and the future results did not meet expectations, then the investor would probably incur a loss on the position.  The margin of safety offers a measure of protection against the uncertainty of the future, but in no way gaurentees a prevention of losses.

Furthermore, investors must realize that they will make investments that will yield negative returns.  Great investors are usually correct, at the highest levels, 40% to 60% of the time.  Some are correct much less, but have relatively more money invested when they are correct.   To help protect against uncertainty investors must not invest too much of their portfolio into one investment.  This process is known as diversification.  There are many theories involving diversification and the extent an investor should pursue it.  CB has its own theories regarding this topic and will not detail them in this post.  The main goal of diversification is to mitigate the unforeseen or a realized risk in one of the investor’s companies.  Furthermore, diversification should be used so that an investor does not have all his money exposed to one industry.  Thus, when an unforeseen event or a known risk is realized that affects all the companies in one industry, the investor’s exposure to that event is mitigated by his other non-related investments.  Finally, an investor should not want a portfolio of 10 stocks with 90% of his money invested in one.  If the one stock the investor was certain of declines 90% in a couple of days and he does not have other risk management tools established, then the whole portfolio suffers regardless of how well the other nine companies perform.  Smart diversification can be an investor’s way of accepting uncertainty and realizing that a sound investment process will not always result in large investment returns.

(3)  The above discussions regard only a few aspects of investing strategy and are not meant to be all encompassing.  Value investing tends to focus more on fundamentals and less on the technical aspect of the markets like price determination and represents one of many strategies.  A significant part of CB’s investing philosophy is based on value investing concepts.

For the purposes of full disclosure,  CB does receive a small commission from Amazon for the purchase of any books from the links in this post and website.

Chain Bridge Investing (“we” or “CBI”) states at the outset that the opinions, judgments and derivation of thinking in this writing are solely Chain Bridge Investing’s. It is imperative that any judgment or valuation you take from information dispersed by CBI be examined within the context of your portfolio investment and overall objectives. To that end we urge you to contact your investment advisor or portfolio manager to insure that the information or suggestions proposed by CBI conforms to your needs and financial strategy.

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Tagged with Bruce Greenwald, Diversification, Financial Times, John Authers, Margin of Safety, Security Analysis, Uncertainty, Warren Buffett