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Thursday, 25 April 2019

Benjamin Graham’s 1949 book The Intelligent Investor is still widely recognised as the definitive work on value investing. Vastly simplified, his philosophy was to find and invest in companies that were trading at prices below their book value – in other words, what their assets were worth – with the view that in time that value must be recognised and therefore the share price must appreciate.

One of the most quoted lines from the book is the famous observation that: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Graham was however writing at a time when financial analysis was in its infancy. When he began investing, listed companies weren’t even required to publish audited financial statements.

Markets were therefore almost entirely ruled by sentiment and speculation. This meant that an investor willing and able to evaluate the true intrinsic value of a business was in a strong position to benefit from frequent gross mispricings.

Times have changed

Today, however, stock markets look very different. Information about listed companies is available to everyone, and available so quickly that all investors are able to see the same things and have the same chance to find these mispricings. Thousands of analysts are also constantly studying financial statements and economic data, trying to identify opportunities.

In this environment, is it still possible to invest along the principles that Graham proposed? Value investing globally has underperformed for the past decade, leading some to question whether it is still a relevant philosophy.

However Simon Adler, a fund manager within the global value team at Schroders argues that despite the world having changed substantially, there are fundamental truths that remain in place. The first is that markets will always be inefficient because inefficiency is really a function of human emotion.

“You would have thought with the benefit of technology, hindsight and experience, humans would have become far better at avoiding their own emotions taking over,” says Adler. “But if you think about today’s market, I would say its just as emotional as its always been.”

Fear and greed

The two human emotions identified by Graham that impact heavily on markets are fear and greed. When prices are rising, whether it’s of an individual share, a sector or a particular asset class, investors will greedily overpay for something that is in demand. There is no better recent example of this than the surge in the bitcoin price from $900 to $20 000 in 2017.

Conversely, when news is bad and prices are falling, investors will be overly fearful. They will sell down assets to prices that do not reflect their true value. The dramatic slump in Anglo American’s share price from around R300 per share in mid-2014 to R55 per share by the start of 2016 is a telling example. The stock is now trading at close to R400.

“An efficient market doesn’t take it down to the share price it went down to and then to where it is today, which incidentally we still think is attractive,” Adler argues.

“So you could say that everything has changed since Benjamin Graham. Only one thing hasn’t changed, which is market participants are just as greedy and just as fearful as they’ve always been – and that is what drives markets.”

Adler also believes that just because everyone has access to the same information does not mean that investors are all looking at it in the same way.

“Most people spend their time stargazing into the future – whether that’s trying to predict interest rates, foreign exchange rates or earnings per share – despite the overwhelming evidence to suggest that nobody is capable of forecasting those things,” Adler notes. “So the information is there, but we think most people are looking in the wrong direction.”

What you pay determines what you get

This is why he believes value investing will continue to work, however markets evolve. As proof, he points to 150 years of evidence that looks at future returns relative to cyclically adjusted price-to-earnings (Cape) ratios. What it demonstrates, quite simply, is that the lower the price you pay, the higher the return you get.

“This is also interesting for what it doesn’t say,” says Adler. “It doesn’t talk about any of the things most fund managers will talk to you about – the growth of a business, how many subscribers in China it has, the size of its competitive moat, or how brilliant the management team is. It just says buy the cheapest companies and you will get the best returns.

“Yes, the nature of companies and balance sheet analysis makes it harder to use book value,” he adds. “But if you look at Cape-type earnings ratios, there is still a very significant factor at play and an opportunity for value investors to take advantage of that.”

This is due to a simple market fact.

“The value of a business prevails over a long period of time,” Adler says. “If you buy it cheaply that’s a good thing, if you pay too much that’s a bad thing.”

This is common sense, but common sense rarely rules markets. This is why Adler believes that value investing will always be attractive.

“Facebook has a value, Intel has a value, banks have a value, but if you want to pay far too much for one of these companies, it doesn’t matter how good the business is or how much growth it has, you will lose money,” says Adler. “A terrible business in a terrible sector is probably terrible, but if you can buy it for one pence in the pound you will probably make money.”

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