Price Vs Value

A few years ago, a friend offered to sell me an early childhood education business in Kayu Ara area. I surveyed the neighbourhood to see the housing areas around if they are affluent areas. I went to his office and see how many students they have, and how the students enjoyed learning there. I also requested an audited account from him to see what has been the revenue, expenses, and how much the business made in a year. I also tried to project if I bought over the business and put in effort, how much I would be able to earn in a year, etc.

Things didn’t work out as the offered price was not right for me, and I decided to spent my time doing other things, one of which was to do investing in the stock market as then the market was very attractive just after the US subprime mortgage crisis. You can read here about the market then and the great opportunity provided to fundamental value investors.

http://klse.i3investor.com/blogs/kcchongnz/74098.jsp

So for me, either investing in that education business, or a stock, follows the same process. This is because a stock represent a tiny proportion of a company listed on the stock exchange - a company that employs people, produces goods or services and, hopefully, generates revenue, profit and cash flow. The share price I pay must take account of a company's underlying, or "intrinsic" value. Every stock has an estimated intrinsic value.

Share prices, you may have noticed, vary enormously over the course of a year, sometimes even over a week, a day, for all kinds of reasons, but mainly due to the crowd mentality, the human nature of fear and greed. Here is where the crazy Mr Market is described.

http://klse.i3investor.com/blogs/kcchongnz/75858.jsp

But a business's revenue, profit and cash flow rarely change as much as that. Hence the price of a share does not necessary represent the value of a company. The price of a company's shares is only a reflection of what people are willing to pay for them at any given time. Sometimes, usually when prices are rising, they're greedy and pay a high price. When prices fall, they become fearful and rush for the exits. All this emotion can push the share price a long way from the intrinsic value of the underlying business.

Value investors aim to benefit from this by buying shares when they're trading at significantly less than their intrinsic value, or at a margin of safety. Or, to put it another way, buying a dollar's worth of value for 50 cents. Unlike the stock price, you can never get the exact figure for the intrinsic value but you can sometimes make a reasonable estimate by undertaking "fundamental analysis", which involves looking at a company's financial statements over time and making an assessment of its management, markets and growth potential.

Does value investing always work? Why do you think it will work?

In life, very rarely things work all the time, especially when you talk about the stock market where there are human emotion and various economic and industrial variables. But it works better than all the alternatives I can think of, and it has many plausible reasons why it should work, unlike many other alternative investment strategies.

Why value investing works

If value investing works so well, why doesn't everyone jump on the bandwagon? And if that happens, how can you find value better than others? How can it work anymore?

First of all, in Bursa, many retail investors have their funny ways of investing as shown in the appended post here:

http://klse.i3investor.com/blogs/kcchongnz/75858.jsp

They, almost all of them, know everything about price, but very few know anything about value. They don’t care about value anyway. Value investors can hence dwell in those lower market capitalization stocks where the institutional investors can’t involve in for various reasons as explained here:

http://klse.i3investor.com/blogs/kcchongnz/75376.jsp

Secondly, retail investors are emotional biased. Few retail participants in Bursa are interested in dull stocks with not much of trading activities. There is no fun watching them with little or no movement in share prices of these stocks every day. They want actions; plenty of news about their stocks, buy and sell, getting in and out of the market all the time. Hence there is less competitions investing there.

But in other areas, there are many institutional investors, fund managers who have all the human, financial, and technical resources in the stock market. How can we play the game against them? The beauty is you don’t have to dance to their tunes; you just play your game in your own field. Fund managers are more concern about their career risks if following a winning strategy if it involves enduring long stretches of relative underperformance which does happen in the short term, but usually not in the long term. They feel that it is safer to be wrong when everyone else is losing money than to be wrong when everyone else is making money which the formula can do. Hence a knowledgeable and experience retail investor has every chance to be better than the institutional investors in the stock market.

Most investors, institutional investors included, are unable to view movements in stock prices with the detachment that's required of a value investor; if they could, then the share market extremes caused by fear and greed would not occur. This paradox is one of the keys to the success of the value approach: the concepts are extremely simple to grasp but can be very difficult to put into action. Why? Human psychology. Most stocks tend to be priced about right much of the time. Something significant usually has to happen for a stock to become under or overpriced; a profit warning or a competitor releasing a super-duper new product, for example. In other words, an attractive opportunity for value investors is very often caused by bad news, while good news is very often the signal to head for the exits. So value investors have to be contrarian, looking for the positives when everyone else is looking at the negatives (and vice versa). Humans are hard-wired to follow the crowd, but that's usually unprofitable in the share market.

Value investing is extremely simple in theory, but tougher in practice as you have seen.  If you compare the price of a stock with a confident valuation of its true worth (intrinsic value) and find you can buy it at a considerable discount (margin of safety) then you may be onto a winner. But value investing is much harder than it looks for two reasons, firstly the real intrinsic value of a company can be tricky to calculate but also the practice of buying beaten down stocks also runs contrary to almost all human instincts.  But it’s precisely these tendencies that lead to so many investors over-reacting, driving prices down so low that value stocks become so profitable in future for the value investors.

How Profitable is Value Investing?

Benjamin Graham is widely regarded as the dean of value investing as well as the whole industry of Security Analysis.  This influence stems not only from his published works but also from the eventual fame and fortune of the pupils that he taught at Columbia University who included Warren Buffett. It is thanks to Graham that we have a whole catalogue of quantitative bargain stock strategies at our disposal with such obscure titles as ‘Net Net Bargains’ and ‘Net Current Asset Value Bargains’ as well as a whole ream of other concepts including Margin of Safety.

In a paper titled “The Super Investors of Graham and Doddsville”, Warren Buffet showed the track records of each of nine disciples of Benjamin Graham showing that they all generated annual compounded returns of between 18% and 29% over track records lasting between 14 to 30 years. Is it likely that these individuals from the same school of thought could all beat the market over a generation if the stock market was a place of luck? Warren Buffett doubted it most eloquently when he said “I'd be a bum on the street with a tin cup if the market was always efficient”.  Let’s have a look at their profit history...

There is another style of value investing introduced by Joel Greenblatt, buying good companies at cheap price, or the magic formula investing strategy as shown in the link below:

http://klse.i3investor.com/blogs/kcchongnz/51631.jsp

Performance of the Magic Formula in US

Table 1 below shows that the Magic Formula outperformed the S&P500 by a wide margin for the 22 years from 1988 to 2009.

The Magic formula outperformed S&P 17 out of the 22 years and achieved a compounded annual growth of 23.8%  as compared to the 9.6% of S&P. $10000 invested 22 years ago in 1988 has grown to 1.09m by the end of 2009, even after the US sublime crisis in 2008-2009. This is by no means a small feat.

Table 1: Performance of the Magic Formula

Does value investing work in Bursa?

Ample proofs have been given above that fundamental value investing work in the US. It has in fact worked for a long time stretch of time. It has also been shown that it is still working very well even now.

The question is does it work in our Bursa market? Do you have any evidence to show?

That would be the next topic of discussions.

For those who wish to learn the fundamental of value investing in order to be able to embark on a journey with a better chance to build up wealth for the future, please contact me at

ckc15training2@gmail.com

K C Chong (30^th April 2015, on the Eve of Labour Day)