Anyone who has studied value investing has probably read The Intelligent Investor and Security Analysis, now in its sixth edition. Although less well known, Bruce Greenwald’s Value Investing: From Graham to Buffett and Beyond is no less important than the seminal books written by Benjamin Graham. Greenwald systematically lays out the methodology that can best be described as modern value investing. Although the basic principles of value investing have not changed, Greenwald has done an excellent job of identifying the key components of value-oriented stock analysis and how a company should be valued using a modern Graham and Dodd approach. In my personal experience, following the correct methodology and sticking to it is probably more important to long-term investing success than even superior intelligence. Greenwald clearly lays out the three criteria that are important to investment success: 1) a selection methodology, 2) a valuation methodology, and 3) sticking to your process through market cycles. Unfortunately, Greenwald doesn’t go into much detail about selection techniques, and most of the book is about his approach to value investing.
Chapter 1 begins with an overview of value investing. He reviews various studies showing how mechanically constructed value portfolios, such as low P/B stocks, have outperformed broad market indices. It also addresses the main criticism of efficient market theorists, who believe that value portfolios provide inordinate returns due to inordinate risks. However, he provides a devastating critique by explaining that based on standard risk criteria such as Beta or annual return variability and, in my opinion, the most relevant risk measures such as maximum realized loss or stock reactions To the bad news, value-based portfolios have outperformed. I’m going on a tangent here, but want to stress that Beta (ie historical volatility) is a bad measure of risk. Knowing that you have a low beta portfolio will provide little comfort as you watch your stock portfolio plummet in a bear market. In bear markets, stock returns become highly correlated and Beta goes to 1 for everything. Therefore, recognizing the existence of a stock’s intrinsic value and being able to measure it accurately will give you the confidence to stick with your investments even in a bear market. In fact, like any good value investor, you’ll have the confidence to start bargain hunting, as Mr. Market provides you with numerous opportunities to buy businesses below intrinsic value.
The book does a good job of describing how to value a stock, but it provides limited detail on where to look for undervalued stocks. Greenwald identifies areas such as small-cap stocks, downtrodden stocks, and spin-offs as areas to look for undervalued gems. While these are all good places to start, Greenwald doesn’t provide enough additional detail on the criteria he would use to identify interesting long candidates. For example, what factors should an investor focus on to avoid investing in a value trap? In my opinion, Joel Greenblatt does a better job of explaining where to look for interesting investment opportunities in his book. You can be a stock market genius. I’ll also review Greenblatt’s book, but for now we’ll return to Greenwald’s book.
The core of the book deals with the three main components of its valuation methodology, which are Net Asset Value (NAV), Earning Power Value (EPV), and Growth Value (GV). Modern value investing can be viewed as a continuum where intrinsic value is first determined by the value of the company’s assets. Net asset value is the most conservative measure of a stock’s value, as it is based on a company’s reported assets based on the latest balance sheet. However, a number of adjustments are made that can be quite subjective. Essentially, the Greenwald NAV analysis attempts to determine how much it would cost a competitor to recreate a company’s balance sheet. Although the analysis is based on the balance sheet, there is a great deal of subjectivity as we move from current assets to longer-term assets. The area of greatest subjectivity is how to measure goodwill, which from a balance sheet playback perspective measures everything from brand equity, customer loyalty, and distribution networks. Clearly, all of these components of a business have significant value, but measuring these intangible assets is extremely difficult. I think this is the area that needs the most work in terms of developing a better framework under the modern Graham and Dodd approach. In my view, Warren Buffett has been so successful because he has been able to determine the value of these intangible assets with a greater degree of accuracy than his peers. After doing some NAV analysis, I now understand the difficulty of accurately measuring the value of intangible assets. The EPV analysis is similar to the DCF analysis but is more conservative because it assumes no growth. Essentially, the firm’s latest adjusted annualized cash flows are assumed to be sustainable for the indefinite future. EPV is the second most reliable measure of a company’s intrinsic value after NAV, since it is based on historical and observed values of distributable cash flow. Greenwald does an excellent job of providing relevant valuation examples and case studies using real companies, helping to bridge the gap between theory and practical application. The final and most subjective valuation tool in the modern Graham and Dodd approach is the growth value methodology. Greenwald emphasizes that growth valuation should only be used when it is clear that a company has franchise value due to significant and defensible competitive advantages. In the language of Warren Buffett, growth value multiples should only apply to companies with a deep and wide moat.
The second half of the book provides detailed profiles of eight modern value investors, many of whom are considered legends. The profiles are interesting because the reader is exposed to a professional level view of modern value investing. I’m not going to provide a summary of all eight profiles, but I will highlight some of the important lessons I learned from the Warren Buffett profile. Greenwald states, “While Buffett in the Berkshire years still speaks reverently of Graham, he looks for companies that have unassailable franchises even if they sell for multiples of book value.” It’s interesting to see how Buffett has continued to change and push the boundaries of what constitutes value investing. I think his change from following a strict Graham-based approach has been a key factor in his success.
In general, this book should be read by all students of value investing. Greenwald, a professor at Columbia Business School, has expanded and deepened Graham’s original work by clearly defining the practice of modern value investing. My main criticisms would be that he did not spend enough time on the selection process. I think the next version of the book should focus more on selection criteria and the development of a more detailed framework for measuring intangible assets. For those readers who are currently students at Columbia Business School, I would recommend taking all of the courses that Professor Greenwald offers. For the rest of us, he actually teaches an executive education course twice a year. At some point I would like to attend and will provide a detailed review of the course in the Value Investing India Report.
