Global Value Investing

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A multifaceted approach to value investing with stock valuation based on intrinsic value estimated from cash returns, appraised value of assets, and other facets of value.

 

 

Margin of Safety

 

Margin of Safety   |   Value Vs Price   |   Efficient Markets Fallacy   |   Analogy with Bridge

 

Price is not value. Pricing models are not valuation models.

Model labels can be misleading. Models that appear to be valuation models are sometimes pricing models. Only a close look inside at the assumptions will reveal the type of model it is. The beta coefficient is the sole explanatory investment risk factor in the conventional academic capital asset pricing model. The use of the beta factor is not valid in a valuation model. This is not merely a semantic distinction. The difference between price and value, referred to as the safety margin, is the raison d'être of models that estimate intrinsic value of common stocks and other investment assets.

 

 

 

Margin of Safety

Intrinsic value is independent of the market and current quoted price. It is the absolute standard against which all market prices are compared. Thus with the method of valuation, companies are considered neither under-valued nor over-valued relative to the stock market. This would be bringing truth to error for correction, a backward approach. Rather, common stock issues are considered either under-priced or over-priced in the market relative to the intrinsic value of their companies. This brings error to truth for correction. To identify mispriced stocks, the value of a company is compared to its stock market price.

The concept of price is not without ambiguity. We can choose among closing price, opening price, asking price, bidding price, actual price of latest trade for any number of shares, or actual price of latest trade for the same number of shares in the contemplated transaction.

Thus we focus on the important concept of safety margin rather than emphasize price with its potential quick and large changes from one transaction to the next. The variability of the price of a stock in part represents mispricing by the market. Such lack of convergence of market price to intrinsic value, however transient, represents market inefficiency. The irrationality of the stock market has been observed by de la Vega, John Maynard Keynes, Kindleberger, Lefèvre, Mackay, and others (see these citations in the General Books).

John Maynard Keynes in his General Theory (Book IV "The Inducement to Invest", Chapter 12 "The State of Long-Term Expectation", Section V, pages 156-157) introduced the metaphor of newspaper photograph competitions to explain the working of the stock market. His explanation emphasized anticipation of the opinions of other market participants and the resulting infinite regress, i.e., I think that he thinks that I think that he thinks, ad infinitum (see the citation in the General Books). This stresses that market prices are determined by opinion.

Safety margin represents an excess of intrinsic value over market price, or alternately, a discount of price below intrinsic value. A safety margin of at least twenty percent is desirable. Intrinsic value is what a company would be worth to a private owner independent of the stock market and its daily quotations. The concept of a margin of safety was introduced by Graham and Dodd in Security Analysis. See the citations in the General Books.

It is more important to wait for a favorable buy price than to be dependent on fortuitous timing to realize a profitable sell price. A buy and hold approach involves more than the platitudinous adage to "buy low and sell high." The margin of safety requires knowing when the buying price is low in absolute terms rather than merely relative to the market as a whole.


 

Value versus Price
Two Perspectives on Worth

 

  VALUATION PRICING
End truth -- intrinsic value illusion -- marginal opinion
Means method of appraisal * auction mechanism
Terms case-by-case standardized
Institution private contracts public exchanges
Approach rational, logical arational, emotional
Knowledge economics psychology, sociology
Principle theory of investment ad hoc, empirical
Result value range single price
Precision highly imprecise highly precise
Accuracy within value range outside value range
Investment real assets claims on assets
Units operating enterprise common stock issue
Data Source company reports market-generated
Measurement absolute relative, comparative
Analysis Type investment portfolio of stocks
Analysis-Units one company compare two stocks
Analysis-Time one point in time compare two times
Horizon long-term (years) short-term (minutes)
Frequency sporadic, on demand continuous supply
Stability slow, small changes quick, large changes
Application individual stock selection stock trading
* In contrast, the method of anticipation emphasizes earnings growth for the sake of growth rather than the sake of value. Thus, it is not recommended for purposes of estimating value.

In Security Analysis by Graham and Dodd, 1934 edition (see citation in the General Books) on page 23: "The Relationship of Intrinsic Value to Market Price.--The general question of the relation of intrinsic value to the market quotation may be made clearer by the appended chart [see table below], which traces the various steps culminating in market price. It will be evident from the chart that the influence of what we call analytical factors over the market price is both partial and indirect--partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people's sentiments and decisions. In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.

Relationship of Intrinsic Value Factors to Market Price

I.General market factors

 

} Attitude of public toward the issue (leads to)

} Bids and offers (lead to)

} Market price

II.Individual factors

A.Speculative

1.Market factors

a.Technical

 

b.Manipulative

 

c.Psychological

 

A.Speculative
B.Investment

2.Future value factors

a.Management and reputation

 

b.Competitive conditions and prospects

 

c.Possible and probably changes in volume, price, and costs

 

B.Investment

3.Intrinsic value

a.Earnings

 

b.Dividends

 

c.Assets

 

d.Capital structure

 

e.Terms of the issue

 

f.Others

The radical difference between value and price is explained by John Burr Williams in The Theory of Investment Value (see the citation in the Special Books) as indicated in the following quotations: (1938: 33): "If opinion were not founded in part on current dividends and changes therein, there would be nothing to prevent price and value from drifting miles apart." (1938: 191): "Since market price depends on popular opinion, and since the public is more emotional than logical, it is foolish to expect a relentless convergence of market price toward investment value. Corroboration of estimates [of intrinsic economic value] by subsequent market action, therefore, ought not to be expected. After all, investment value and market price are two quite different things."

Thus:

Price is not value.
Pricing is
not valuation.
Pricing models are
not valuation models.

Pricing models include:
capital asset
pricing model (CAPM),
arbitrage
pricing theory (APT), and
option
pricing.

For a comparison of market price to one version of estimated value, see the Bull & Bear Profile.


 

 

Efficient Markets Fallacy

The efficient markets hypothesis (EMH) in all of its forms, whether strong, semi-strong, or weak, is normative, not positive, i.e., it is an assertion about the way markets should behave in an ideal, utopian world, not a statement about the way markets actually do work in the real, practical world. Simple observation shows that the EMH in all its forms is fallacious. Both Kindleberger and Mackay give historical examples of stock market irrationality and inefficiency (see the citations in the General Books).

The efficient markets hypothesis may have advanced many academic careers, but it has not demonstrably increased the wealth of any investor over what would have been created otherwise. The EMH and the related capital asset pricing model, as opposed to the operating enterprise valuation model, may be useful as a standard of market perfection in studies of the market as a whole, but not in the valuation or selection of common stocks for investment.

The term "efficient" in the efficient markets hypothesis refers to informational efficiency only. It does not include mechanical operational efficiency or necessarily societal welfare efficiency. The EMH explicitly assumes that all market participants have access to the same information in either a strong, semi-strong, or weak sense of the hypothesis. This simplifying assumption is chosen because it is necessary for mathematical tractability and thus highly convenient. What makes this assumption unacceptably implausible is the meaning of the term "information" which is often overlooked. Data is not information. Rather, information is data that has been processed and interpreted with judgment based on intelligence, knowledge and experience. Does anyone believe that all market participants are endowed equally, not with access to data, but with the same intelligence, knowledge and experience?

Competitive, properly-regulated markets may approach the semblance of "data efficiency" in the relative sense of eliminating arbitrage opportunities subject to trading costs and taxes, but no market is efficient in any absolute sense of equating price at all times to intrinsic economic value. This margin between value and price is the major key to successful value investing.


 

 

Analogy with Bridge
Evaluation versus Bidding

Stock market investing which is not a game can be compared and contrasted with the card game of bridge. Some brief background may be helpful for those unfamiliar with bridge. There are several types of bridge. Contract bridge includes rubber bridge and duplicate bridge. Contract bridge is the basic form played by four players, usually informally and socially. Duplicate bridge is the form normally played in clubs, tournaments and matches, and requires at least eight players. Duplicate bridge is basically the same as rubber bridge, but the element of chance is equalized for all the players by having the same deals replayed by different sets of players. Chicago bridge is played by four people like rubber bridge, but the scoring is more similar to duplicate bridge. Contract bridge developed from auction bridge, which is mainly different in the scoring. In auction bridge, overtricks count towards making game, so it is only necessary to bid high enough to win the contract and there is no incentive to bid all the tricks you can make. Similarly, auction bridge developed from bridge-whist.

There are 53,644,737,765,488,792,839,237,440,000 possible bridge deals. You do not have enough time to learn how to play every one of them. What you do have time to learn is a problem solving process that you can apply to every bridge hand that you encounter. You must have a hand evaluation system before the auction begins and a playing plan after the auction is over and before you begin playing each hand. In bridge, both natural and artificial or conventional bidding systems are used in the auction. There are many such systems including Goren, Precision, Modern Standard American, and ACBL Standard Yellow Card (SAY-C). The best system is the one that when strictly adhered to by both partners and by all pairs of partners and across all possible deals wins more often than any other competing system.

By comparison, there are over 5,000 stocks listed on the major U.S. stock exchanges. Unlike any given bridge deal which always remains the same, each common stock is continuously changing and never stays the same. Thus the number of stock "deals" is unlimited. You do not have enough time to estimate the intrinsic economic value of every common stock for every moment of every trading session. The competitive, open-outcry, price-auction markets continuously provide bid and ask price quotations. Pricing conventions are used to provide a semblance of rationality in lieu of valuation. These conventions include price multiples such as the price/earnings, price/book value, price/dividends, price/cash flow, price/sales and other accounting ratios. Stock pricing conventions vary in applicability and popularity.

Hand evaluation is to auction-contract bidding in bridge as intrinsic economic valuation is to price bidding in the market. The major difference is that bridge, even with its signals, subtleties, nuances, finesse, psychics and diverse conventions, is exceedingly rational, whereas stock market participants at the price-setting margin and occasionally the market as a whole are exceedingly irrational. The most important similarity that concerns us is that, both in stock market investing and in the game of bridge, no bidding system can ever replace human judgment and interpretation of the facts based on intelligence, knowledge, and experience.


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