A lot can be learned about any discipline by studying its greatest performers. Basketball players can learn by studying how greats such as Michael Jordan and LeBron James practiced and prepared for opponents. Cellists can learn a great deal by observing how Yo-Yo Ma plays the cello. And investors can benefit from studying the best investors from history and the present day.
The world's greatest value investors have produced gains that, over time, have absolutely crushed the S&P 500 index's returns. Both collectively and individually, these investors have proven that beating the market is not mere chance but, rather, can be accomplished by trusting the process of careful stock analysis and selection. While there are similar themes present throughout these investors' stock selection methods, they have all added their own unique twist on how to value and invest in stocks.
While no such list can ever be exhaustive, there are several important lessons I've taken away from each of these value investors: Benjamin Graham, Shelby Davis, Warren Buffett, and Joel Greenblatt. Before we get to the investors, however, let's take a moment to review what value investing is.
What is value investing?
Value investing, when boiled down to its core, is the attempt to buy a stock below its actual worth, in much the same way a bargain shopper only buys items when they're on sale at the supermarket. Value investors attempt to value a stock using a variety of methods and looking at different metrics. When the real value of the stock, the intrinsic value, is above the current stock price, value investors consider the stock undervalued. The difference between the current price and the intrinsic value is called the margin of safety. The greater the margin of safety, the less likely it is that the value investor is wrong in the assessment and lose money on the investment.
How can you value a stock?
Value investors have a tool box full of tools at their disposal to arrive at a fair estimate of what a company's stock should be worth. The most popular of these methods is undoubtedly the price-to-earnings ratio, which is calculated by dividing the stock price by the earnings per share (EPS). Investors also use a variation of this by taking the company's guidance or analyst projections for the EPS to the fiscal year ahead to calculate the company's forward P/E ratio. Generally speaking, the lower the P/E ratio the better; as in, the lower the ratio the less time it will take the company to pay back its investors in earnings.
Of course, companies with higher projected rates of growth will also generally sell at higher P/E ratios than companies with lower projected growth rates. To account for this difference, some investors use the PEG ratio as another way to value higher-growth companies. This ratio is solved by dividing a company's P/E ratio by its expected EPS growth rate. As a general rule of thumb, anytime the PEG ratio is below 1.0 it is considered a worthy investment.
For companies not yet profitable or with inconsistent earnings growth, the price-to-sales ratio is another useful valuation tool. This formula works for such companies because earnings and profits never come into play with this metric, only revenue. It is determined by dividing company's market cap by its annual revenue. Although this ratio is extremely useful when comparing companies from the same industry, it is almost worthless when comparing companies from different sectors. For instance, software companies need far less revenue to generate the same amount of profits as big box supermarkets.
These are just some of the basic tools these great investors, and many others, have used in their attempts to value a stock. Now let's take a closer look at these investors, their claims to fame, and what lessons investors can learn from studying their investing methods.
Benjamin Graham: The father of value investing
Graham became a partner at a Wall Street firm just six years after graduating college. For 30 years, from 1926 to 1956, he lectured on a range of financial matters at Columbia University. After suffering great losses in the crash of 1929, Benjamin Graham learned his lessons and described them in his seminal books, Security Analysis in 1934 and The Intelligent Investor in 1949. In Security Analysis, Graham defined the difference between investments and speculations as, "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
Graham's notions of careful selection of stocks for a portfolio paved the way for fundamental analysis, the attempt to determine a company's intrinsic value, or what a company is actually worth, by studying the business's underlying quantitative and qualitative factors.
Investment track record: After the publication of Security Analysis in 1934, the Graham-Newsome Corporation averaged 17% annual returns until 1956 when the company was terminated. During this time, Graham outperformed the market average by at least 2.5% annually.
Though normally widely diversified by investing in stocks across a number of different sectors, Graham once invested more than 20% of his portfolio to acquire GEICO, the property and casualty insurance company. While they held it, the value of the holding increased an incredible 200 times, from about $700,000 to more than $1 billion!
Important lesson: I believe the most valuable lesson to take away from Graham is that the market is not always efficient, meaning that stocks often sell below their intrinsic value, what a stock is actually worth. In Intelligent Investor, Graham wrote:
"Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly."
Graham developed the notion of the margin of safety, the gap between the stock's intrinsic value and current market price. The further the market price was below the intrinsic value, the more likely it is that investors will score a winning investment. This stands in stark contrast to the efficient market hypothesis, which states that all information is factored into a stock's market price. The implication of this theory being that "beating the market" is a matter of chance, not skill and hard work.
Graham's track record is a testament, however, to the belief that waiting for Mr. Market to irrationally offer investors great entry points for stocks is a proven way to beat the market.
Shelby Cullom Davis: The insurance investor
Shleby Cullom Davis (it is important to use his middle name because his son by the same name was also a successful investor) is unique because he did not start investing until he turned 38. Before turning to a life in investment, Davis was a freelance writer and economic advisor to New York Governor Thomas Dewey. In 1947, Davis took an inheritance his wife received from a family owned furniture chain, and began investing. For years, Davis would stick almost wholly to investing in insurance companies because he liked their business model of being able to invest the float, the money insurers can invest between the time they collect a premium to when they have to pay out a claim.
Davis studied the principles of Benjamin Graham religiously and purposefully sought out insurance companies with low P/E ratios and good management teams. He also checked their balance sheets to ensure they did not invest the float in risky assets like junk bonds, debt issued to companies with questionable credit ratings . A trip to Japan in the 1960s proved especially fortuitous, as he discovered Japanese insurance companies were not only more undervalued than American insurance companies but also enjoyed a bigger moat, or competitive advantage, due to regulations limiting the number of insurers allowed to operate.
Investment track record: Davis started investing with $50,000 and ended, at the time of his death in 1994, with a fortune worth more than $900 million, an incredible 23% average annual compound growth rate! His most notable investments, outside of Japan, included insurers such as American International Group, Chubb, and Progressive.
Important lesson: Davis liked to buy companies with low P/E ratios that would double their earnings growth over time. As the earnings grew, however, so did the companies' valuation levels as expressed by metrics such as the P/E ratio.. When the P/E ratio and earnings both doubled, Davis would affectionately call this the "Davis Double Play". Each of these, by definition, would result in an investment returning at least four times its value. As John Rothchild wrote in his biography on the Davis family, The Davis Dynasty, this quickly became powerful math:
"In 1950, insurance companies sold for four times earnings. Ten years later, they sold for 15 to 20 times earnings, and their earnings had quadrupled ... What he'd bought for four times $1, they bought for 18 times $8. His $4,000 investment was now worth $144,000 in Mr. Market's estimation ... Davis called this sort of lucrative transformation "Davis Double Play." As a company's earnings advanced, giving the stock an initial boost, investors put a higher price tag on the earnings, giving the stock a second boost."
While it might be almost impossible to find a stock with a valuation that has the potential to double in a few years in this market, the principle behind the Davis Double Play is as powerful as ever. Stocks with potential for earnings growth and multiple expansion, provide a powerful combination to boost investors' returns.
Warren Buffett: The Oracle of Omaha
As if he even needs an introduction , Buffett was born in 1930 in Nebraska. After graduating high school, he attended Columbia Business School where he studied under, who else, Benjamin Graham. Buffett would credit Graham's teachings for his successful investment career for the rest of his life. After running several successful investing partnerships, Buffett eventually disbanded them and invested in Berkshire Hathaway Inc. (NYSE:BRK-A)(NYSE:BRK.B), a textile manufacturing company. In the mid-1960s, Buffett took control of the company after aggressively buying shares and turned it into a diversified holding company, a corporate umbrella under which largely independent companies run their businesses separate from each other. Berkshire's market cap, the total market value of a company's outstanding shares, is now near $500 billion.
Despite his incredible success, Buffett still lives in the same house in Omaha that he purchased in 1957 for $31,500. To this day, he "only" makes $100,000 a year in salary for performing his CEO duties at Berkshire. Due to his incredible investing success, however, his estimated net worth is about $87.5 billion, making him the third richest person on earth.
Investment track record: From 1965 to 2017, shares in Berkshire Hathaway had annual returns of 20.9% compared to the S&P 500 index's 9.9% return. To put that into perspective, in 2015 the New York Times calculated that, since 1965, shares in Berkshire Hathaway had gained a cumulative 1,826,163%! The company is a longtime shareholder of stalwarts like American Express Company (NYSE:AXP), Coca-Cola Co (NYSE:KO), and Wells Fargo & Co (NYSE:WFC).
Important lesson: Enough ink has been spilled distilling Buffett's investing wisdom to fill a large library, but my personal favorite comes from Buffett's 1989 shareholder letter. In this letter, he wrote, "Time is the friend of the wonderful business, the enemy of the mediocre... It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Buffett first followed what he called a "cigar butt" approach to investing, trying to find a company that was good for a last few puffs before disposing of it. Later, he came to understand that buying quality companies, defined as businesses with substantial economic moats, and holding them for long periods of time was a far superior approach to investing. This method allowed the magic of compound interest to do the heavy lifting. Compound interest is not only gains on the original principle, but also gains on accumulated interest. While this sounds trivial, over time, it exponentially powers returns.
As he put it, "Time is the friend to the wonderful business." Indeed.
Joel Greenblatt and his magic formula
Before he turned 30, Greenblatt started the Gotham Capital hedge fund in 1985 and ran it until 2006, when he returned investors' money and stepped aside. He is now a professor at the Columbia Business School and is the co-founder of the Value Investors Club website. What has captured the attention of avid value investors, however, are his books; most notably, the best-selling The Little Book That Beats the Market.
In the book, after explaining the basics of value investing, Greenblatt claims to have a "magic formula" that will beat the market. The big secret? Rank companies by their earnings yields and on their return on capital, combine the rankings, and buy the top dozen or so companies. The earnings yield of a stock is calculated by flipping the P/E ratio. Instead of dividing the price by EPS, divide the EPS by the stock's price. The result, when expressed as a percentage, is the earnings yield. This percentage can be easily compared to bond yields, assuring investors they are accepting a greater potential for rewards by investing in stocks, a riskier asset class than bonds. The return on capital looks for how much companies have to pay to buy the assets that created their earnings.
That simple formula, Greenblatt insists, is the secret to successful and simple investing.
Investment track record: For the two decades that Greenblatt managed Gotham Capital, the fund returned an annualized rate of 40%. That return is simply staggering and is more than Buffett averaged over any two-decade period.
Important lesson: While there are several lessons I've personally taken away from Greenblatt over the years, one of my most profound epiphanies was when I realized why Greenblatt was so high on companies that had high returns on capital. It was a way to quantify a company's moat, a competitive advantage a business holds over its competition and one of the singular factors Buffett seeks out in his investments. In The Little Book, Greenblatt explains:
"To earn a high return on capital even for one year, it's likely that, at least temporarily, there's something special about that company's business. Otherwise, competition would already have driven down returns on capital to lower levels.
It could be that the company has a relatively new business concept (perhaps a candy store that sells only gum), or a new product (like a hot video game), or a better product (such as an iPod that's smaller and easier to use than a competitors' products), a good brand name, ... or a company could have a very strong competitive position...
In short, companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits."
There's a reason why I decided to tackle these investors in chronological order. To some extent, I believe the lessons I shared all built on the principles of those who went before them. Davis, Buffett, and Greenblatt all were students of Graham and believed stocks could be bought at a discount relative to their intrinsic value at opportune times. Buffett and Greenblatt both seemed to seek out investments that could be long-term compounders, stocks that not only were bought with a significant margin of safety, as Graham taught, but that could also grow their earnings over time as well-a principle straight out of Davis's Double Play playbook. Greenblatt attempts to quantify a company's moat, something Buffett thought was fundamental to finding a long-term winning investment.
The great opportunity we have is to learn from these great value investors and apply the principles they believed that were important, to our investments today.