What is Value Investing

Philip Vanstraceele 20 Jul 2011

Our Mission Statement !

What is the MFIE investment strategy? Many people asked us this question, so I'll try to explain it in this post.

Actually, it is simple. We are value investors, but we invest mechanically, cutting out all emotions. We use our tool called ValueScreeners to identify undervalued stocks, and we buy and hold these stocks for one year, no matter how the market performs. But what is value investing? And how does it differ from other investors' strategies? How can we be so confident that this will deliver good returns? We backtested this thoroughly and fine-tuned the model to generate high returns with less volatility than the market.

Let's start by explaining what value investing and security analysis is. It starts with a Benjamin Graham. His publication in 1934 of Security analysis with David Dodd marks the start of a profession. At that time, back in the 1920s, the investment world had been dominated by speculation, insider information, and other shady and unsound practices.

Graham made his ideas and techniques available for professionals and amateurs with his publication of The Intelligent Investor in 1949. Graham put investing on a more rational foundation. To present the most simple description, the value investor seeks to purchase a security at a bargain price, the proverbial dollar for 50 cents. So Graham initiated an approach that remains relevant today. Value investing is exploits three key characteristics of financial markets :

  1. The price of financial securities is subject to significant and erratic movement. Graham's favorite allegory is that of Mr. Market, a fellow who turns up every day at the stock holder's door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but often it's ridiculous. The investor is free to either agree with the quoted price and trade with him or completely ignore him. Mr. Market doesn't mind this and will be back the following day to quote another price. The point is that the investor should not regard the whims of Mr. Market as determining the value of the shares that the investor owns. He should profit from market folly rather than participate in it.
  2. The intrinsic value of the security is one thing, the current price at which it is trading is something else. This is one of the cornerstones of our investing approach. Though value and price may, on any given day, be identical, they often diverge. The markets prices of financial assets can have many variations, but many of them have fundamental economic values that are relatively stable, and that can be measured with reasonable accuracy by the disciplined investor.
  3. A strategy of buying securities only when their market prices are significantly below the calculated intrinsic value will produce superior returns in the long run. Graham referred to this gap between value and price as ' the margin of safety'. The margin of safety protects the investor from both poor decisions and downturns in the market. Because fair value is difficult to compute accurately, the margin of safety gives the investor room for error. A common interpretation of margin of safety is how far below intrinsic value one pays for a stock. For high-quality issues, value investors typically want to pay 90 cents for a dollar (90% of intrinsic value) while more speculative stocks should be purchased for up to a 50 percent discount to intrinsic value (pay 50 cents for a dollar)

So, a value investor estimates the fundamental value of a security (stock, bond, etc.) and compares that value to the current price Mr. Market is offering it. If the price is lower than the value by a sufficient margin of safety, the value investor buys the security. If not, he does not buy it.

This differentiates value investors from other investors like "technical analysts" or technicians. This type of investor avoids fundamental analysis of any kind. Instead, they focus on trading data (price movements, volume figures) for any security. They construct charts to represent this information, and they scrutinize them for signs that will predict how prices will move next and thus allow them to make a profitable trade. They often have complicated models, which are very time-consuming and have hours to watch on a computer display. This strategy also requires a lot of transactions and, therefore, transaction costs. We dare not say it too loud, but we think that technical analysis a waste of time!

At MFIE, we spend no more than a few hours per week managing our portfolios. And before we invest, the security price must scream at us (with a big margin of safety). We spend little time on big ideas, future projections on industries/countries, or discounted cash flow guesswork. Concerning valuations, we are very conservative: we prefer to have a bird in the hand- cash in the bank or something close equivalent- to the rosiest riches or projections of growth. So growth is good, but we are not willing to pay for it, or only at a reasonable price. (ERP5). We cast our nets wide and try to find the cheapest stocks worldwide, not just in our own country. We use our small investor advantage to invest part of our funds in Micro-cap companies with or without analyst following.

How do we find our bargains?

In fact, we are searching for needles in a haystack, and finding these, we use our ValueScreener tool. This is a powerful stock screening technology for value investors based on backtested ranking algorithms and a reliable, high-quality database. The tool comes with a set of high-performance classification schemes amongst which:

  • Greenblatt Magic Formula
  • Piotroski Stock Screener
  • O' Shaughnessy Tiny Titans
  • ERP5 Stock Screener

More information about these screening methods, you can find on our website, and most of the screenings have been backtested by many investors and academics. We have also published our own backtests on the European stock markets.

But the basic strategy stays to buy securities with a margin of security.

Mechanical Value Investing, Behavioral Finance and Prospect Theory vs. Modern Investment Theory

In the 1950s and 1960s, a new investment analysis, sometimes called 'Modern Investment Theory', emerged from scholars who have been trained in economics and statistics. The basic rule of this theory posits that people will always behave rationally and pick optimum solutions (CAPM) when facing a gain or a loss. The markets work very efficiently, so it is impossible to outperform.

This is, of course, nonsense. The last decade shows that people act especially not rationally and our backtests show that it is possible to beat the market systematically. Many value investors (Warren Buffett, Seth Klarman, Walter Schloss, etc.) have outperformed the market to prove the opposite truth.

Over the last 20 years, several academic studies began to challenge this modern finance. In these studies, mechanical variants of value investing (low price to earnings, low price to book) have bested the indexes, as have some variants of momentum investing. The general outcome has been to destroy the efficient Market orthodoxy and to reinforce the worth of Graham's approach.

Also, a body of work labeled behavioral finance has built on psychological research to dispute the idea that investors act as dispassionate calculating machines. It turns out that investors respond to events with powerful biases and that the markets are far from being efficient. Also, the 'Prospect Theory' (Daniel Kahneman) explains why people sell their winners too soon and hold their losers too long.

With our mechanical way of investing (we don't look too often at the stock market news, we would be depressed!) and a buy and hold strategy of 12 months, we try to eliminate emotional influences to optimize our returns. Also, we don't follow experts and analyst, because this is a sure way to lose money!

Another important edge we have against institutional funds is that we use our small investor advantage to include small & micro caps in our portfolios. Several studies indicate that small-cap stocks can increase your portfolio returns (*). The key point regarding small caps is these professional analysts overwhelmingly concentrate on larger companies. So we are investing under the radar screen of Wall Street.

Profitable Investing,

Philip Vanstraceele

(*) "Ibbotson Associates analyzed data from 1926 to 2010 and concluded that small-cap value stocks outperformed the general market by 4.3% annually - more than any other class of stocks. Vanguard has published data that shows that, from 1927-2010, small-cap value outperformed large-cap value, blended, and growth portfolios. A Fama and French study show this class outperform all others in recessionary periods as well. Another study by Fund Evaluation Group shows that small-cap value has outperformed every other group and a wide margin."