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Forbes has posted a video and transcript of an interview with Joel Greenblatt.  Greenblatt is the founder of Gotham Capital, an adjunct professor at Columbia Business School where he teaches “Value and Special Situation Investing.”  He is the author of three investment books and, through Gotham, the advisor to four mutual funds, which select stocks based on Gotham’s proprietary system of ranking stocks according to value metrics (essentially an institutional version of the “Magic Formula” from Greenblatt’s The Little Book That Beats the Market)Greenblatt is also the co-founder of the Value Investors Club, a private forum for discussing value and special situation equity ideas.

In the interview, Greenblatt criticizes market-cap weighted indexes and the short-term focus of individual investors and money managers.  He also claims that an equal-weighted basket of value stocks can beat market-cap weighted indexes like the S&P 500 by 6-7% per year, which is what his Formula Investing Funds aim to do.  He also had this to say about value investing in general:

Most business schools do not really teach Benjamin Graham.  There are a few around the country that do.  But for the most case, people are still being taught the efficient market model, and all the math that goes along with that. We kind of feel the way Warren Buffett does: that’s good news for us.  That if everyone’s told you can’t beat the market – and this is the way to go about investing and it makes no sense to you and everyone’s being taught that – it gives a little more opportunity to value investors if you have less competition actually doing the work.

You can watch the video and read the full transcript here.

founded Gotham Capital, a private investment firm, in 1985. Since 1996, he has been a professor on the adjunct faculty of Columbia Business School where he teaches “Value and Special Situation Investing.” He is the author of three investment books: You Can Be a Stock Market Genius (Simon & Schuster, 1997); The Little Book that Beats the Market (Wiley, 2005) and The Big Secret for the Small Investor (Random House, 2011)

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We introduce a value-based investment model as alternative to the Capital Asset Pricing Model (CAPM) used by business schools, investment banks, and portfolio managers today around the world. We believe that the Capital Asset Valuation Model (CAVM) is a common sense approach to modeling risk-return in a way consistent with Graham and Dodd. We call it a model with some hesitation, as we only use simple algebra and common-sense to arrive at a solution. But the final solution may not come to much surprise many value investors.

Our Starting Point

In CAPM, expected return is dependent on beta, or price volatility relative to the general market as well as the average risk-free rate. It is inconceivable to us how expected returns can be measured as a function of past historical performance and the risk-free rate, as both are outside of the investor’s control.

Our starting point for the new model is recognizing that volatility is not equivalent to risk. To the contrary, as Graham points out in the Intelligent Investor, volatility is simply an opportunity to buy wisely when prices fall.

graham_quote

Our model defines risk as the probability of capital loss associated with a particular investment decision. Defining risk as the probability of loss allows us to define key points in what will become the equation for CAVM. The two key points are:

1) The expected return will be greatest when the probability of loss is zero.

2) The expected return will be zero when the probability of loss is 100%.

 

Derivation of CAVM Equation

Mathematically, the two points above can be plotted in a x-y axis, where y is the expected return and x is the probability of loss (risk).

 plot1

The max and min points on the plot can be incorporated into a linear relationship between expected return and risk, where as expected, investment returns will be a function of risk. This yields the following linear relationship:

Re = Rmax – (Rmax)*[risk]

Since risk has been defined as the probability of loss, then: risk = 1-p, where p is the probability of gain, or a gain confidence interval. The equation becomes:

Re = Rmax – (Rmax)*[1-p]               

 or

Re = Rmax*p

 

This simple equation makes sense. It tells us that the expected return on an investment will be the maximum possible return one can achieve on a particular idea multiplied by a confidence interval. We believe that confidence interval p is dependent on only two things:

1) The certainty to which the gap between value and price will close within the desired or expected time frame.

2) The certainty to which the value of the investment can be measured from the information available to us.

To add a time variable into our equation, we add variable T as one with inverse effect on the expected returns. Our equation becomes:

Re = Rmax*[p/T]

 

Value investors may also recognize that the maximum expected return Rmax occurs when the gap between intrinsic value and price is zero, such that:

Rmax = (IV-Price)/Price

Where IV is the estimated intrinsic value and price is the current price. This equation is zero when IV=Price, or when margin of safety (MOS) is zero.

We, as value investors, define margin of safety as:

MOS = 1-[Price/IV]

So that if price for an investment is for example $20, with an estimated IV of $30, the margin of safety would be 33%. This means that we as investors are paying 67 cents for every dollar of intrinsic value.

Combining the equations for Rmax and MOS provides us with an equation for Rmax solely dependent on MOS:

Rmax = MOS/(1-MOS)

So our equation for expected return becomes:

Re = [MOS/(1-MOS)] *[p/T]

 We believe, as value investors, that this is the equation every investor should be using as an alternative to CAPM. In fact, we believe value investors unknowingly make such calculation when evaluating potential upside vs. downside for each of their investments. The equation is simple, and implies that the only things that matter when making investment decisions are: the margin of safety (MOS), one’s confidence that our calculations are correct (p), and the time it takes for the price-value gap to close (T).

 

Thoughts on the Risk-Return Equation

There are several interesting thoughts that arise from the equation we have derived. Some are outlined below.

– Contrary to CAPM, risk decreases the probability of returns. Maximum expected return is only achieved by completely eliminating risk.

– The maximum risk on an investment is obtained on 3 different ways: margin of safety is zero, confidence interval p is zero, and time is infinity. Therefore, minimum risk comes from having large margin of safety, high confidence interval, and realizing value in the shortest time possible.

– Equation supports Buffett’s idea to investment in businesses whose “cash flows are highly predictable”. A highly predictable business would imply the investor has a high confidence interval p, since the probability of properly establishing an appropriate intrinsic value is high.

– Equation is valid in any type of investment scenario, e.g. stocks, bonds, real estate, etc.

– Equation is undefined as MOS = 1, so a margin of safety of 100% is impossible in the investment world (cannot invest at 0 cents on the dollar).

– Risk is independent of sector and/or diversification strategy. E.g. 1000 holdings will have equal expected returns as 10 holdings as long as the average margin of safety and average confidence interval is identical (though transaction costs would increase in proportion with the number of holdings).

– Investors concentrating in situations with high confidence intervals p (e.g. Buffett) have the ability to make high returns at lower margin of safety than average investor Investors with low p need to invest with higher MOS to make up for the difference.

– Portfolio of investors with identical stocks purchased at identical prices may pose widely different risks. First, MOS estimates will vary between investors. Second, investors may have different confidence intervals p because some the uncertainties of intrinsic value estimation will vary among them.

– Lower MOS will shift return line downward, diminishing returns for investors at identical risks.

 plot31

 

Challenges

– What confidence interval p corresponds to the average stock market investor? We believe that the average investor decision-making process on risk amounts to a coin flip, so we believe p = 50% is appropriate.

 plot2

 
– Confidence interval p is a “fuzzy” parameter which requires skill to evaluate:

1) The certainty to which the gap between value and price will close within the desired or expected time frame.

2) The certainty to which the value of the investment can be measured from the information available.

The skill to deal with these certainties (or uncertainties) can widely vary among investors.

 

 – Average S&P500 return of ~ 6% suggests average investor has historically purchased stocks with an average MOS of 10%.

 

CAVM in Practice: The ValueHuntr Portfolio

We calculate the average MOS for our portfolio both at cost and at the current market price. Our analysis indicates that MOS at purchase was 38%, and a current MOS of 29%.

 mos11

From MOS, we can then obtain the maximum return possible for our portfolio.  Assuming an average confidence interval p of 50%, we can then obtain the expected return of our portfolio.

 rmax1

At the time of our purchases, our portfolio had an expected annualized return of 43%. Our gains have since lowered the expected gains to roughly 26%.

 cavm-plot1

Afterthoughts on ValueHuntr Portfolio Analysis

– Importance of MOS is evident on the risk-return graph above. Even at 80% risk, expected return is still 10%.

– Steep value lines possible due to our focus on small caps, where big discrepancies between IV and Price occur more often than in mid- and large caps.

– Our expected return has gone from 43% to 24% due to investment gains. Ideally, we would re-balance our portfolio to shift to curve upwards by selling stocks with low MOS and buying stocks with larger return prospects.

– We assume that our ability to evaluate the certainty of investment returns given the information we obtain for our various companies is at par with the average investor. Hence, p = 50% (ability to evaluate risk amounts to a coin flip).

 

Any questions or comments regarding CAVM are welcomed.

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There are several documents written by Ben Graham that are currently stored at the New York Research Library, and amongst them is a microfilm document titled “The Renaissance of Value”, written in 1974 by Ben Graham and which I have just obtained for our readers.

 

The document discusses several questions posed by Graham, one being the following: to what degree should the valuation techniques presented in Graham & Dodd’s Security Analysis be modified to account for recent developments?

 

According to Graham, the midpoint of the value range has typically been found by applying an appropriate multiplier to estimated future earnings, which is not the best technique to use (This technique is still used today). Instead, the earnings figure taken should be what Graham calls “normal current earnings” and all the future prospects – favorable or unfavorable, specific or general – should enter into the multiplier. This procedural change obviates the necessity of establishing a future value, and then discounting the same to its present worth.

 

In this document, Graham also corrects some of the formulas he proposed in Security Analysis. For example, Graham had previously suggested that the intrinsic value could be approximated by a formula that employs a single variable G, representing the expected growth rate over the next seven to ten years. The formula read:

 

Value = “current normal earnings” x (8.5+2G)

 

However, Graham states that this formula had the great defect of failing to allow for changes in the basic rate of interest. To account for this, Graham re-states his intrinsic value formula as:

 

Value = “current normal earnings” x (37.5+8.8G)/AAA rate

 

With the AAA rate at 5.39% today and a historical GNP growth rate of 4%, Graham’s equation indicates that the current multiplier for the market should be 13.5. With operating earnings at $49 for the S&P500, Graham’s formula seems to indicate a fair value of 661 for the S&P500 benchmark relative to its current value of 831. At ValueHuntr, we do not believe in a single formula for valuation estimates, but it is an interesting exercise.

 

Additionally, it is clear that Graham saw no systematic way of reducing multipliers to allow for investments in companies with a below par debt position. His advice to analysts is to rather avoid attempting a formal valuation of such companies. In other words, analysts should limit their appraisals to enterprises of investment quality.

 

In general, “Renaissance of Value”, as Graham noted in 1974, involved the reappearance of sub-working capital opportunities. It seems that 2008 was a year which Graham would hail as the “Re-Renaissance of Value”.

 

A scan of the microfilm document has been posted in our resources section. Click here to read.

 

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(Written by Levi Folk for the Financial Post)

Security Analysis, the original book on value investing by Benjamin Graham and David Dodd, published in 1934, was inspired by the market crash of 1929. The book said investors were on solid ground if they owned shares in “net-nets” –companies whose liquidation values exceed by a wide margin their market capitalizations net of all liabilities.Net-nets were a proven strategy for protecting capital and achieving long-term gains.

Marty Whitman, chairman of Third Avenue Management and manager of the Third Avenue Value Fund, is the closest thing we have to Benjamin Graham today. Coming off an uncharacteristically difficult year, Whitman is finding bigger discounts in the market than at any time in his 50-plus year career.

A vociferous critic of Generally Accepted Accounting Principles (GAAP), Whitman makes refinements to the Graham and Dodd concept of net-net.

First and foremost, companies must be well-financed in keeping with the core tenet of Third Avenue’s “safe and cheap” method of value investing.

The goal is to own companies that are going concerns, not ones destined for liquidation. This difference is a crucial point of distinction between the focus of equity investors, who are often wiped out in liquidation, and bond investors, who have rights to the assets of a company in liquidation.

The second adjustment is to the assets themselves. Graham and Dodd focused exclusively on current assets when calculating liquidation value whereas Whitman includes long-term assets that are easily liquidated.

For example, roughly one third of long-term assets of Toyota Industries Corp. are investment securities, including a 6% position in Toyota Motor Corp. (TSX: TM), says Ian Lapey, portfolio manager at Third Avenue and designated successor to Whitman on the Third Avenue Value Fund.

These securities are therefore included in Third Avenue’s calculations of net-net.

Closer to home, oil and gas producer Encana Corp. (TSX: ECA) has proved reserves of oil and natural gas that are not included in current assets, says Lapey.

“They are liquid in that there is a real market, current commodity prices notwithstanding, for high-quality proved reserves of oil and gas.” Encana is a top holding in AIC Global Focused Fund, sub-advised by Third Avenue and managed by Lapey.

The third adjustment is the inclusion of off-balance-sheet liabilities. Here, U. S. banks’ structured investment vehicles readily spring to mind.

The fourth and final adjustment to Graham and Dodd is the inclusion of “some property, plant and equipment” for their liquidated cash value and associated tax losses that often produce cash savings.

Hong Kong real estate companies, such as top holding Henderson Land Development Co. Ltd. (HK: 0012/),are required to mark property values to market prices, so liquidation values are easily ascertained.

“In most time periods, the market for fully leased office buildings is quite liquid,” says Lapey, justifying their inclusion in net-net calculations of these companies.

Sycamore Networks Inc. (NASDAQ: SCMR) is the most compelling example of a net-net situation in the United States offered up by Lapey.

The telecom equipment company has more cash — US$935-million in all — than the total value assessed to it by the market, in light of its US$800-million market capitalization and US$38-million in total liabilities.

“We feel that there is value to their technology that is being recognized by some of the large telecom carriers,” says Lapey of Sycamore Networks, but he acknowledges its current weak earnings power. Lapey is also attracted to the one-third of outstanding share ownership by management because it presents an important alignment of their interests with those of Third Avenue, who are by and large passive investors.

These large valuation discounts in the market are reassuring words for investors from the one of the finest practitioners of Graham and Dodd.

“We are holding these companies trading at huge discounts,” says Lapey, “and if these companies were to sell assets or sell the whole companies we think the result would be a terrific return for our investment.”

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Most analysts feel they must choose between two investing approaches customarily thought to be in opposition: “value” and “growth”. But the Warren Buffett Letters (available in our resources section) make it clear that the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

 

Buffett’s 1992 letter points out that although growth often has a positive impact on value, such effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless growth. For these investors, it would have been far better if Orville Wright had failed to get off the ground at Kitty Hawk: the more the industry has grown, the worse the disaster for owners.

 

So growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.

 

What kind of businesses are these in which growth hurts or benefits investors? Bruce Greenwald, director of the Heilbrun Center for Value Investing at Columbia Business School, provides an enticing answer:

 

If a firm operates with no competitive advantages, or with no barriers to entry in any given industry, returns above the cost of capital will attract new entrants whose competition will eliminate those higher rates of return. Without barriers to entry, competition will sooner or later force the rate of return downward until it equals the cost of capital. Since the most common competitive condition is a level playing field, for most firms return on capital is nearly equal to cost of capital. For these firms, growth adds zero to shareholder value. For firms that are on the wrong side of barriers of entry, outside and looking in, the cost of capital exceeds return on capital, so growth destroys shareholder value. Only in markets where a company enjoys a sustainable competitive advantage, protected within its franchise by barriers to entry, will returns on capital be greater than the cost of capital.

 

So the basic relation between value and growth comes down to this: Only growth created through a competitive advantage creates value.

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 According to modern investment theory, diversification is a central feature to proper investment strategy. The theory holds that it is possible to diversify away the risks of holding securities by spreading this risk among many uncorrelated holdings. It’s a theory that has been widely followed, but one that has been tested by the recent financial meltdown in which stocks, bonds, commodities and real estate have all dropped in unison.

 

For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, “risk” is theoretically the standard deviation from the average return. Hence, diversification is not necessarily a way to reduce risk, but rather to lower volatility. We explore the flaws in this theory through two thought experiments.

 

Our first thought experiment consists of two investors with widely different portfolios. Investor A is aware of modern investment theory and is sure he can lower his investment risk by holding 3 uncorrelated investments: a real estate property, a stock, and a bond certificate. On the other side, investor B has decided to invest only in 3 real estate properties. Which investor has the riskier portfolio?

 

According to modern investment theory, investor A is more diversified, and therefore holds the less risky portfolio because his deviation from average return would ultimately be lower than the more correlated portfolio of investor B. This may be true, but let’s now imagine the portfolios look as follows:

 

Investor A

 

1. A stock whose company has no competitive advantage

2. A real estate property currently under water

3. Bonds of a company which cannot meet its future obligations

 

Investor B

 

1. Three real estate properties below fair value

 

Now that the content of each portfolio is known, I would argue, as most sane investors would, that the probability of permanent loss are higher in investor A’s portfolio. Thus, investor B’s portfolio is less risky.

 

This is the obvious flaw that haunts the diversification strategy most funds employ today, where holding hundreds (and sometimes thousands) of positions is considered less risky than concentration regardless of the fundamentals of each individual investment.

 

Unfortunately, these misguided definitions of diversification and risk are also employed in hedging strategies. For example, funds employing the so called “market-neutral” strategy aim to decrease risk by maintaining a balance between long and short positions. Though these funds may be better immunized from wild market volatility, this does not mean that the probability of capital loss is lower than any other strategies. In fact, the “a market neutral” strategy is used not to decrease investment risk, but rather to minimize redemptions, since investors are more likely to pull their money out of these funds when volatility is greater.

 

This takes us to our second thought experiment. Consider a portfolio that holds two stocks: one that pays off when it rains and another that pays off when it doesn’t rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. But the payoff in either case will always be 50% lower than the return we would realize on rainy days by concentrating on stocks that pay off only when it rains, and so on for shiny days. This thought experiment indicates that volatility is reduced, but above-average returns are more difficult to obtain. Many investors fall into this trap.

 

Since value investors tend to reject modern investment theory, it is not surprising that many also refuse to diversify. So how should value investors manage risk?

 

1.                 Forget about volatility

 

Volatility is not risk. In fact, volatility is what allows value investors to purchase companies at bargain prices. Unless you are a hedge fund trying to keep investors by making the market rides easier on their stomachs, volatility is not where your focus should be.

 

2.                 Don’t swing at every pitch

 

The standard response of value investors regarding diversification has been best expressed by Warren Buffett in his frequently cited baseball analogy. Buffett argues that great hitters such as Ted Williams were able to achieve high batting averages because they swung only to the pitches they were sure they could hit. Ted Williams stated:

 

My first rule of hitting was to get a good ball to hit. I learned down to percentage points where those good balls were. The box shows my particular preferences, from what I considered my “happy zone” – where I could hit .400 or better – to the low outside corner – where the most I could hope to bat was .230. Only when the situation demands it should a hitter go for the low-percentage pitch.

 

williams-zone

 

 

Similarly, investors are more likely to invest successfully only in situations where the probability of return is high. This may mean investing only within a circle of competence (investing in understandable companies), staying on the sidelines during bullish times, and purchasing heavily during periods of uncertainty.

Those who invest in hundreds of opportunities at a time, as most funds do, are bound to be obtain returns almost identical to the general market. In this case, investors may be better served by simply buying the S&P500 index.

 

3.                 Place bets according to odds

 

It has been mathematically proven that the best gamblers are those who bet heavily when the odds are in their favor, and who stay on the sidelines when the odds are against them. Similarly, value investors tend to bet according to the likelihood of a positive outcome. In probability theory, the Kelly criterion is used to obtain the optimize size of a series of bets.  In the simplest cases, it can be shown that the size of each bet or investment is proportional to the difference between the probability of winning and that of losing. For example, if an investment has a 60% chance of success – or 40% chance of failure – the size of the optimum bet should be 60%-40%, or 20% of the total portfolio.

 

4.                 Remain pessimistic: challenge own judgement

 

So how do value investors evaluate the probability of success for their investments? They tend to do so by continually focusing on what can go wrong with an investment rather than what can go right. Focusing on the negative prospects of each investment serves as a check in situations where the prevailing market sentiment is irrational (tech bubble, credit bubble, etc.)

 

 

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Our electronic collection of rare value investing articles, lectures, videos, and books is now open to the public. All the scanning and copying was paid for by your small donations. Visit our resources section to access the collection, and help us grow it.
 

 

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