Greenwald et al contented that company intrinsic value can be determined by careful analysis. It is actually the task that is essential to successful value investors with accuracy to take advantage of the market's mispricing. As we all understand, there are many methods to do so and each method has its own features and benefits.

PV analysis is usually the common approach most finance students should think of when it comes to valuation. But Greenwald et al advocated that the Graham & Dodd approach should be used instead of the common PV analysis. Greenwald et al opinions about the valuation methods are summarized below:

So, what is Graham & Dodd approach to valuation?

In the approach, there are three essential elements - Assets, Earning Power & Profitable Growth.

Assets

Asset value among the three elements is the most reliable measure in valuing the firm, while the earning power is second and profitable growth is the least reliable measure.

Value investors need to begin with the balance sheet, find the asset value and then find the net asset value by subtracting debt and then arrive at Benjamin Graham famous net-net working capital figures for the company value. For the calculation mentioned above, adjustment needs to be made.

On the other hand, strategic judgment about the company position & its industry is equally important. It can affect the value of assets such as p.p.e. & goodwill and whether these asset items should be valued at reproduction cost. (reproduction cost means the amount the company needs to replace them today.) p.p.e. & goodwill are sometimes taken into consideration in contemporary value investing because nowadays the net-net working capital is a threshold too stringent for finding undervalued stocks in the world.

Earning Power

As for the Earning Power Value (EPV), Graham and Dodd thought that it is the second most reliable measure of a firm's intrinsic value if the current earnings are properly adjusted. Its formula is: 'EPV = adjusted earnings x 1/R', where R is the current cost of capital. To many people, this actually looks like just another multiple-based valuation just criticized. But Greenwald et al argued that this EPV is based entirely on current available information that is uncontaminated by more uncertain conjectures about the future. And, there is a close connection between EPV and its strategic position. I agreed that, compared to the other common valuation models, the EPV calculation relies relatively less on uncertain factors such as growth rate and growth is very hard to be projected. In the EPV calculation, assumption is made that the earning level remains constant for the indefinite future.

Profitable Growth

Difficult growth estimation is one of the reasons why the growth issue is quite isolated from the other two elements into which the more reliable information is incorporated. On the other hand, another reason why growth is least reliable measure actually comes from an interesting argument. Growth on a level economic playing field creates no value. The only growth that creates value is growth in markets where the firm enjoys a competitive advantage. Greenwald et al used the case of WD-40 and Intel to discuss this issue in the book.

Though growth is the element of value that many value investors usually remain skeptical, the other two elements are integrated with it to form a full picture of what a good company should look like. Indeed, these three elements have been covered in great details in the book, particularly including all the adjustments made in the accounting items. Will discuss more about them later.

Reference:

Greenwald. B. C. N. & Kiviat. B. (2001). Value Investing: From Graham to Buffett and Beyond. Wiley.

As powerful as the funds are in the stock market, they are run by human (i.e. money managers). Greenwald et al. tried to explain why, if the money managers were not guided solely by reason and evidence, enduring biases that are going to be discussed below may create investment opportunities that should not exist.

His explanation is based on the fact that money managers are also employees hired to produce results by prescribed investment policies. For job security, it makes sense for them to strive to keep average performance instead of making smart move. The reason is simple. If the exceptional move unfortunately turned out to be bad, this record could tarnish the manager reputation which as a result negatively affects the future career. This consequence is severe. So, the money manager interests or agendas may possibly not be in line with the interests of the institutions they work for.

Money managers may follow a herd mentality. The rather loose definition of "herd mentality" is when various money managers seemingly all invest in the same stocks. Of course, the reasons why money managers herd may actually be much more varied. Some said money managers herd on the sell side for the fear of falling stock price, while another found that low transparency of relatively small and growth stocks can also be the reason why money mangers herd. Andrew Koch who has done the research on "herd behavior and mutual fund performance” supports Green et al. arguments. The research results suggested that managers who make similar investment decisions as the others do so for non-informational reasons. The evidence is consistent with a career concern explanation. Regardless of the reasons why the money managers herd, this behavior does create opportunities for value investors to pick up the undervalued stocks.

To avoid poor performance, money managers may window dress their portfolios, dumping the stocks that have fallen in price and longing the position of stocks that achieved outstanding performance over the past year or the last quarter. Greenward et al. contended that the portfolio window-dress effect could drive up the price of currently successful stocks and depressing stocks with low stock price. So, the end of the reporting period has historically been a good month the value stocks that window-dressing managers have sold. This window-dressing effect, as a matter of facts, seems quite universal. In Hong Kong, when the quarterly or yearly reporting period end date is closely approaching, there will always be news or commentary around featuring its impact on the securities market. On the other hand, scholars from the US suggested window dressing as a possible explanation of the "January Effect" which showed substantial increase in the DJIA in the last week of December. They also thought that this effect is more common for smaller funds as their portfolio are monitored less frequently and completely than that of large funds. Now, this effect is a signal in the securities market that will boost the stock indexes.

In Summary investment institution polices and money manager psychologies facilitate the existence of biases that allow stocks being undervalued persistently even though investors are smart and active.

In the next article, I will talk about another interesting topic about value investing namely how valuation works.

Reference:

Greenwald. B. C. N. & Kiviat. B. (2001). Value Investing: From Graham to Buffett and Beyond. Wiley.

market folly. (2010). The Hedge Fund Herd Mentality, Piggybacking & Crowded Trades. Retrieved from http://www.marketfolly.com/2010/06/hedge-fund-herd-mentality-piggybacking.html

Fong. K., Gallagher. D. R., Gardner. P. & Swan. P. L. A. (2004). Closer Examination of Investment Manager Herding Behavior. Retrieved from http://wwwdocs.fce.unsw.edu.au/banking/staff/profiles/dgallagher/HerdingBehaviour.pdf

Koch. A. (2012). Herd Behavior and Mutual Fund Performance. Retrieved from http://www.business.pitt.edu/faculty/papers/koch1.pdf

Lakonishok. J., Shleifer. A., Thaler. R. & Vishny. R. (1991). Window Dressing By Pension Fund Managers. Retrieved from http://www.knopers.net/webspace/bjorn/artikelenvalueinvestingdeel2/lakonishok2.pdf

In Hong Kong, and other securities trading countries, the fund pool size in the market is expanding. As the pool size increases, their influence on the price movement becomes greater. However, these institutions are run by human and they are always subject to stringent rules & regulations. These various constraints might give us answers to why the value anomaly might persist in the face of intelligent and energetic investors who are always eager to outperform the market average.

Institutions, as stipulated in their policy, are sometimes not allowed to purchase certain types of stock (e.g. socially irresponsible companies like tobacco companies). If there are a number of institutional investment funds prevented from owning certain kinds of stock, the demand for their shares will be reduced. So as measured by current earnings or growth prospects, these stocks are usually undervalued. However if the policy restriction is not lifted, they could be undervalued permanently.

Greenward et al. further contended that funds cannot purchase small valued stocks because their mandates do not allow it. Or in compliance with the regulation, small companies cannot be a worthwhile investment for funds. Greenward et al. explained that fund does not want or is not allowed to own more than 10 percent of any company's stock*. So, if the fund has $ 5 billion ($ 5,000 million) to invest in say 100 companies. On average, it needs to buy $50 million in each. But if the small company market capitalization is only $50 million. Constrained by the rules of owning less than 10% of the stocks, the fund can only invest $5 million at maximum, which is just 0.1 % of the total fund size. So, funds are usually not interested in buying small company shares.

Greenward et al. also discuss how corporate spin-offs result in some stocks being undervalued. It is interesting as the new spin-off company is usually small, especially when compared with the giant from which it has just been separated. Funds holding these the giant companies are eager to sell or dump the new spin-off shares as their size is too small. This type of reasons unrelated to the company's prospects creates a good opportunity for investors. Greenward et. al. has of course covered more details in their book. These details should not be missed so I highly recommend the readers to go check the book out.

In the next part in this series I will explore the equally interesting factor of money manager psychologies.

Notes: *This issue might be slightly different in HK. According to the SFC takeovers code, mandatory general offer will be triggered if a person or group persons acting together buys 30% or more of voting shares in the company. Funds are likely to comply with more stringent regulation stipulated by their own, no more related information is available here though. But, the general rule in a takeover requires the offer to be announced. Though not a prohibition, this rule is already trouble enough to decrease the fund appetite to own too much of just one stock in my opinion.

Reference:

Greenwald. B. C. N. & Kiviat. B. (2001). Value Investing: From Graham to Buffett and Beyond. Wiley.

InvestEd Intelligence. Retrieved from http://www.invested.hk/invested/en/html/section/products/stocks/privatizations/trigger.html

To understand the concept of buying a stock at a price lower than its value is one thing, to put it into real practice is nonetheless another. The first question most value investors encountered is where the undervalued stocks can be found. In "Value Investing: From Graham to Buffett and Beyond ", there are several searching methods discussed by the authors. One that particularly intrigues me is the Anomaly of Value.

It explained that some stocks are persistently undervalued by some biases that are so obvious to not just intelligent and energetic investors but also everyone else. There are several different types of biases described in the chapter.

Let's start with the one that I think may be common to us first and keep the rest for us to enjoy at our future leisure. To the anomaly of value, one explanation is that investors, regardless of the individual or institutional type, always hunt for winners such as those potential growth companies with great stories and bright futures. Losers such as those boring, poor performing, unknown, or unloved companies draw little attention. The investment decision is influenced by the biases, so are the investment returns. Stock prices have usually reflected the stunning performance of companies that are known to be good in the public. On the contrary, if the company performance is not outstanding or the companies underperformed in the industry, their stock price has also reflected the possibility that they can perpetually stumble or foul up. They are undervalued because all they need to do is to get back to normal and they will surprise investors.

Also, many investors predict by extrapolation, the process of estimating the future performance on the basis of the relationship with the stock past performance. However, if we more thoroughly examine the correlation of past performance with future return, we will reveal that stocks that performed poorly yesterday may have been the top performer over the past several years. However, people informally generalize from a few cases that are memorable rather than use the full set of data to analyze, and people remember the recent past better than the distant past. From the recent history, they pick up the winner and loser. Then they select the winner to invest, hoping that they will continue to outperform in the near future.

Greenward et al. also discussed how biases exist thanks to investment institution polices and money manager psychologies. More details will be discussed later in the next chapter review.

Reference:

Greenwald. B. C. N. & Kiviat. B. (2001). Value Investing: From Graham to Buffett and Beyond. Wiley.

Value investing has been advocated by many professional investors, since it is initially defined by Benhamin Graham and David Dodd. The key point of Value Investing is to making investment decision based on a rational foundation. Over the last three or four decades, value investing has always been an important approach to investment analysis so today I would like to share what I have learnt from "Value Investing: From Graham to Buffett and Beyond" written by Bruce C. N. Greenwald and Barbara Kiviat.

There are three key features of financial markets in value investing:

1. The price of financial securities can move significantly and randomly, which is determined by the market forces at any moment.
2. Many of the financial assets have underlying or fundamental economic values that are relatively stable and that can be measured with reasonable accuracy by a diligent and disciplined investor. Intrinsic value of the security and the security current price are often two different things, though on any given day they may be identical.
3. To get high returns in the long run, buy securities only when the market prices are significantly below the calculated intrinsic value. According to Graham, the gap between value and the price is called 'the margin of safety'. The ideal gap should close to one-half, but not be less than one-third, of the fundamental value.

As mentioned earlier, the investment decision is based on rational foundation. As such, a value investor should figure out the fundamental value of a financial security and compares the value to the current price in the market. If the current market price is lower than the fundamental value, then the stock should be undervalued.

P.S. As a calculation of risk, safety margin has nothing in common with the volatility of a security's price. The volatility can sometimes be high as the price is dropping very sharply, but to value investors it might not be risky but another investment opportunity as the margin of safety has also widened as well.

Reference:

Greenwald. B. C. N. & Kiviat. B. (2001). Value Investing: From Graham to Buffett and Beyond. Wiley.