A further complicating factor is the increasing extent to which service and modern technology companies operate in local geographic markets or niche product markets. These local/niche markets are characterized by potential economies of scale and, through continuous customer interactions, high degrees of customer captivity. The result is an increased incidence of dominant local/niche market competitors who benefit from significant barriers to entry. In the language of value investing, franchise businesses with wide moats constitute an increasingly large fraction of overall economic activity. For franchise businesses, net assets play a diminished role in determining profits and growth contributes significantly to overall value. The consequence is that equity valuations depend heavily on future cash flows, and often far distant future cash flows, whose values are difficult to measure using Graham and Dodd asset value/earnings power value methods. Also for franchise businesses, management performance, especially with respect to capital allocation, has an enhanced impact on firm valuations. Not surprisingly in this environment, many traditional balance sheet focused value investors have not done well.
These changes mean that we have to revisit all aspects of the approach to value investing laid out in the first edition of this book. We have rethought the imperatives of searching for and then valuing potentially attractive opportunities once they have been identified. We have also carefully examined active research processes once a preliminary valuation has been made and have looked at the issue of risk management far more extensively than we did in the first edition. In this revision we have benefited from observing practicing value investors and noting the adaptations they have made to changing economic circumstances. In all these areas, we have explicitly measured the advantages of a modern Graham and Dodd approach against what is ultimately the fundamental challenge facing any active investor. While there is now overwhelming evidence that financial markets are not efficient in the academic sense, there is a fundamental and inescapable way in which markets are efficient. The average return to all investors in any asset class must be equal to the average return to all the assets in that asset class (i.e., the market return for that asset class). All the assets are owned by somebody and derivative arrangements (e.g., uncovered short sales) net out since for every seller there is an offsetting buyer. Therefore, if one investor outperforms the market for a particular asset class, another investor must underperform by a compensating amount, weighted by the assets under management. Since this constraint applies to all asset classes, it applies to investments as a whole.
When we began working on the first edition of this book in 1999, Bruce had taught the value investing MBA course about five times, with some additional run-throughs in Executive MBA and 2 day Executive Ed versions. Twenty years later, even with a sabbatical now and then, he has taught it more or less continuously for around 25 years. In 2005, we published Competition Demystified, a detailed study of the factors that constitute sustainable competitive advantages and what distinguishes franchise businesses, firms protected by barrier to entry, from companies subject to competitive pressures. And during those years, both of us have had direct investment experience, working in a large global mutual fund and three smaller hedge funds. There is no doubt that all the additional teaching, thanks to the students and the guest investors who generously contributed their time and expertise to developing the Graham and Dodd tradition, has expanded our own understanding. At least as important has been our time in the field, so to speak. As the historian Edward Gibbon wrote in his Memoirs about his service in the Seven Years' War, The discipline and evolutions of a modern battalion gave me a clearer notion of the phalanx and the legion; and the captain of the Hampshire Grenadiers (the reader may smile) has not been useless to the historian of the Roman Empire.
A common and brief summary of value investing is that value investors search for and buy only bargains, securities selling for less than their true or intrinsic values. There is a problem with this simple definition. No rational investor admits to searching for securities selling for more than their underlying value. Everyone is looking to buy low and sell high.¹ We need to be clear about what differentiates real value investors from all the others who trade in the securities markets (see Figure 1.1).
Though this approach shares with value investing a concentration on economic fundamentals and specific securities, there are major differences. First, it focuses on prior and anticipated changes in prices, not on the level of prices relative to underlying values. One could apply this analysis equally well to a stock trading at 10, 20, or 50 times forecast earnings. A value investor would not regard these situations as equivalent. Second, this approach does not incorporate an identifiable margin of safety to safeguard the investment from Mr. Market's capricious behavior, which, after all, has been known to sink the price of shares in response to good news. So while Graham and Dodd value investing is most frequently a microfundamentalist approach, not all, or even most, microfundamentalists are value investors.
Each of these alternatives to value investing can lead to a successful investment record, provided it is carefully and diligently pursued. Statistical studies increasingly suggest that security prices and volumes do trace consistent and recognizable patterns; there are positive serial correlations in the short run and reversion to the mean over the longer term. There are successful technical investors. Macroeconomic variables can be forecast with some accuracy and will affect securities markets in systematic and identifiable ways. There are successful macrofundamentalist investors. Analysts who energetically pursue information from company and industry sources, ferreting out trends ahead of the pack, should in theory and sometimes do in practice obtain above-average investment returns.
Another approach to investing outside the value tradition rejects all these possibilities. It arose from Modern Portfolio Theory and its sibling the Efficient Market Hypothesis, which were developed in academic finance departments beginning in the 1960s. The underlying premise of the theory is that current prices for securities, which are set by the collective perceptions of all market participants, accurately incorporate all the legally accessible information about future prices and values. Misperceptions and non-rational decisions are assumed to be essentially random. Excessive optimism, for example, on the part of some investors would be offset by excessive pessimism on the part of others. Correct perception, by contrast, being shared by many energetic and intelligent investors, would determine market prices. These prices would reflect the best forecasts of future developments affecting the companies' value. As a result, future price movements would depend either on random investor behavior or relevant new information that could not have been anticipated. Given these assumptions, future price changes would be unpredictable and current prices would be the best predictor of average future prices. All attempts by individual investors to outperform a portfolio based on current prices would be futile, since all changes would be random.
In addition to the text between the covers of this book, we have been able to make available online some of the presentations delivered over the years in the value investing course at Columbia Business School, taught for a quarter century by Bruce Greenwald and now by Tano Santos. Some of the most extraordinary value investors have devoted time and effort to make these presentations, in some cases virtually annually. We are grateful beyond measure to them and the contributions they have made to the evolving discipline of value investing. 2b1af7f3a8