Library
At Howson Tattersall, we’ve been building portfolios using a value investment style since 1985. Although much has changed in the intervening years, our style has remained the same. Tried and tested through many bull and bear markets, it continues to provide reliable results for our investors. In the following article, written in 1986, Bob Tattersall outlines our approach.
The Value Approach to Common Stock Investing
By Bob Tattersall
Investors in Saxon World Growth (one of four mutual funds managed by Horgan Investment Counsel) will have noted the following statement in the Fund objective: “The major emphasis is the identification of “value”, whether in the form of hidden assets, sustainable earning power or other criteria determined by the Manager.” This sentence is designed to alert potential investors to the fact that the Fund has a long-term strategy which makes little use of technical analysis, market timing or other short-term trading rules. Even so, we can hardly expect our clients to understand the concept of value investing on the basis of a 25 word sentence, so this article explores the topic in more detail.
A cynic has been described as a person who knows the price of everything and the value of nothing, and so it is in the stock market. The daily stock quotation pages show the price of every available investment, but only rarely does this price correspond to the underlying or intrinsic value. Price movements reflect only the short-term judgment of those few individuals who choose to transact their business on any given day. For the vast majority of investors who are not buying or selling on that day, the value of the company does not change in proportion to the daily price movement.
A value-oriented investor therefore tends to have a long time horizon and a basic investment thesis when he selects a stock for purchase. As a result, his analysis concentrates on sustainable profitability rather than quarterly earnings forecasts. There are many random factors which affect short-term earnings performance and most of them do not reflect on the capability of management or the profitability of the product line. It is true that accurate forecasts of quarterly earnings would substantially enhance portfolio performance, but the same evidence indicates that few, if any, investors have this capability. Value-oriented investors therefore concentrate their efforts on the things that can be analyzed and which are reasonably stable over time.
Fundamental financial analysis is obviously the starting point for the value approach, but it is not a sufficient condition. Many companies have impeccable financial records and yet would not be attractive to an investor seeking value because this financial superiority is fully reflected in the stock price. Alternatively, an average company may be extremely attractive because the stock price is unusually depressed due to a strike, a poor quarter or an adverse report from an analyst.
A value investor will not confine his attention to any one group of stocks, but will instead have a rather eclectic portfolio where all of the holdings have one feature in common – a margin of safety. If we are seeking a return in excess of that from the market, it is not rational to pay a price equal to the estimated value of the proposed investment, since this will not provide any incremental return if we are right or margin of safety if we are wrong. Although value may exist in any part of the market, it is likely to be absent from one sector – the recognized growth stocks. This is not because the companies do not have superior characteristics, but because these characteristics are typically widely recognized and investors consequently overpay for them.
No one, of course, deliberately overpays for any investment and so the value investor needs some type of valuation model which concentrates on financial rather than emotional criteria. There is no single model which is used by all value investors, but many of them are based on balance sheet strength, low price-earnings ratios and the concept of sustainable or normalized earnings. None of these models is concerned with short-term earnings forecasts or even the product line being sold, but instead concentrates on the price to be paid for earning power or liquid assets per share.
Perhaps the simplest method of summarizing the value approach is to provide a list of activities which would be followed by such an investor:
- The value investor will be more interested in indicators of sustainable profitability, such as return on equity and asset turnover, than earnings forecasts for any single calendar period.
- He will also spend an unusual amount of time on balance sheet analysis, since this is often the basis for the margin of safety. A low level of financial leverage will permit a company to weather unforeseen earnings shortfalls and maintain dividend payments.
- The starting point for structuring a portfolio is typically the economic forecast and the value investor will also begin here. Instead of automatically overweighting those areas with the most favourable economic outlook, however, he will consider the possibility that those stocks already fully reflect that favourable assessment. Better investment value may not be available elsewhere and as a result, the model portfolio may not mirror the economic outlook.
- Because of his long term horizon and margin of safety, the value investor does not place undue emphasis on liquidity. Even if he has correctly identified an undervalued situation, he has no idea when this will be recognized and so it is irrational to pay a premium for short-run liquidity.
It should be pointed out that not all value investments are small, illiquid, obscure companies. Like beauty, value is where you find it and a well thought out valuation approach should permit investment in a wide range of companies.
- New marketing concepts, technological breakthroughs and other items of investment sex appeal will be of interest to the value investor only if he can participate without having to pay in full for these expectations. If the company has to deliver the consensus estimate of earnings simply to sustain the current price level, then there is no margin of safety. The value investor is not required to predict what specific adverse event will occur, but simply to establish that the stock price leaves no room for error.
The five guidelines for value investing obviously have a common prerequisite; the need for patience. It is surprising how many investors will review this checklist and then protest, “But what if you have identified value and no one else discovers it; What will make the stock go up?” There is no answer to this question except the voice of experience. In a diversified portfolio of value investments, one or more of them will be in the discovery phase at any given moment. Sometimes there may be a dry spell of several months while investors pursue the latest fashions, but value comes through in the end.
Saxon World Growth provides a perfect example of this phenomenon. After a slow but steady gain during the first half of 1986, four of the holdings became takeover candidates during the month of August along – McNeil Corporation, Hammermill Paper, Color Tile and Naarden International. It may some time before we again enjoy such a prolific month, but we are replacing these holdings with other value investments.
In summary, the value approach to common stock investing requires thorough analysis, patience and a willingness to be a contrarian. Before you assume that all contrarians are value investors, however, you should keep in mind the following comment from Bertrand Russell:
“There are infinite possibilities for error, and more cranks take up unfashionable errors than unfashionable truths.”
Robert Tattersall, CFA
August 1986