Robert W. Bruce Lectures 2004-2007 to Bruce Greenwald's Columbia ClassVW Staff
Why do you expect that a stock purchased below intrinsic value will rise to intrinsic value and close the gap between price and value? The answer is not scientific–because stocks have always migrated back to intrinsic value. There is a pull towards intrinsic value. Stocks overvalued move down, while stocks undervalued move up (Regression to the Mean). It would be extremely unusual for a diversified portfolio of undervalued stocks not to return to value. Ben Graham in his later years studied a method of mechanically buying stocks at 50% of book value or net working capital with no debt and then selling either when the stocks returned to value or after three years if the gap between price and value had not been closed.
Insert more on R-T-M
How and Why Value anomalies occur.
How do these kinds of sizable discounts arise?
I did not define for you how big (a discount) is enough. My experience is a Margin of Safety of 25% to 30% is something that can be found with some frequency. I could say I would like to find some investment at 20% of value or with a 50% or 80% discount to intrinsic value—that may be a perfectly reasonable idea to have, but I may have to wait until 1932 (or 1973 for those opportunities to buy at 50% to 40% of intrinsic value) to come around again.
Example from Fischer Black and the Revolutionary Idea of Finance by John Wiley & Sons 2005, p. 236: “We might define an efficient market as one in which price is within a factor of 2 of value; i.e. the price is more than half of value and less than twice value. By this definition, I think almost all markets are efficient almost all of the time. “Almost all” means at least 90%.” (Fischer Black, 1986, Journal of Finance 410).
I gave you quotes from these book excerpts, an excerpt from Fischer Black and the Revolutionary Idea of Finance that most markets are efficient. Most sell for ½ of value and twice (2x) value. I can’t address the twice value part of that claim. I have almost had no success in many, many years of my investing career of finding companies trading at ½ of value. Usually when I find them, I go back and try to figure out what happened. That is not to say they don’t happen, but they are so infrequent. The people who tell you they find values at ½ of value are probably deluding themselves.
I know such people. People who tell spell-binding stories about incredibly cheap stocks they have found. If a cheap stock is at a 50% discount–usually, I find they are wrong.
Placing opportunities into Context-Greenblatt.
III. Why stocks do become so significantly undervalued?
Many people believe the market is efficient–why pick up a $100 bill from the ground, because it can’t be there! What allows me to buy stocks at a discount to intrinsic value? This is a commonality among all value investors whether they invest in big caps, small caps or real-estate; they are contrarians–buying when others are selling. Value investors have the ability to go against the emotions of the crowd. Research shows that valuations get carried to extremes on the upside and downside relative to intrinsic value. People become too emotional, overreact, and focus on the short-term news.
Another characteristic of value investors is our timeframes. We have longer than normal time horizons. Most of us, including me, manage money not being measured every day or living in fear that money will be taken away based on short-term performance. If you were to manage a mutual fund, you would be aware of being monitored daily and if there was a short period of underperformance, the money under-management could be removed. This pressure creates a mad dash for the exits, which we see when a company comes out with disappointing news or earnings. Frequently the market reaction is frequently far out of proportion to the actual reality. This creates opportunities to buy. Having a longer time frame offers an opportunity to take advantage of time arbitrage—the market slowly overcomes the short-term focus on news and eventually recognizes true values.
In fact, if you think about it in a general sense, what are the circumstances that are going to create valuation disparities that are favorable to investing? The bad news either relates to the company or to the market in general like an act of terrorism.
Another related question is how long does it take for the gap to close? You must understand that it takes time for psychology to change from negative to positive. Understand the concept of regression to the mean. Nothing is ever as good or as bad as it seems. Companies have a central tendency to normalize profitability and growth. If there should be some short-run deviations especially on the disappointing side, it creates an opportunity for a value investor. There is a tendency for a business to regress to its mean of LR performance. In fact, these opportunities present themselves. If I knew enough to determine the value of IBM. And I have looked recently at IBM, but I don’t have nearly enough expertise to value IBM. But I can look at a Value Line. I can see over a long period of time that IBM as been a remarkably stable and predictable business in terms of its revenue growth, in terms of its profit margins, its cash generation. It is a financial engine that doesn’t really change much. However, there is enormous volatility in the price of the stock.
If I could establish a real, bedrock intrinsic value, there is not much that could radically change my appraisal of the intrinsic value of IBM from year to year given the size of IBM, the diversity and stability of its businesses–with one big exception–a change in interest rates. If interest rates, say, were to rise in the 30-year bond, it would effect my appraisal of intrinsic value because of the discount rate that I use.
Discount Rates to Use in Valuation
For the types of businesses that I invest in they have a long-term track record, which enables me to normalize their earnings. Value means where I find it–big or small. I don’t define myself as small, mid or large cap.
My valuation is a function of interest rates. I am sure none of you here will not make the mistake made on CNBC or Bloomberg of comparing stocks, which are very long duration assets–particularly in a time of very low cash dividends–against short term interest rates. When someone says, “I can’t afford to get sub 1% on my cash, so I must buy stocks.” This isn’t comparing apples-to-oranges; it is much larger apart than that. If you want to compare a fixed income instrument to a stock, it must be the longest risk free duration bond you can find.
Insert Hussman’s discussion of Stocks as perpetual assets.
The discount rate that I use would be the long-term risk free rate plus whatever premium you demand. There is no right answer to that, because each of you has a different demanded return. Each of you has different tolerance for risk. But if you say I will only buy companies selling at 1/3 to 1/2 intrinsic value or discount at 500 basis points over 30 year Treasuries, then you won’t find very much to buy. The tougher you are at setting discounts, the less you will find to buy.
The 1977 Buffett Article in Fortune, talks about 12% equity returns. Those numbers are obsolete in 2004 (more like 6% to 7%). I am sure he would like to rewrite that article. Buffett is saying the normalized earnings figure for the stock market is 12%. Over a long period