Monday, February 10, 2014

Horan, Johnson, & Robinson, Strategic Value Investing

The three authors of Strategic Value Investing: Practical Techniques of Leading Value Investors (McGraw-Hill, 2014)—Stephen M. Horan, Robert R. Johnson, and Thomas R. Robinson—are all Ph.D.s with ties to the CFA Institute. Their credentials shine through in this cogent, comprehensive book.

The authors advocate strategic value investing, where by “strategic” they mean “being thoughtful about the characteristics of a particular security rather than blindly applying some sort of trading or classification rule.” (p. 21) There are no magic formulas to successful strategic value investing. Each investor has to find his own style, do his own leg work, and remain patient and disciplined.

The book is divided into three sections—introduction, measuring value, and value investing styles and applications. In the section on measuring value the authors discuss concepts of value, dividend discount models, free cash flow models, asset-based approaches, residual income models, and relative valuation. The most interesting section, at least for someone with a grasp of the principles of value investing, is the third. There the authors address value investing styles, choosing the right style and valuation model, distressed investing, and applying value investing to the market.

They introduce the chapter on value investing styles with an apt quotation from Christopher H. Browne: “Value stocks are about as exciting as watching grass grow. But have you ever noticed how much your grass grows in a week?” (p. 227) Here they examine the styles of nine noted value investors—Benjamin Graham, Warren Buffett, Seth Klarman, Bill Ruane, John Neff, Tweedy Browne Company, Wally Weitz, Charles Brandes, and Bill Miller. Bill Miller is presented as a “cautionary tale”: “Confidence is a positive quality in an investment manager. On the other hand, overconfidence can be lethal. Value investors often see falling prices as buying opportunities. If you like the stock at $30 per share, then you should love it at $20 per share. Miller underestimated the depth of the financial crisis and kept purchasing shares of financial stocks as prices continued to weaken. This overconfidence was exemplified by his remark that ‘the only way he would stop buying more when a stock’s price fell was when we can no longer get a quote.’” (p. 243)

Although, over time, value stocks outperform growth stocks and small stocks outperform large stocks, the authors point out one major downside to value investing—that “value stocks tend to have greater variability in returns than growth stocks, and small stocks have greater variability in returns than large stocks.” (p. 250) Value investors therefore have to decide how much volatility they can tolerate in their portfolio at every stage of their investing career.

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