Monday, November 10, 2014

Brandes on Value

Brandes on Value: The Independent Investor (McGraw-Hill) is a paean to the “practicality and universal application of Graham-and-Dodd principles.” Charles H. Brandes became a convert to value investing through a most unlikely encounter. In 1971, three years out of college and a broker/analyst in San Diego, he was taking his turn keeping an eye out for the admittedly rare walk-in brokerage customer “when an elderly, unassuming man walked through the door.” That man was Benjamin Graham—yes, the Benjamin Graham. Graham was spending his winters in La Jolla and wanted to open an account so he could buy a stock he had been tracking for months. Well, one thing led to another, and soon enough Brandes was hooked. In 1974, a year that most investors would have considered inauspicious but Graham called “an excellent time to launch a venture of this sort,” Brandes opened his own firm. Forty years later he remains convinced that “the fundamentals of value investing [make] total practical sense for long-term investors.” (p. xiv)

Here I’ll highlight three concepts that are basic to Brandes’ framework: investing versus speculation, value philosophy, and risk.

Brandes expands on Graham’s distinction between investing and speculation. In The Intelligent Investor Graham wrote: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Brandes adds two more criteria that define speculation: “any contemplated holding period shorter than a normal business cycle (typically three to five years)” and “any purchase based solely on anticipated market movements.” (p. 26)

Value investors agonize over—and disagree about—what characteristics a company must have to be considered a value play. Brandes simplifies the selection process, condensing “the most significant precepts of the value philosophy into a four-step test that you can quickly apply to any company that catches your eye”: “1. No losses were sustained within the past five years. 2. Total debt is less than 100 percent of total tangible equity. 3. Share price is less than book value per share. 4. Earnings yield is at least twice the yield on long-term (20-year) AAA bonds.” (p. 71)

There’s some wiggle room in using these guidelines. As Brandes writes, “Utilities, which are usually buffered from economic influences, may allow a little more leniency on the debt-to-equity or annual earnings growth tests, while for a potentially more volatile technology-based business, these would be two must-pass criteria before we would even consider it.” (p. 73) Moreover, lest one think that value investing can be reduced to a straightforward four-step process, the professional value investor will typically subject any company in which he is interested to much more detailed analysis.

Finally, let’s look at Brandes’ understanding of risk. He rails against conflating volatility with risk. Risk is just what the average investor thinks it is—the possibility of losing money. He argues that “working with equities is not about reading the beta or standard deviation and diversifying away the alpha potential. It means doing some homework, stepping up, and taking on some additional volatility risk that could turn out to be an excellent value opportunity.” (p. 217)

Risk in its true sense cannot be measured in the way that volatility and similar mathematical notions can. But it follows a general pattern. Investors lose money when they overpay, when they sell at a loss (that is, when they didn’t wait patiently for the stock to turn around), when the company itself deteriorated, and when they strayed from fundamental investing discipline and lost focus. Note that only one of these reasons for a loss of capital is outside the control of the investor. In the investing world, where uncertainty is said to reign supreme, that definitely shifts the balance of power.

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