Invest like Buffett

Simon Denison-Smith, fund manager at the SF Metropolis Valuefund, explains the investment technique that helped make Warren Buffet such a success.

The Berkshire Hathaway AGM is like no other in the world:

  • It fills a 30,000 seat sports stadium in Omaha Nebraska
  • Warren Buffett, the Chairman and Charlie Munger, the Vice Chairman, sit on the stage and take questions from the audience for six hours. Both men are in their eighties and are keen value investors
  • They are both billionaires with Buffett worth over $50 billion – by a clear distance the most successful investor of all time

In this article, we explain the core tenets of value investing, show that there is clear evidence for its long-term success and explain the behavioural reasons why it cannot often be applied within the mainstream investment world.

Value investing was developed in the early twentieth century by Benjamin Graham and has been popularised in recent decades by the success of many investors who follow the approach, most notably Warren Buffett. It is now a well-respected investment style in the US but is still a small sector of the investment universe elsewhere.

The distinguishing feature of value investors is that we look at a share as ‘a piece of a business’ rather than ‘a piece of paper’. We first evaluate what the business is worth and then what a single share is worth.

This is done by taking an analytical view on the future cashflows of the business and by studying its assets and liabilities (including those off balance sheet, such as its intellectual property or brands). Most importantly, we are focused on buying a piece of the business at a discount to what we believe to be its true value.  

Essentially as value investors, we are always taking a view that is ‘contrarian’ because, to believe a business is worth more than the price offered by the market, means that we believe that the market has mis-priced the asset. This, of course, goes completely against the tenets of the Efficient Market Hypothesis. Benjamin Graham summed this up by encouraging stock owners not to be too concerned about erratic fluctuations in stock prices, “since in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine.” Graham’s metaphors explain that in the long run (by this he meant potentially years), the price of the stock will eventually reach its true underlying value.  

Buying an asset when you think it is cheap and selling it when it gets to a fair price, or higher, sounds like common sense – “isn’t this what all investors do”? It is helpful therefore to also describe some investment styles not grounded in fundamental value.  

  • 1 A trading strategy, which is simply looking at short-term movements in share prices as a guide to the future movement – chartists or trend followers, for example
  • 2 Thematic investing which attempts to take broad-brush macroeconomic themes and identify investments based on the winners and losers from these themes.  The concepts of price and value are often secondary here or even ignored
  • 3 Growth investors who focus on investing in businesses that are growing fast with little concern to the underlying price 

I am sure that many readers will automatically disassociate themselves from any of the categories above and quickly perceive that they are likely to be value investors. Maybe this question above all else will help you to determine this: “If you are holding a stock and its price drops sharply, is your instinct to sell the stock”? A value investor will always have the opposite instinct. We see the company as now being cheaper and, provided we do not think that the underlying business has changed dramatically (or at least as much as the price fall), then we will are inclined to buy more.  Quoting Benjamin Graham again:  

“Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

There is a great deal of evidence that this style of investing works but only when you apply it diligently over a long period of time. Société Générale conducted research on the US stock market looking at 100 years of stock market data. The research compared the 10-year returns from investing in a basket of stocks with low price earnings ratios (value stocks) against stocks with higher price earnings ratios.

This analysis showed the superior returns earned from buying the low price earnings ratio stocks, as shown in the graph above. Other analysis has come to similar conclusions when looking at five-year time frames. We have however seen nothing that suggests that this style of investing regularly delivers returns in excess of the market when measured over six months, one year or even two years. Herein lies the challenge for most institutional investors.  

Research into behavioural investing has demonstrated the reasons our brains are simply not wired to accept the short-term pain of loss (paper loss if you don’t sell). It is also psychologically difficult to buy businesses that are on low valuation multiples. These businesses are, by definition, the companies that are out of favour. Furthermore everyone you know, and the press, will tell you the reasons why you are being irrational when you invest in them.  

Consider examples such as BP immediately after the Macondo well disaster, Barratt in the depths of the credit crunch or GlaxoSmithKline when it touched £10 in 2009 – 10 years after being valued at £20. 

US stock market annualised returns

Once we have made an investment, we never know how long it will take for prices to reach their correct value and in the meantime, our patience is often tested as it is very difficult to hold out against the crowd for a long period of time. To be a good value investor you need to be financially, institutionally and psychologically able to do this, while also being aware that your analysis needs to be constantly re-evaluated to make sure that it is correct. Doing so requires a strange combination of the conviction that comes from self-confidence and the humility to be able to admit that sometimes you were wrong.

If it is psychologically difficult for you to execute this style of investment, you should spare a thought for most institutional investors and analysts. Their bonuses and even their careers are staked on how successful they are within a six-month or a 12-month period. It is for this reason, despite the fact that it is both common sense and statistically proven, that value investing is never going to be mainstream.  

As my colleague, Jonathan Mills, chair of Metropolis International Group, said at the London Value Investor Conference (londonvalueinvestor.com) this year “value investing is a lonely occupation”. Individual investors should welcome this. Having a value based investment framework and patience offers a significant edge over most professional investors over the long term.

About the author: Simon Denison-Smith is one of the two fund managers at the SF Metropolis Valuefund – a long-only fund, with a concentrated portfolio of undervalued global securities.

Originally distributed in July 2013.