Navigating the value investors’ conundrum

How can Graham and Greenblatt both be right? Some thoughts on Mark Carter’s algebraic illustration of Geoff Gannon’s ‘value investing paradox’.

Profitability as it concerns shareholders is determined by dividing earnings, the profit remaining for shareholders once all other costs have been deducted, by book value, the value of the company’s assets less everything it owes external parties (liabilities). The remainder belongs to shareholders, and their annual profit divided by their equity is the Return on Equity.

The relationship between profitability, and the price investors pay in relation to earnings (profit) and book value (equity) is:

Where B = Book value, E = earnings and P = price. To keep things simple, I’ll refer to these fractions by their ratio names from now on, so:

Where ROE = Return on Equity, PBV = Price to book value and PE = Price Earnings Ratio.

Here’s the conundrum.

Ben Graham, the original value investor, favoured companies on low multiples of earnings (low PERs) and book values (low Price to Book) and from the above equation, you can see that if a company with a low PER is to have a low PBV it will also have low ROE (profitability).

Joel Greenblatt, one of Graham’s fêted successors, favours companies on low multiples of earnings with high levels of profitability. If we use the same ratios to illustrate the principle (Greenblatt uses alternative measures of profitability and value) and assume the PE is relatively low and the ROE is relatively high then our equation:

Is going to give us a middling PBV. How can both strategies work?

Relatively unprofitable companies can be good investments if:

Low profitability is temporary, and in future they will be more profitable
The price investors are paying is so low they will still get a good return.

Graham found that on average, over long periods of time, the gains made by the very cheapest shares when they recover more than outweigh the losses from companies in the same pool of shares that don’t recover. This, he believed, was because in general the market underrates the prospects of companies that are currently doing badly, and that companies gradually work out how to improve profitability and erode that of their competitors.

Highly profitable companies can be good investments if:

High profitability is persistent, and in future they will still be highly profitable
The price investors are paying is low enough for them still to get a good return.

Greenblatt found that on average, over long periods of time, the gains made by shares in companies that have the best combination of profitability and value and remain highly profitable more than outweigh the losses from companies in the same pool of shares that don’t. This, he believes, is because some companies can withstand competition from rivals and defend their high levels of profitability for long periods of time.

The two rationales seem contradictory, but they’re not necessarily.

Though he’s not particularly keen on Greenblatt’s approach, Geoff says this isn’t a paradox. Though profitability does generally revert towards the mean some companies are special, and Greenblatt’s formula may find enough of them to beat the market.

I think it’s critical to recognise which camp you’re in, especially if, like me, you’re in both. My Thrifty screen attempts to improve on the Graham strategy, and my Nifty screen attempts to improve on the Greenblatt one.

Sometimes, when I go from looking at a Nifty company to a Thrifty company I’m put off by the Thrifty company’s dismal profitability. That’s ludicrous. The Thrifty companies are potential bargains and, as I hope I have demonstrated, I should be expecting low ROE. Poor results, albeit temporarily so, present the opportunity to profit.

Thrifty companies, or the environments they operate in, must change, so the following are positive signs because they might lead to higher ROE in the future:

New management, especially if they’re buying shares
Restructuring, asset sales, write offs
Talk of cost control and organic growth
An improvement in business performance (indicated by the F_Score).

Nifty companies, those special companies that remain highly profitable, must stay the same. The past is our guide to the future and change increase risk. The following are positive signs because they are signs of stability:

Consistently high ROE at a consistent level of leverage over a long period of time
A management team responsible for the company’s past success, that owns a significant stake in the business
Talk of cost control, organic growth, and extending a successful business model gradually into closely related markets.

11 Comments

blippy September 26, 2011 at 5:45 pm

I guess one way of squaring the circle is to look at the general pattern of historical ROEs. If they are generally high, then you’ve got yourself a Greenblatt share. If they’re inconsistent, then you may have a Graham share. The ROE you currently see should fit in with the the way you classify the share; by which I mean, if you think you’ve got a Greenblatt share then you would expect the ROE to be high, but if you think it’s a Graham company, then you want the ROE to be low. Just be careful not to mix the two types up.

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- Richard Beddard September 27, 2011 at 8:21 am
  
  Exactly
  
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John @ UKValueInvestor.com September 26, 2011 at 10:25 pm

Nice post. Value investing is a wide field and as you say it’s important to know which niche you’re working in and to use the tools appropriate to that niche. I’ve invested on both sides of this Graham/Greenblatt divide (although I’d call it the Graham/Buffett divide) and I see it like this:

Investors are too short sighted and don’t take into account the long term strength or weakness of a company to a large enough degree. They have in their minds some idea of a fair price, like a PE of perhaps 10, or a dividend yield of 3% or whatever the going rate is for an industry at the time. They apply these ballpark figures to both good and bad companies and buy or sell depending on short term good or bad news.

So when the economy is ticking along okay a cigar butt is valued at almost the same level as a wonderful company, meaning the cigar butt is overvalued and perhaps the wonderful company is fairly valued. In a bubbly market even the wonderful companies can become overvalued.

When there is bad news of some sort both types of company can become undervalued, although since the cigar butt is typically overvalued it takes a real bad piece of news to make it undervalued, or a recession. The wonderful company can be undervalued more easily as investors don’t typically look at the long term growth potential.

This means that cigar butts make good investments in recessions and depressions, assuming their balance sheets are strong enough to avoid failure. They can then rebound fantastically in the ‘dash for trash’ but soon become overvalued again as their long term potential is highly uncertain.

The wonderful companies provide less bang coming out of a recession, but they have better potential as investments in a broader range of markets as they are more often undervalued since their strong future cash flows aren’t fully appreciated.

That’s one way to look at it anyway. Neither is ‘better’, it’s just which style suits you and the current market.

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- Richard Beddard September 27, 2011 at 8:20 am
  
  Hi John, thanks for your comment on the Graham/Buffett divide. Generally I agree with you with the following caveats:
  
  1. Graham warned of buying low quality companies during buoyant markets and relied on analysis of the balance sheet to protect himself against big falls. I think that approach has been born out by the experience of 2008/9. The term ‘cigar butt’ is pejorative and doesn’t apply to all ‘bargains’. A bit like the Greenblatt argument – some companies are special.
  
  2. It’s very hard to determine long-term strength. Personally I find the reliance on high profitability indicating ‘the company must be doing something right’ (in the Greenblatt example) quite weak as we know in general ROE does revert towards the mean. Buffett allegedly can identify ‘sustainable competitive advantage’, the fabled moats, but he, rather like the companies he targets, appears to be special!
  
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- blippy September 27, 2011 at 5:26 pm
  
  John, I agree with you.
  
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Mike September 27, 2011 at 5:51 am

I believe Graham’s approach is always rational and Greenblatts is “sometimes” rational. Greenblatts stocks are often trading above book value. In this case, they do not have the asset based downside protection of a typical Graham stock. Sustainable earnings power and high yields are therefore the driving force. This is where Buffetts concept of moats, economic goodwill, and sustainable competitive advantages comes into play. With this in mind I think that a Greenblatts stock can be a Graham stock, but only if it has a moat. Without a moat it may be very difficult determining the earnings power with any resonable certainty.

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Mike September 27, 2011 at 6:01 am

Cont’d
If the earnings power can’t be computed with any certainty other than the past, then what is there to provide a margin of safety. A Moat or excess assets to the price payed are the only thing that would provide this margin of safety with any certainty.

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- Richard Beddard September 27, 2011 at 8:06 am
  
  Hi Mike, thanks for your comment. That’s it in a nutshell, I think, although just as Greenblatt’s selections sometimes don’t have moats, the ‘asset-based downside protection’ backing Graham’s selections sometimes isn’t enough. So they’re both only rational if you either:
  
  a. you are very good at validating assets/moats
  b. you own a lot of companies for a long time
  
  I should have included a discernible competitive advantage (moat) as point four in my list!
  
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- John @ ukvalueinvestor.com September 27, 2011 at 10:00 am
  
  Margin of safety means different things in different contexts.
  
  For example, if I buy a company with a net-net value of £100M and the market cap is £50M, I have a margin of safety against the company’s collapse since the sale of the assets will probably cover the cost of the shares. But if the company doesn’t collapse and it has rubbish earnings power then there is nothing to say that the value of the shares will ever go up, and perhaps no dividend to compensate me either. Although we all know that if you buy enough of these companies for long enough you’re likely to do very well.
  
  On the other hand, if I buy gilts then I expect to get my income, but again it isn’t really guaranteed as the UK might default. That’s pretty unlikely though so the going assumption is that it wont.
  
  With something like Vodafone, I don’t know what the future earnings are, but because of the industry, the company and its past, I can say with some reason that Vodafone is likely to continue to earn something in the region of what it has earned before. It isn’t guaranteed, but it’s highly unlikely that they will go from earning about 10 billion pounds a year to say 10 million. It’s not going to happen, or at least it’s highly unlikely. So the margin of safety can come from earnings if they are from the right sort of company and you’re buying at a low level compared to the 10 year earnings average, or some other similar measure.
  
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Robert Johns September 27, 2011 at 8:54 pm

Hi all. Well I think a major bearing on solvency has been the change in repayable interest for liabilitys over the last 40 years or so making certain decissions harder, perhaps forcing the buffet/green hand more. Im mostly on the graham side/approach but when good heavy duty moated comps with outstanding FCF appear at book..well it’s Christmas for me

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blippy September 28, 2011 at 1:37 pm

One thing I’m investigating at the moment is the standard deviations of the ROEs for companies. One thing I’m finding is that there doesn’t seem to be much correlation between a company’s “stability” of earnings and the stddev. For example, Aviva had a stdev of ROE of 4.18, only slightly above Brit Amer Tobacco of 3.98. However, its much lower than the likes of Unliver and Smint & Nephew that came out as 16.89 and 7.51. It’s a bit of a paradox! I wonder what it means.

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