There's a big difference between being a value investor and merely being a cheapskate. The dictum goes, "Price is what you pay; value's what you get." To the skilled investor, value reflects the exploitable wedge between price and value. It's a relative concept, rather than an absolute level. This is often hard to remember because we use the same words - "cheap" and "expensive" - to describe two concepts. Something can be cheap relative to its inherent qualities, or cheap in an absolute sense, which is to say selling at a low dollar price. It's often helpful to clarify which people mean.
The father of value investing, Ben Graham, was occasionally unclear on this point. His most famous disciple, Warren Buffett, notably adapted his investing style to incorporate quality as a component of value (influenced by Charlie Munger). In fact, Graham almost made a gigantic error by being a cheapskate rather than a value investor. Buffett recounts, "I offered to go to work at Graham-Newman for nothing after I took Ben Graham's class but he turned me down as overvalued. He took this value stuff very seriously!" Buffett might just be being kind here - if I recall correctly, I've read elsewhere that Graham turned Buffett down because young Jewish men were being barred from so many places on Wall Street that he felt inclined to save spots for them to work at Graham-Newman. But at any rate, the thought of Graham turning away the bright young Buffett seems like an act of folly.
The distinction between value investing and being a cheapskate applies to regular life too. I posted about a month ago about this paper by Bronnenberg, Dube, Gentzkow and Shapiro that found that informed consumers of headache remedies (such as pharmacists) were less likely to pay extra for national brands, preferring store brands and generics. BDGS suggest therefore that "misinformation explains a sizeable share of the brand premium for health products." In other words, those who are better informed can see past marketing and therefore opt for a lower priced product with the same efficacy.
About a week after writing that post, I found myself choosing between a brand name health product costing $90 and a generic brand at $60. "Screw you, brand name," I proudly thought. "I've read my BDGS." Big mistake. Three weeks later, I discovered the product wasn't working, and was forced to cough up for the more expensive alternative.
Really, I made two mistakes. First, I incorrectly extrapolated the BDGS finding from the relatively narrow world of headache remedies to a completely separate product. Second, the BDGS finding referred to informed consumers. Alas, that's not me. I'm just a guy who heard a podcast and read a paper. I believed I'd found an exploitable wedge between price and value - and I was wrong.
Thankfully the mistake was minor, and reversible (well, I hope so!). Investing forces us to be both arrogant and humble at the same time, believing that the multitude of investors we call the market is wrong, but being conscious that we might be wrong. The world is full of value traps - investments that look "cheap" but are not. Equally, there are opportunities that appear expensive, when in fact the odds of success and future cash flows are sufficiently favourable as so offset a purportedly high price. I credit Charlie Munger and certainly Phil Fisher for clarifying my thinking on this point. Similarly, value investors sometimes take pride in being thrifty or being out-and-out cheapskates in their daily lives. That, I believe, is a big mistake. Knowing the difference between price and value is a crucial component of value investing - and indeed life.
What Buffett is saying is indeed true but did he goof up by talking about the specific rather than the general? In other words, taken in isolation, cheap, cigar butt stocks indeed carry higher risks. However, as a group, there could be a sizeable portion amongst them that turn around and end up giving huge returns to investors.
ReplyDeleteAt least this is what Graham ended up doing and with great results, generating nearly 20% per annum by investing in cheap hated stocks over a period as long as 30 years!
As a matter of fact, a lot of other studies have come away with the same conclusion. The biggest by far was the one conducted by noted analyst James Montier who monitored a global basket of stocks such that almost all of them traded below their liquidation value. And how did it perform? Well, the strategy returned a whopping 35% per annum between 1985 to 2007! Indeed, almost anyone would be willing to be a part of such an outstanding long term record.
I will search for the link of the video / statement from Mohnish Parbai... He asked Munger about if their portfolio is smaller whether they will buy and sell based on Ben Graham model... Munger said yes !!!
ReplyDeleteThanks Jai, if you find that Mohnish Pabrai video, I'd be interested to see it.
DeleteHi nice blog, is there a way to subscribe to your blog??
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