Leverage and Value Investing

When I speak of value investing here, I’m not talking about the fame academician’s Eugene Fama notion of value investing. In his version of value investing, returns are 3 dimensional, i.e. they’re ruled by the trinity factors of equity, value and small-cap premium. Prof Fama version of value investing would of course make good money. I am, however, talking about Benjamin Graham’s version of value investing with his notion of margin of safety in investments in stocks of high intrinsic value. In Benjamin’s world, high returns are not the end-all and be-all. There’s, in addition to high return, the additional facet of risk.

Mr. Graham doesn’t believe in risky stocks. In fact, he doesn’t believe that high risk equals high return. This is a fact permeated in his 2 books (Security Analysis and The Intelligent Investor) with his emphasis of safety and financial strength of the bonds and stocks he recommends. He uses metrics such as current ratio and debt to book ratio to screen the stocks universe for companies with utmost financial strength and low leverages.
As a fundamental analyst who uses liquidity and financial strength as a tool at the company level, he is distinct from most modern day investors who prefer to use stock price statistics such as standard deviations and betas. Both types of investors can of course achieve the same aim of a low volatility portfolio; after all, all roads lead to Rome. Having suffered the Great Depression in the 1930s early in his career has left an indelible mark on his investing psyche. Low risk investing in Benjamin’s vocabulary is not something the amnesia-prone modern investors only talk about in an ex-post bear market.

So, are there any downsides to his selection criteria? Not that I know of. The only bias I can think of is he would avert, wholesale, high leverage industries like financial companies such as banks and insurers. I’ve read the 1st and 4th editions of The Intelligent Investor and never once did he recommend a financial institution in the entire book. He did not even bother to use financials as a counter example even though he denounces high leverage. Does it matter to avert entire high leverage industries such as the financial industry? Apparently, Mr. Graham thinks not. Even in his days, the breadth and scope of NYSE is immense and Mr. Graham has plenty of other companies to select from such as railroad, industrial and utility etc. In the whole book of The Intelligent Investor, Benjamin only devotes only a short section to financials where he warns the investor not to buy financial institutions that have too high a price compared to the book value. That’s it!

Highly leveraged companies, as can often be seen, are the speculator advocates, their zigs and zags are often amplified in major bulls and bears markets. In a bull market, they can and do rise spectacularly; in a bear market, they fall precipitously, returning their gains and more to the markets. They’re, however, not the investors’ tool of the trade where the participants tread carefully and conservatively to avoid major mistakes that can cause irreversible loss to their portfolios.

Mr. Graham’s teachings are not in theory only. They contain highly actionable items that perform well both in his day and today. How have the modern day investors performed with the methodology? In fact, very well indeed. If we were to invest in the market since year 2000, his criteria to select cheap stocks based on P/E and P/B will help investors avoid dot-com shares that subsequently fall in prices like nobody business. As the saying goes, the more things change, the more they remain the same. It seems like Mr. Graham has foretold the dot-com debacle and taught us how to avoid it.

How about the financial crisis, you say? Mr. Graham’s emphasis on liquidity and safety would have resulted in his disciples’ avoidance of profitable but highly geared financial stocks. Again, the more things change, the more they remain the same. Sound financial advice, despite the curse of technological and time, remains as sage as ever.

Note also that in the previous 2 bull/bear cycles, Benjamin stock selection criteria did not endear us with exceptional profits in good time; rather, his stock-picking technique makes the bear market much more bearable compared to the rest of the investors. Note also that if you were to follow Fama/French techniques of single-factor selection model, you would have avoided the dot-com bust but not the financial crisis. Therein lays the difference!

In the times ahead, we’re certain that we will face some other crisis just as serious as or even more so than what we have faced in the past. But whatever it is, good financial policy will last and have the last say/laugh in our endeavor with the stock market. Is Mr. Graham’s policy foolproof in every cycle? Your guess is as good as mine. But, I’m sure that on average, he will make my financial journey as pleasant as possible making the bumpy roads ahead much smoother. True, we might face another crisis as severe and long-lasting as the Great Depression and makes all stock investments look foolish, but, I don’t count on that in my planning and decision-making. History has shown that value investing has made up for all that losses made in the Great Depression and much more. As a book title says, it’s the Triumph of the Optimists. Enough said.

(Note: for those fundamental analysts who study financials since before the financial crisis starts until today, you would have noticed that there’s a tremendous de-leveraging process going on. For example, Citigroup, one of US’s largest banks, has a total assets to equity ratio drop from 16.6 pre-financial crises to 9.9 today. US banks such as Citigroup are much safer today, but whether they’re good investments are anyone’s guess. Hopefully, these banks are also more prudent in their loan business and would avoid subprime mortgages unless these are really good deals.)

One thought on “Leverage and Value Investing”

  1. Hi, I am working on a thesis on international portfolio diversification, emerging market, frontier markets. Can you contact me if you are alright to take a short interview? Thank You

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