Value Investing
At its core, all investing is value investing, whether we call it growth or value. The essence of investing lies in laying out money today to receive more in the future. It’s about perceiving greater value in an asset than what you’re paying for it now, whether it’s a financial asset or another form of investment.
Until Ben Graham, the methodologies for valuing companies were not well-structured. Valuing a business requires various skill sets, but the most challenging part is quantifying value into numbers. Financial statements are essentially approximations designed to give a better understanding of a company. The numbers represent the best available knowledge, not absolute certainty. During Ben Graham’s time, there were few systematic methods to value a business. He introduced a more structured approach, focusing on the balance sheet or liquidation value. Graham’s framework determined whether a company was cheap or expensive based on its assets and liabilities. It was highly effective at the time. By correctly interpreting balance sheets, applying a margin of safety, and diversifying adequately, investors could outperform the market using Graham’s principles.
The Evolution of Value Investing
Value investing is not dead, but it has evolved since Graham’s time. Several factors have contributed to these changes:
Instant Access to Information: Today, financial information is readily available to everyone. Markets react quickly to changes, reducing the opportunity to capitalize on inefficiencies.
Simpler Financial Analysis: Financial statements are now standardized, making it easier to understand a company’s position from its balance sheet.
Changing Business Models: The world and businesses have transformed. While traditional companies rely heavily on fixed assets, modern technology companies may have minimal asset requirements.
Increased Competition: Investing has become more competitive. The market is crowded with participants searching for bargains, making traditional Graham-style value investing more challenging.
Warren Buffett: From Cigar Butts to Compounders
Graham’s most famous student, Warren Buffett, provides a perfect example of the evolution of value investing. Over time, Buffett shifted his focus from "cigar butt" investments—cheap companies with a few remaining profitable puffs—to high-quality businesses capable of reinvesting earnings and compounding value. These businesses cannot be valued solely based on liquidation value or balance sheets.
Take Coca-Cola as an example. When Buffett invested in Coca-Cola, the valuation seemed expensive by Graham’s standards, but Buffett saw the company differently. He studied its financial history—possibly dating back to 1919 when Coca-Cola first went public. Understanding a company’s history helps reveal how it has navigated challenges in the past. Buffett calculated Coca-Cola’s earnings power by analyzing trends like per capita consumption and its potential for international growth. During Berkshire Hathaway’s shareholder meetings, Buffett often mentioned Coca-Cola, highlighting his calculation that consumption per capita would rise over time. His analysis was correct. The decision to invest in Coca-Cola was based on a simple but powerful formula: identifying predictable earnings growth over the next 5–10 years. Buffett paid a fair price for a wonderful company, rather than focusing solely on finding cheap bargains.
Modern Investing
Investing today is far more complex due to the instant availability of data. Gone are the days of waiting weeks for company reports from regulatory bodies. While access to real-time data offers advantages, it also presents challenges. Rapid decision-making can lead to mistakes, especially for investors who struggle to manage their emotions. Though financial statements are public and easily accessible, relying solely on numbers can increase the risk of making poor investment decisions.
For example, consider a company earning $200 million EBIT, valued at $1 billion USD. Its operating cash flow is $220 million, with $70 million in capital expenditures, resulting in $140 million in free cash flow. On the surface, paying 5x EBIT or 6.6x free cash flow seems attractive, especially compared to the S&P 500. However, if the company’s earnings before tax decline by 40% the next year, 25% the following year, and 15% the year after, earnings drop to $76 million USD. The valuation would then effectively be 13x EBIT instead of 5x. If earnings continue to deteriorate, the company’s value will inevitably follow. The reasons for declining earnings could include competition, failed product launches, regulatory changes, tariffs, or poor capital allocation by management. What initially seemed like a bargain becomes a costly mistake when viewed through a longer-term lens.
A Broader Perspective
Investing is a complex business. Reading financial statements is one thing, but interpreting them through a broader lens is another. Understanding the nuances behind the numbers is key to making sound investment decisions.
On this topic, I recently read Where the Money Is by Adam Seessel. It’s an excellent book for anyone looking to understand earnings power and the principles behind it. I highly recommend it