Book Review: The Little Book of Value Investing, by Christopher H. Browne

Summary

There’s a simple distinction between momentum investing, which is buying when prices are rising, and value investing, which is buying when prices are falling.  The entire book is dedicated to the art and science of value investing.

About the author

Christopher Browne is a career broker at his father’s firm of Tweedy, Browne, and Knapp.  The founder, Bill Tweedy, made a fortune by marketing shares of obscure stocks that frequently sold at bargain prices.  The famous Benjamin Graham was one of Tweedy’s clients and advisors.  Graham championed the method of appraising the auction value of a stock in the same way that a banker appraises a loan.  Loan appraisals are based on the borrower’s annual income and the value of the underlying asset.  Graham’s stock appraisal was based on the company’s earnings and net worth.  If the stock of a good company was valued below its net worth with an added margin of safety, then Graham bought the stock.  Many readers consider Graham’s book, Security Analysis, to be the best book on investing.  Christopher Browne’s book is a close runner-up.

Christopher Browne’s core message

The goal of value investing is to outsmart other investors by purchasing stocks at bargain prices for resale at handsome profits.  Market sell-offs (i.e., decline in prices) create opportunities for buying good stocks at prices below their intrinsic value (synonyms: fair value, book value, net worth).  Intrinsic value is determined by a statistical and fundamental analysis.  The statistical model is a set of financial ratios aimed at screening stocks for bargain prices.  For example, the author’s screening criteria are a price-to-book ratio (P/B) of no more than 1.4 and a market capitalization value of at least one million dollars.   The fundamental model is an appraisal of the company for its auction value.  Buying a stock at intrinsic value offers no margin of safety for protecting the investor’s future profit.  Some stocks recover slowly from a sell-off (or never at all!) and the stock price drifts below the investor’s purchase price.  The investor’s principal margin of safety is a market price discounted well below the intrinsic value of the stock.  For example, Benjamin Graham sought stocks that were priced one-third below their intrinsic value in anticipation of profiting from a 50% rebound in price.  The stocks of solid companies with strong balance sheets usually recover from sell-offs and are likely to increase in price at some future date.  An extra margin of safety is achieved by:

  1. Excluding stocks with a high ratio of debt to net worth.  These are likely to liquidate from declining earnings.
  2. Diversifying the stock portfolio to protect from unpredictable adverse conditions.  The diverse stock portfolio inevitably holds winners and losers in any given year.  The idea is to hold more winners than losers.
  3. Avoiding stocks in emerging economies, where speculative earnings reduce the margin of safety.

 “Due diligence” is the examination of financial health to determine if the company has dependable earnings.  Three signs of dependable earnings:

  1. SEC filings of insider trading.  Buying is a sign of confidence that operations are improving and that there will be future gains
  2. Corporate buyback of discounted stock is a sign of future gain.
  3. Activist investors who accumulate at least 5% of outstanding shares must file with the SEC and state whether they are investing or lobbying for change.  Taking an investment position with discounted stock is a sign of future gain.

Conclusions

Browne identified six peer-reviewed studies which show that lower ratios of P/E and P/B outperform higher ratios over holding periods of 14-46 years.  Fewer studies of global stocks also show that low-ratio stocks outperformed high-ratio stocks.  The short chapters of this book present clear descriptions of value investing and financial analysis.  It is well worth reading.

The Little Book of Value Investing, Christopher H. Browne, Forward by Roger Lowenstein, John Wiley & Sons, Inc., Hoboken, 2007.

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