Ben Graham and his disciples like Warren Buffett, Howard Marks and Seth Klarman have developed a system called “value investing.” Eugene Fama and Ken French developed a completely different factor investing approach which identifies “value stocks.” Although Ben Graham’s system and Fama/French’s approach share the word “value,” they are vastly and fundamentally different.
A very smart friend recently said to me that it is important to: “draw a clear and simple definitional distinction between value as a statistical factor (Fama/French) and value as an analytical style or goal (Ben Graham). The two methods are solving for different questions: Fama/French is solving for what creates a persistent disparity of return across large numbers of stocks, while Graham-style value investors are solving for where can I find low risk of permanent impairment of capital and a high probability of an attractive return?”
As a result of the fundamental differences in investing style, value stocks as identified by Fama/French’s factor investing model may not be attractive at all to a value investor as practiced by the disciples of Ben Graham and that a fund constructed using factor investing has nothing to do with Ben Graham’s value investing system.
The backbone of Fama/French’s top-down factors model is the assumption that markets are efficient and therefore returns that outperform the market can only be achieved by taking on greater risk. But when Fama/French looked at the real returns of investors they found anomalies. Since they did not want to abandon the efficient markets hypothesis Fama/French augmented their construct with the idea that there must be undiscovered systematic “risk factors.” Fama/French are now up to five such factors, one of which is the ratio of a company’s Book Equity (Shareholders’ Equity) to Market Equity (Market Capitalization). Thus, “Book to Market” was christened the “value factor.”
In contrast to Fama/French’s top-down approach, the Ben Graham value investing system is based on the premise that to value the stock you must value the specific business on a bottoms-up basis. The value investor’s goal is to estimate a company’s future distributable cash flows and buy it when its share price is trading significantly lower that the intrinsic value implied by these cash flows. For example, the value investor might estimate that a company’s long term cash flows will be $100M per year and buy it because the company’s enterprise value is $500M. It doesn’t take a rocket scientist to see that if you bought something for $500M and it returned $100M per year you would be getting a fantastic return on your investment (20% in this case). The value investing system can outperform the market over the long term, but only if the investor can do the significant work required to implement the four value investing principles: (1) value shares like a proportional interest in a business, (2) have a margin of safety when purchasing shares; (3) understand Mr. Market is bi-polar rather than wise and should be your servant not your master and (4) be rational. The fourth principle is the hardest of all for investors.
Factor-investing does not involve doing any of these things. When someone uses Book to Market as a ratio to measure the inexpensiveness of a stock, he or she is effectively saying there is no difference between a pile of cash in a bank account and an operating company. To such a person, product, customers, production capacity, brand, and operating ability mean absolutely nothing. That’s because Book Value in the ratio is being used as a proxy for intrinsic value and Book Value tells you nothing about a company’s earnings power.
True value investors view the world in reverse. They are concerned with what a company’s operating characteristics tell you about that company’s likely future cash flows. Companies with greater future cash flows are intrinsically worth more than those with less, regardless of what the Book Value of the companies may be.
The bridge between Book Value and earnings/cash flow can be found in a company’s Return on Equity. That is:
Earnings Yield = Return on Equity * Book To Market
Although Fama would concede that the value of business is its discounted future cash flows, he assumes that no one can be better than average at discerning how well a company is likely to perform in the future. The implication in Fama’s framework is that you might as well assume all companies have the same Return on Equity. If all companies have the same Return on Equity then Book to Market tells you everything you need to know about a company’s value. But to the value investor, it is absurd to assume that there is no basis for conservatively estimating companies’ future Returns on Equity.
Value investors spend a lot of time thinking about Return on Equity and Return on Capital. These are the concepts that allow them to differentiate the earnings power of one company vs. another. To Fama/French, value is determined strictly by a database screen that sorts based on book value and price. To a value investor, value is a function of margin of safety, which can be established only by measuring market price against a range of intrinsic values, constructed through a conservative estimation of future cash flows.
Here is a simple way to think about this difference using an analogy. Suppose you want to put together a basketball team (let’s call it Team A). The Fama/French approach would be to recruit 100 of the tallest males in town. This team would do better than average since there is a correlation between height and ability. In the same way there is going to be a statistical correlation between an undervalued company (e.g., a real value investment) and a company with low Book to Market.
Another approach to building the team would be hold tryouts and actually evaluate everyone’s basketball skills (as a Ben Graham style investor might evaluate a company). Someone using this style would pick the top 15 players for this Team B. Team B is probably going to do better than Team A by a large margin even though Team A is better than average. In the same way, a properly constructed portfolio of value investments is going to be better (by a large margin) than a portfolio with several hundred stocks with high Book to Market.
When all is said and done the factor investing approach is essentially a tweak, perhaps an enhancement, on index investing. In contrast, the goal of a value investor is to achieve returns which are significantly higher than a 1 to 2% premium. In other words, factor investing is trying to scrape out a slight statistical edge by tweaking an index fund approach, while the value investor is seeking more significant returns. The proof of each approach’s success is “in the doing.” Investors would benefit from reflecting on the results shared in Warren Buffett’s famous essay The SuperInvestors of Graham and Doddsville to appreciate the superior results value investors have historically achieved and can prospectively aspire to and the updating of those results with actual market performance of investors like Seth Klarman and Howard Marks.
Perhaps this is why many funds do their best to encourage confusion about how value investing differs from factor investing. They want “value” funds that are really factor investing funds to benefit from the halo of a value investing system as successfully practiced by the “superinvestors” descended from the school of Benjamin Graham.
One less known descendent resembles Fama in their use of data, but comes to starkly different conclusions. The firm is named Euclidean Technologies and they use machine learning to do a bottoms-up comparison of the entire operating histories of current companies against thousands of other companies across the past 50 years. They do this to build a foundation for estimating the range of future cash flows a company, with a given set of operating characteristics, might deliver. Then, they invest with an uber-rational systematic process that is protected from the human psychological barriers to buying good companies when Mr. Market offers them at great prices. This approach aligns much more closely with the value investing system and is nothing like buying a collection of companies with the highest book-to-market ratio.
It is an unfortunate fact that many investors appear to assume that what Warren Buffett and other value investors are doing is a form of what Fama talks about when he discusses the value factor. If more investors actually read Ben Graham’s The Intelligent Investor and other books on value investing they would realize that the approaches are fundamentally different.