Quoting Ben Graham is the investing equivalent of calling for the rare B side at a rock concert. The objective is to seem knowledgeable, but all too often the result is to seem pretentious.
The Ben Graham hit most commonly requested by investment fans is “intrinsic value”. The term itself supports an entire sub-industry of professionals who market themselves on the basis of following an intrinsic value process. Take the following quote from the website of an “intrinsic value” fund manager:
“Intrinsic value is not a range of values, rather it is a precise assessment of a company’s value (worth) based on the performance of a company and a view of its future sustainable profitability, also known as normalised return on equity.”
Unfortunately, like plenty of good wisdom, intrinsic value has been tortured from simple concept to simplistic application.
The Myth of Intrinsic Value
There are two problems with this modern interpretation of intrinsic value.
In a narrow sense, it is wrong, bearing little resemblence to Graham’s original idea:
“The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate – e.g. to protect a bond or to justify a stock purchase – or else that the value is considerably higher or considerable lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient”
.. and further..
“Security Analysis cannot presume to lay down general rules as to the “proper value” of any given stock. Practically speaking, there is no such thing. The bases of value are too shifting to admit of any formulation that could claim to be even reasonably accurate.”
Whereas Graham’s focus was on the important idea of value, this is now remarketed as the process of valuation. What began as a critical input into the investment process is often now sold as an output of that process. The former is an essential ingredient to the fundamental value story. The later is a potentially misleading confidence trick.
The second problem is that the idea of fundamental analysis and intrinsic value is often taken too seriously. Like all zealots, fundamental investors believe that theirs is the universal truth. But as Yuval Harari argued in Sapiens, commercial fundamentals are just another form of ‘imagined reality’:
“How exactly did Armand Peugeot, the man, create Peugeot, the company? In much the same way that priests and sorcerers have created gods and demons throughout history, and in which thousands of French curés were still creating Christ’s body every Sunday in the parish churches. It all revolved around telling stories, and convincing people to believe them….
Telling effective stories is not easy. The difficulty lies not in telling the story, but in convincing everyone else to believe it. Much of history revolves around this question: how does one convince millions of people to believe particular stories about gods, or nations, or limited liability companies?”
In essence, intrinsic value is neither intrinsic nor precise. Rather, it is a set of stories about of piece of paper, that is linked to another set of stories about a “company”. We call these types of stories Fundamental Analysis, or Intrinsic Value, but they are stories nonetheless. Graham himself recognised this in perhaps the most frequently misquoted passage in investment history:
“It will be evident from the chart that the influence of what we call analytical factors over the market price is both partial and indirect – partial, becuase is frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions. In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather … the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.“
Avoiding the Myth
There is obviously a large dollop of irony in making fun of people who quote Ben Graham … by quoting Ben Graham. However, there is a broader message to this post.
The message is not that the process of Fundamental Analysis or the idea of Intrinsic Value is a waste of time. Value stories are arguably both more enduring and better capable of understanding than stories that focus on technical analysis or momentum indicators.
The message is to view the elements of the value story as both subjective and subject to the storytelling whims of the market. As Graham again noted:
“… the [PER] ratio itself can scarecely be called a standard, since it is controlled by investment practice instead of controlling it. In other words the “right” price-earnings ratio for any stock is what the market says it is.”
In any fundamental analysis we must understand that a large part of what we are focussed on relates to the stories that other investors tell about fundamentals, not the so called fundamentals themselves. For example:
|Fundamental Belief||Fundamental Story|
|“Our DCF value of stock xyz is $1.15”||“We believe future cash flows will be enough to justfiy investors paying >$1.00 for the company.”|
|“We have done rigourous company and industry analysis and believe that the current PER of 40 is justified by future cash flows.”||“We believe that cash flow growth in the short to medium term will be sufficient to convince investors to continue paying a premium PER for the stock.”|
|“We have met with management many times and believe they are a highly capable team able to execute on their plans.”||“We met with management and thought they were very impressive and so will likely impress other investors too. “|
The simple message could probably be summarised as don’t believe your own bullshit. Understand that the value in fundamental analysis derives primarily from the durability of fundamental and value stories, not from some higher truth. The reaction to the story is often as important to the story itself. Many great novels go unread and plenty of trash becomes best sellers.
Value is certainly a great genre for investment analysis. But taking the step from the concept of value to the process of valuation is not straightforward and it is certainly not precise. We have started on this journey with our recent overview of Value Stories, which summarises the consistent elements in the value narrative (probabilistic, personal, dynamic) and the many different valuation tools that are used to explain this story.