Accounting for Value by Stephen Penman

Yesterday, I received a copy of Accounting for Value written by Stephen Penman. His last name is appropriate because he writes well. There are not many accountants who can write about the relationship between value investing and the principles of financial accounting and keep his audience awake; Penman pulls it off and in the process has made a fantastic contribution to this value investor’s library. From the introduction:

“Investors like accounting numbers for another reason. We understand that investing is risky and that risk cannot be eliminated. Modern finance has given us ways to measure risk and ways to reduce it—diversification and hedging, for example—but modern finance does not deal with a primary source of risk: the risk of paying too much for an investment. This, of course, is the concern of the fundamental investor, and that investor needs an accounting that supplies assurance in this regard, an accounting that helps to distinguish value from price.”

I had identified Penman’s “primary risk” in my fund’s marketing materials. Risk is not volatility. To the contrary, volatility creates the opportunity to reduce risk by buying businesses at prices that are much less than they are worth. Too many investors have been indoctrinated with modern finance theory to truly understand this concept.

I quote from my marketing materials here, but similar sentiments are found throughout this blog: “Bottom-up, contrarian investing—investing only when one has a Margin of Safety (MOS)—captures the value premium. A tremendous amount of (our) time and effort is spent in bottom-up analysis of a business’s intrinsic value…A risk-management focus is key. (We) a. require an MOS (which creates asymmetric opportunities); b. concentrate investment in high MOS businesses; c. avoid credit-plagued businesses; d. moderately diversify; and e. hedge.

I disagree slightly with the statement that modern finance has given us ways to measure and reduce risk if by that the author means that we did not have that ability before 1952 (the year Markowitz completed his dissertation). The ability to measure and reduce investment risk has been with us for a long time. From the adage “don’t put all your eggs in one basket” to Graham’s margin of safety investing, measuring and reducing risk was contemplated long before Markowitz used mathematics to prove that diversification reduces risk.

 I highly recommend the book and I am placing it in the Bookstore above.

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