Attached is an excerpt from one such letter written by Paul D. Sonkin of Hummingbird. It was written in 2009, when bargains were abundant. Sonkin was one of the value investors profiled in Bruce Greenwald’s book Value Investing, which can be found in the bookstore above.

1 COMMITMENT TO TRADITIONAL GRAHAM AND DODD VALUE INVESTING

Our strategy is built on the foundation of value investing in the Graham and Dodd tradition. Though value investing may not be exciting, glamorous or sexy, it has been consistently profitable. This discipline was pioneered by Benjamin Graham and advanced by his students Walter Schloss, Irving Kahn, Warren Buffett, and by other alumni of Columbia Business School such as Chuck Royce and Mario Gabelli.

Value investing rests on two intellectual commitments:

• It is possible for the diligent and intelligent investor to establish the real, fundamental, or intrinsic value of some investment securities. A company’s intrinsic value may be based on its assets or its earnings power.
• There are times when the market offers to sell these securities for substantially less than their intrinsic value. The difference between market price and intrinsic value is what Benjamin Graham, in The Intelligent Investor, defined as the margin of safety. The true value investor buys securities only when there is a sufficient margin of safety both to protect the capital that has been invested and to provide a substantial return once the market realizes that the securities have been mispriced.

Over the long run – as long as records have been kept – value investing has outperformed all other styles, although there have been periods during which growth or momentum investing has excelled. Studies by academics and the track records of value managers support this claim. We feel we are in an extraordinary time for value investors–opportunities abound in the current market.

Our basic aim is to buy securities – a fractional ownership in a company – at a discount of their intrinsic value. The questions we are seeking to answer are: (1) Why should I buy the stock? (2) What is going to make the stock go up? (3) How long will it take?

Five factors are crucial in deciding whether a security is a legitimate candidate:

1. Potential upside – the discount to our estimate of intrinsic value

2. Valuation — whether we have the ability to estimate the intrinsic value of this security

3. Certainty – how sure we are of the outcome

4. Time – how long will it take to close the gap between the current price and the intrinsic value

5. The margin of safety – to protect us in case we make a mistake or if something goes wrong

Like most value investors, we do not try to forecast the future course of the securities market. In evaluating the prospects of individual companies, we do not let rosy conjectures of future developments enter into our calculations. Our preference for tangible assets and current earnings implies that we may trail the market during periods of speculative euphoria, when people are willing to pay exorbitant multiples for companies on the basis of little more than hopes and dreams…

 

Share on Facebook

Shiller’s ratio is the same as the one created by Benjamin Graham and David Dodd in 1934. It is self-explanatory. If we ignore the outrageous peak in the Technology, Media, and Telecom (TMT) bubble of 2000, we can see that the P / 10-Year Earnings Ratio is approaching the level of prior peaks in 1929, 1937 and 1966, and that it has already surpassed the peak of 1906. In each case, equity returns after those peaks were less than satisfactory (Source for Shiller data: http://www.econ.yale.edu/~shiller/data.htm).   

After economic conditions, perhaps the most important factor affecting the multiple is investor psychology. Investors were ebullient over the “new” economy in the late 1990s and were willing to pay more for each dollar of earnings than ever before. They bid equity price multiples up to astronomical levels. The moods after 1906, 1929, 1937, and 1966 were less sanguine; so much so that they were given proper names: The “Panic of 1907,” the “Great Depression,” and the “1970s Malaise.”

The moods then were perhaps very similar to today’s mood as most individuals and governments in the aging, developed world (US, Europe, Japan) wonder how they are going to get out from under massive debts. Professor Jeremy Siegal from Wharton thinks he knows the answer: we in the aging, developed world are going to sell all of our assets to the people from the young, developing world.  

Tobin’s Q ratio measures the market value of all public companies relative to what it would cost to replace the assets of those companies. It is already significantly higher than all prior peaks except the 2000 TMT Bubble (Source for Tobin chart: www.dshort.com).

So, are you willing to bet that this time is different? If so, what are the factors that allow you to believe that? What makes you believe that the earnings of US companies will rise significantly in the next several years?

As all value investors know, valuation matters.

Share on Facebook