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While working on the 6th edition of my textbook, Corporate Financial Management, I came across a paper which discusses some key points about the nature of true value investing. I thought they might be worth passing on.
The paper is by Dan Hanson. Published in 2013, it is titled “ESG Investing in Graham and Doddsville”, (Journal of Applied Corporate Finance, Vol 25, 3, Summer). ESG stands for environmental, social, and governance. The thesis is that value investors incorporating these considerations into their investment decision-making perform better.
Of course, “Graham and Doddsville” refers to the school of value investing that stems from the book Security Analysis written in the 1930s by Benjamin Graham and David Dodds. Followers of this approach include some very famous investors, not least Warren Buffett, who wrote a speech in 1984 titled The Superinvestors of Graham and Doddsville.
Inspiration
The link between value investing and environmental, social and governance issues is hinted at in a statement Warren Buffett issued about Johns Manville’s sustainability report in 2011 (a subsidiary of Berkshire Hathaway):
“[T]aking shortcuts is not the pathway to achieving sustainable competitive advantage, nor is it an avenue toward satisfying customers. In times such as these, a company must invest in the key ingredients of profitability: its people, communities and the environment.”
Different types of value investing
There are many different types of value investing, but Hanson splits the field into two overarching categories.
1.Intrinsic value business investing. Fundamental analysis. Analysing a business. Estimating intrinsic value by thinking through likely long-term income from the operating business. Only buying an interest when the price is sufficiently attractive relative to intrinsic value to provide a margin of safety.
2.Statistical value investing. E.g. simply obtaining price earnings ratios, book to market ratios, etc. and investing in those below the arbitrary cut off.
Statistical value investing suffers from (a) disregard of fundamentals such as balance sheet quality in terms of risk or financial distress, (b) disregard of earnings quality in terms of knowledge of high-quality, or sustainable, earnings and low-quality cyclical earnings.
Quantitative and qualitative
The intrinsic value business investor needs to examine both the quantitative factors and the qualitative factors to estimate intrinsic value. Quantitative includes balance sheets, income statements and cash flow statements.
Qualitative includes business prospects, competence and integrity of managers, and stability. This incorporates such elements as governance, corporate culture, employee, customer, and supplier relations, and competitive position.
Shift to intangible factors
Hanson points out that profits more often than not these days come from intangible factors such as goodwill or mind-share of consumers.
“as the main source of value in companies has increasingly shifted from tangible to less tangible assets, many followers of Graham & Dodd have delivered exceptional investment results by taking an “earnings-power” approach to high-quality businesses, with enduring competitive advantages that are reflected in high profitability and elevated returns on capital.”
Sustainability framework
Hanson makes the case that ESG has been and will be “an important and effective way of evaluating corporate assets and attributes whose values do not show up on the financial statements” and therefore are key input factors for intrinsic value analysis.
Knowledge of ESG helps us size up sustainable competitive advantage by highlighting the quality of such things as customer franchise, brand attractiveness and intellectual property.
The “E” in “ESG” refers to “Environmental”
It incorporates “efficiency” or “energy intensity.”
Making a profit and being mindful of the environment are not mutually exclusive. Energy use is a cost that is directly borne on the P&L. And a more efficient operational footprint can be a major source of competitive advantage.
•Example: Wal-Mart cut energy use by reducing supply chain complexity. Wal-Mart has also forced suppliers to cut packaging waste and produce less bulky products, e.g. less watered-down liquid detergent. It also increased local sourcing.
There are reputational advantages to general operational excellence.
The “S” in ESG refers to “Social”
Other key words here are Stakeholders, Safety, Social Contract, and Scuttlebutt. The perception of the firm by the general public, business partners, employees, regulators and counterparties. Its social standing and level of respectability.
Phil Fisher, the father of analytical growth investing, described “scuttlebutt research”. One element of this…………..To read the rest of this article, and more like it, subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1.
