Q&A: Bruce Greenwald, Professor & Investing Expert

'Value is in cheap, obscure and disappointing stocks'

Bruce Greenwald is a professor at Columbia University’s Graduate School of Business and Director of Research at FirstEagle Funds. Called ‘a guru to Wall Street’s gurus’, he is a recognised authority on value investing. Edited excerpts from an interview with Jitendra Kumar Gupta:

Many people focus on the revenue statement or earnings. How important is the balance sheet and what does one look for as a value investor?
The balance sheet is more important than the income statement for value investors, since it provides more reliable valuation information, that does not depend on projecting the future. The exception to this rule is the case of franchise businesses, where long-run earnings depend on competitive advantages, not just assets.

As a value investor what is the starting point before selecting a stock?
The starting point for a value search strategy is ugly (nuclear today), obscure (small caps in Indonesia) and disappointing (Japan, not China or India) stocks that are cheap. Both statistical history and behavioural finance results indicate these stocks will significantly outperform stocks as a whole. The measures to use in screening for these stocks are low market-to-book, low PE (based on several years of lagged earnings), low price-to-cash flow, low sales growth and/or a declining price over at least two years.

What are the basic criteria a value investor will look for before exiting or selling a stock?
Value investors will normally begin selling when a stock gets within 10 per cent of their estimate of intrinsic value and will be completely out when it is 10 per cent above that price.

Warren Buffett says he is 15 per cent (Philip) Fisher and 85 per cent (Benjamin) Graham. As an individual investor, how would one mix the approaches of value and growth investing? Can a pure value approach work?
The critical judgment that has to be made is whether or not the company at issue enjoys the protection of barriers-to-entry/competitive advantages/franchise positions (they are all different ways of referring to the same basic situation). If it does not, then sooner or later entry and competition will drive returns to a level that just justifies the firm’s asset investments.

Thus, asset values supplemented by current earnings power values will be the best measure of what the stock is worth. Also, in these cases, entry and competition will eliminate the value of any market growth, so you do not have to and should not worry about growth rates/opportunities.

For franchise businesses, the value of earnings will be far in excess of asset values and growth matters. Because growth makes it difficult to assign a particular value to firms, you need in these cases to calculate the returns these firms are likely to yield (including growth benefits) on their market values, assuming no improvement in current earnings multiples. If such a return is 12-15 per cent compared to a “market return” of seven-eight per cent, then you have an adequate return-based margin of safety for these ‘Fisher’ stocks. The main point is that good value investors approach the valuation of Fisher/franchise opportunities completely differently from how they approach Graham/non-franchise stocks.