`Value Investing' a classic for investors of today

If Ben Graham seems a bit dated these days, try Greenwald & Co.

Dollars & Sense

November 18, 2001|By Pat Dorsey | Pat Dorsey,MORNINGSTAR.COM

When people ask me for a list of my favorite finance books, Ben Graham's The Intelligent Investor is usually a top pick. However, more than a few folks to whom I've recommended this classic have subsequently complained that the book is dated, with examples that don't seem relevant to 21st-century investing.

Although I think these quibbles are somewhat misguided - there's an old line about those not remembering the past being doomed to repeat it, after all - I finally have a good solution for those wanting an updated manual on value investing.

The book is called, appropriately, Value Investing, and it was written by Columbia University finance professor Bruce Greenwald and three of his colleagues.

Though it's not quite as accessible to the less-experienced investor as Ben Graham's classic, it's essential reading for anyone looking for a fresh perspective on analyzing companies and selecting investments. Those with a little background in finance will benefit from the book's clear prose and its profiles of eight successful value investors, and stock market veterans will enjoy the detailed case studies in which Greenwald applies his ideas to specific companies. The value of Greenwald's book - if you'll excuse the pun - is twofold.

First, it's simply a darn good synthesis of basic competitive analysis. Greenwald reminds us that stocks are businesses first and foremost, and all profitable businesses eventually attract competition that eats into profit margins.

The key here is "eventually," since the degree to which a firm can slow this profit-eroding process is central to assessing the value of its future-earnings stream. If a firm can keep competitors at bay by creating economies of scale, a strong brand, or a captive customer case, the economic value of its future growth will be higher.

The sticky subject of growth leads me to the second major reason you should read Greenwald's book, which is the elegant framework he lays out for analyzing the sources of a company's intrinsic worth. The key here is separating out the value of three things: what a company owns (assets), what a company is capable of earning with those current assets (earnings power) and what a company may be able to earn in the future if it remains profitable and wisely reinvests those profits in the business (growth).

What's cool about this analysis is that Greenwald goes way beyond the Graham approach to asset valuation. He uses the concept of "reproduction cost," which is what a potential competitor would have to spend to go head-to-head with a company.

For example, if CompeteCo wanted to get into IncumbentInc's business, CompeteCo would need to develop the same customer relationships, create the same products and acquire the same licenses - in addition to buying the property, plant and equipment most frequently thought of as "assets."

Although marking up a company's assets from their recorded value to their reproduction cost is obviously an uncertain venture, Greenwald does an excellent job of walking readers through some examples of how the process works.

Greenwald does recognize that a company's earnings power and growth - as well as its assets - can be worth paying for, but he encourages investors to be skeptical about the degree to which each will truly add economic value. After all, growth can just as easily destroy value as it can create it - especially when that growth consumes capital in a highly competitive environment.

As he puts it, "In a world where market prices already exceed asset values ... a contemporary investor had better be able to identify and understand the sources of a company's franchise and the nature of its competitive advantages. Otherwise, he or she is just another punter, taking a flier rather than making an investment."

Although Value Investing isn't perfect, it is one of the better books on investing to hit the shelves in a while.

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