Notes on Value Investing

February 6, 2022

Today we review some of the central concepts in value investing.  In order to learn, some repetition is required, especially when the subject may be difficult or counter-intuitive for many.

Here’s the outline:

  • Index Funds or Quant Value Funds
  • The Dangers of DCF
  • Notes on Ben Graham
  • Value vs. Growth
  • The Superinvestors of Graham-and-Doddsville



The first important point is that the vast majority of investors are best off buying and holding a broad market, low-cost index fund.  Warren Buffett has repeatedly made this observation.  See:

In other words, most of us who believe that we can outperform the market over the long term (decades) are wrong.  The statistics on this point are clear.  For instance, see pages 21-25 of Buffett’s 2016 Berkshire Hathaway Shareholder Letter:

A quantitative value investment strategy—especially if focused on micro caps—is likely to do better than an index fund over time.  If you understand why this is the case, then you could adopt such an approach, at least for part of your portfolio.  (The Boole Microcap Fund is a quantitative value fund.)  But you have to be able to stick with it over the long term even though there will sometimes be multi-year periods of underperforming the market.  Easier said than done.  Know Thyself.

We all like to think we know ourselves.  But in many ways we know ourselves much less than we believe we do.  This is especially true when it comes to probabilistic decisions or complex computations.  In these areas, we suffer from cognitive biases which generally cause us to make suboptimal or erroneous choices.  See:

The reason value investing—if properly implemented—works over time is due to the behavioral errors of many investors.  Lakonishok, Shleifer, and Vishny give a good explanation of this in their 1994 paper, “Contrarian Investment, Extrapolation, and Risk.”  Link:

Lakonishok, Shleifer, and Vishny (LSV) offer three reasons why investors follow “naive” strategies:

  • Investors often extrapolate high past earnings growth too far into the future.  Similarly, investors extrapolate low past earnings growth too far into the future.
  • Investors overreact to good news and to bad news.
  • Investors think a well-run company is automatically a good investment.

LSV then state that, for whatever reason, investors overvalue stocks that have done well in the past, causing these “glamour” or “growth” stocks to be overpriced in general.  Similarly, investors undervalue stocks that have done poorly in the past, causing these “value” stocks to be underpriced in general.

Important Note:  Cognitive biases—such as overconfidence, confirmation bias, and hindsight bias—are the main reason why investors extrapolate past trends too far into the future.  For simple and clear descriptions of cognitive biases, see:



For most businesses, it’s very difficult—and often impossible—to predict future earnings and free cash flows.  One reason Warren Buffett and Charlie Munger have produced such an outstanding record at Berkshire Hathaway is because they focus on businesses that are highly predictable.  These types of businesses usually have a sustainable competitive advantage, which is what makes their future earnings and cash flows more certain.  As Buffett put it:

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.

Most businesses do not have a sustainable competitive advantage, and thus are not predictable 5 or 10 years into the future.

Buffett calls a sustainable competitive advantage a moat, which defends the economic “castle.”  Here’s how he described it at the Berkshire Hathaway Shareholder Meeting in 2000:

So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business.  And we tell our managers we want the moat widened every year.  That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes.  However, if the moat is widened every year, the business will do very well.  When we see a moat that’s tenuous in any way – it’s just too risky.  We don’t know how to evaluate that.  And, therefore, we leave it alone.  We think that all of our businesses – or virtually all of our businesses – have pretty darned good moats.

There’s a great book, The Art of Value Investing (Wiley, 2013), by John Heins and Whitney Tilson, which is filled with quotes from top value investors.  Here’s a quote from Bill Ackman, which shows that he strives to invest like Buffett and Munger:

We like simple, predictable, free-cash-flow generative, resilient and sustainable businesses with strong profit-growth opportunities and/or scarcity value.  The type of business Warren Buffett would say has a moat around it.  (page 131)

If the future earnings and cash flows of a business are not predictable, then DCF valuation may not be very reliable.  Moreover, it’s often hard to calculate the cost of capital (the discount rate).

  • DCF refers to “discounted cash flows.”  You can value any business if you can estimate future free cash flow with reasonable accuracy.  To get the present value of the business, the free cash flow in each future year must be discounted back to the present by the cost of capital.

To determine the cost of capital, Buffett and Munger use the opportunity cost of capital, which is the next best investment with a similar level of risk.

  • To illustrate, say they’re considering an investment in Company A, which they feel quite certain will return 15% per year.  To figure out the value of this potential investment, they will find their next best investment – which they may already own – that has a similar level of risk.  Perhaps they own Company N and they feel equally certain that its future returns will be 17% per year.  In that case, if possible, they would prefer to buy more of Company N rather than buying any of Company A.  (Often there are other considerations.  But that’s the gist of it.)

The academic definition of cost of capital includes “beta,” which measures how volatile a stock price has been in the past.  But for value investors like Buffett and Munger, all that matters is how much free cash flow the business will produce in the future.  The degree of volatility of a stock in the past generally has no logical relationship with the next 20-30 years of cash flows.

If a business lacks a true moat and if, therefore, DCF probably won’t work, is there any other way to evaluate a business?  James Montier, in Value Investing (Wiley, 2009), mentions three alternatives to DCF that do not require forecasting:

  • Reverse-engineered DCF
  • Asset Value
  • Earnings Power

In a reverse-engineered DCF, instead of forecasting future growth, you take the current share price and figure out what that implies about future growth.  Then you compare the implied future growth of the business against some reasonable benchmark, like growth of a close competitor.  (You still have to determine a cost of capital.)

As for asset value and earnings power, these were the two methods of valuation suggested by Ben Graham.  For asset value, Graham often suggested using liquidation value, which is usually a conservative estimate of asset value.  If the business could be sold as a going concern, then the assets would probably have a higher value than liquidation value.

Regarding earnings power, Montier quotes Graham from Security Analysis:

What the investor chiefly wants to learn… is the indicated earnings power under the given set of conditions, i.e., what the company might be expected to earn year after year if the business conditions prevailing during the period were to continue unchanged.

Montier again quotes Graham:

It combines a statement of actual earnings, shown over a period of years, with a reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene.  The record must be over a number of years, first because a continued or repeated performance is always more impressive than a single occurrence, and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle.

Montier mentions Bruce Greenwald’s excellent book, Value Investing: From Graham to Buffett and Beyond (Wiley, 2004), for a modern take on asset value and earnings power.



When studying Graham’s methods as presented in Security Analysis—first published in 1934—it’s important to bear in mind that Graham invented value investing during the Great Depression.  Therefore, some of Graham’s methods are arguably overly conservative.  Particularly if you think the Great Depression was caused in part by mistakes in fiscal and monetary policy that are unlikely to be repeated.  Charlie Munger put it as follows:

I don’t love Ben Graham and his ideas the way Warren does.  You have to understand, to Warren—who discovered him at such a young age and then went to work for him—Ben Graham’s insights changed his whole life, and he spent much of his early years worshiping the master at close range.

But I have to say, Ben Graham had a lot to learn as an investor.  His ideas of how to value companies were all shaped by how the Great Crash and the Depression almost destroyed him, and he was always a little afraid of what the market can do.  It left him with an aftermath of fear for the rest of his life, and all his methods were designed to keep that at bay.

That being said, Warren Buffett has always maintained that Chapters 8 and 20 of Ben Graham’s The Intelligent Investor—first published in 1949—contain the three fundamental precepts of value investing:

  • Owning stock is part ownership of the underlying business.
  • Market prices are there to serve you, not to instruct you.  When prices drop a great deal, it may be a good opportunity to buy.  When prices rise quite a bit, it may be a good time to sell.  At all other times, it’s best to focus on the operating results of the businesses you own.
  • The margin of safety is the difference between the price you pay and your estimate of the intrinsic value of the business.  Price is what you pay;  value is what you get.  If you think the business is worth $40 per share, then you would like to pay $20 per share.  (Value investors refer to a stock that’s selling for half its intrinsic value as a “50-cent dollar.”)

The purpose of the margin of safety is to minimize the effects of bad luck, human error, and the vagaries of the future.  Good value investors are right about 60% of the time and wrong 40% of the time.  By systematically minimizing the impact of inevitable mistakes and bad luck, a solid value investing strategy will beat the market over time.  Why?

Here’s why:  As you increase your margin of safety, you simultaneously increase your potential return.  The lower the risk, the higher the potential return.  When you’re wrong, you lose less on average.  When you’re right, you make more on average.

For instance, assume again that you estimate the intrinsic value of the business at $40 per share.

  • If you can pay $20 per share, then you have a good margin of safety.  And if you are right about intrinsic value, then you will make 100% on your investment when the price eventually moves from $20 to $40.
  • What if you managed to pay $10 per share for the same stock?  Then you have an even larger margin of safety relative to the estimated intrinsic value of $40.  As well, if you’re right about intrinsic value, then you will make 300% on your investment when the price eventually moves from $10 to $40.

The notion that you can increase your safety and your potential returns at the same time runs directly contrary to what is commonly taught in modern finance.  In modern finance, you can only increase your potential return by increasing your risk.

A final point about Buffett and Munger’s evolution as investors.  Munger realized early in his career that it was better to buy a high-quality business at a reasonable price, rather than a low-quality business at a cheap price.  Buffett also realized this—partly through Munger’s influence—after experiencing a few failed investments in bad businesses purchased at cheap prices.  Ever since, Buffett and Munger have expressed the lesson as follows:

It’s better to buy a wonderful company at a fair price than a fair company at a wonderful price.

The idea is to pay a reasonable price for a company with a high ROE (return on equity) that can be sustained—due to a moat.  If you hold a high-quality business like this, then over time your returns as an investor will approximate the ROE.  High-quality businesses can have sustainably high ROE’s that range from 20% to over 100%.

Note:  Buffett and Munger also insist that the companies they invest in have low debt (or no debt).  Even a great business can fail if it has too much debt.



One of the seminal academic papers on value investing—which was mentioned earlier—is Lakonishok, Shleifer, and Vishny (1994), “Contrarian Investment, Extrapolation, and Risk.”  Link:

Lakonishok, Shleifer, and Vishny (LSV) show that value investing—buying stocks at low multiples (P/B, P/CF, and P/E)—outperformed glamour (growth) investing by about 10-11% per year from 1968 to 1989.

Here’s why, say LSV:  Investors expect the poor recent performance of value stocks to continue, causing these stocks to trade at lower multiples than is justified by subsequent performance.  And investors expect the recent good performance of glamour stocks to continue, causing these stocks to trade at higher multiples than is justified by subsequent performance.

Interestingly, La Porta (1993 paper) shows that contrarian value investing based directly on analysts’ forecasts of future growth can produce even larger excess returns than value investing based on low multiples.  In other words, betting on the stocks for which analysts have the lowest expectations can outperform the market by an even larger margin.

Moreover, LSV demonstrate that value investing is not riskier.  First, excess returns from value investing cannot be explained by excess volatility.  Furthermore, LSV show that value investing does not underperform during market declines or recessions.  If anything, value investing outperforms during down markets, which makes sense because value investing involves paying prices that are, on average, far below intrinsic value.

In conclusion, LSV ask why countless investors continue to buy glamour stocks and to ignore value stocks.  One chief reason is that buying glamour stocks—generally stocks that have been doing well—may seem “prudent” to many professional investors.  After all, glamour stocks are unlikely to become financially distressed in the near future, whereas value stocks are often already in distress.

In reality, a basket of glamour stocks is not prudent because it will far underperform a basket of value stocks over a sufficiently long period of time.  However, if professional investors choose a basket of value stocks, then they will not only own many stocks experiencing financial distress, but they also risk underperforming for several years in a row.  These are potential career risks that most professional investors would rather avoid.  From that point of view, it may indeed be “prudent” to stick with glamour stocks, despite the lower long-term performance of glamour compared to value.

  • An individual value stock is likely to be more distressed—and thus riskier—than either a glamour stock or an average stock.  But LSV have shown that value stocks, as a group, far outperform both glamour stocks and the market in general, and do so with less risk.  This finding that value stocks, as a group, outperform has been confirmed by many academic studies, including Fama and French (1992).
  • If you follow a quantitative value strategy focused on micro caps, one of the best ways to improve long-term performance is by using the Piotroski F_Score.  It’s a simple measure that strengthens a micro-cap value portfolio by reducing the number of “cheap but weak” companies and increasing the number of “cheap and strong” companies.  See:



Buffett gave a talk at Columbia Business School in 1984 entitled, “The Superinvestors of Graham-and-Doddsville.”  Link:

According to the EMH (Efficient Markets Hypothesis), investors who beat the market year after year are just lucky.  In his talk, Buffett argues as follows:  fifteen years before 1984, he knew a group of people who had learned the value investing approach from Ben Graham and David Dodd.  Now in 1984, fifteen years later, all of these individuals have produced investment track records far in excess of the S&P 500 Index.  Moreover, each of these investors applied the value investing approach in his own way—there was very little overlap in terms of which companies these investors bought.  Buffett simply asks whether this could be due to pure chance.

As a way to think about the issue, Buffett says to imagine a national coin-flipping contest in which all 225 million Americans (the population in 1984) participate.  It is one dollar per flip on the first day, so roughly half the people lose and pay one dollar to the other half who won.  Each day the contest is repeated, but the stakes build up based on all previous winnings.  After 10 straight mornings of this contest, there will be about 220,000 flippers left, each with a bit over $1,000.  Buffett jokes:

Now this group will probably start getting a little puffed up about this, human nature being what it is.  They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.  (page 5)

In another 10 days, there will be about 215 people left who had correctly called the toss of a coin 20 times in a row.  Each would have a little over $1,000,000.  Buffett quips:

By then, this group will really lose their heads.  They will probably write books on ‘How I Turned a Dollar into a Million Working Thirty Seconds a Morning.’  Worse yet, they’ll probably start jetting around the country attending seminars on efficient coin-flipping and tackling skeptical professors with, ‘If it can’t be done, why are there 215 of us?’

But then some business school professor will probably be rude enough to bring up the fact that if 225 million orangutans had engaged in a similar exercise, the results would be much the same—215 egotistical orangutans with 20 straight winning flips.

But assume that the original 225 million orangutans were distributed roughly like the U.S. population.  Buffett then asks:  what if 40 of the 215 winning orangutans were discovered to all be from the same zoo in Omaha?  This would lead one to want to identify common factors for these 40 orangutans.  Buffett says (humorously) that you’d probably ask the zookeeper about their diets, what books they read, etc.  In short, you’d try to identify causal factors.

Buffett remarks that scientific inquiry naturally follows this pattern.  He gives another example:  If there was a rare type of cancer, with 1,500 cases a year in the United States, and 400 of these cases happened in a little mining town in Montana, you’d investigate the water supply there or other variables.  Buffett explains:

You know that it’s not random chance that 400 come from a small area.  You would not necessarily know the causal factors, but you would know where to search.  (page 6)

Buffett then draws the simple, logical conclusion:

I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville.  A concentration of winners that simply cannot be explained by chance can be traced to this particular intellectual village.

Again, Buffett stresses that the only thing these successful investors had in common was adherence to the value investing philosophy.  Each investor applied the philosophy in his own way.  Some, like Walter Schloss, used a very diversified approach with over 100 stocks chosen purely on the basis of quantitative cheapness (low P/B).  Others, like Buffett or Munger, ran very concentrated portfolios and included stocks of companies with high ROE.  And looking at this group on the whole, there was very little overlap in terms of which stocks each value investor decided to put in his portfolio.

Buffett observes that all these successful value investors were focused only on one thing:  price vs. value.  Price is what you pay;  value is what you get.  There was no need to use any academic theories about covariance, beta, the EMH, etc.  Buffett comments that the combination of computing power and mathematical training is likely what led many academics to study the history of prices in great detail.  There have been many useful discoveries, but some things (like beta or the EMH) have been overdone.

Buffett goes through the nine different track records of the market-beating value investors.  Then he summarizes:

So these are nine records of ‘coin-flippers’ from Graham-and-Doddsville.  I haven’t selected them with hindsight from among thousands.  It’s not like I am reciting to you the names of a bunch of lottery winners—people I had never heard of before they won the lottery.  I selected these men years ago based upon their framework for investment decision-making… It’s very important to understand that this group has assumed far less risk than average;  note their record in years when the general market was weak….

Buffett concludes that, in his view, the market is far from being perfectly efficient:

I’m convinced that there is much inefficiency in the market.  These Graham-and-Doddsville investors have successfully exploited gaps between price and value.  When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally.  In fact, market prices are frequently nonsensical.

Buffett also states that value investors view risk and reward in opposite terms to the way academics view risk and reward.  The academic view is that a higher potential reward always requires taking greater risk.  But (as discussed in above in “Notes on Ben Graham”) value investors, having made the distinction between price and value, hold that the lower the risk, the higher the potential reward.  Buffett:

If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case.  The greater the potential for reward in the value portfolio, the less risk there is.

Buffett offers an example:

The Washington Post Company in 1973 was selling for $80 million in the market.  At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more…

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, it’s beta would have been greater.  And to people who think beta [or, more importantly, downside volatility] measures risk, the cheaper price would have made it look riskier.  This is truly Alice in Wonderland.  I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million….



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.


If you are interested in finding out more, please e-mail me or leave a comment.

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Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.