Value philosophy of investing
Value investing was pioneered by Benjamin Graham in the 1930’s and has been practiced by many of the world’s most successful investors of whom the most famous is undoubtedly Warren Buffett. In a nutshell, value investing is about investing in the securities of companies when they are under-valued relative to what their respective businesses are worth.
With careful analysis the value of many (but not all) individual stocks can be estimated with a reasonable degree of certainty. This is known as a stock's 'intrinsic value'. In a perfect world stock prices would always accurately reflect intrinsic value. However, in reality they often do not, or at least not always, and therein lies the opportunity.
Although true value investors (to be distinguished from those for whom value is a marketing label) share a common philosophy there are numerous and slightly differing flavours in how value investing is applied in practice.
Citadel Value Fund’s value philosophy
Like all value funds the Citadel Value Fund focuses on finding and investing in shares that our analysis indicates are selling for far less than their intrinsic value. There are a number of characteristics which are specific to Citadel’s value approach. One is that the Fund invests globally, but exclusively in the more developed markets (OECD countries). The Fund likewise invests in all market capitalisations. We reason that the larger the pool of shares to pick from, the greater the odds of finding deeply undervalued stocks. Compared to many other value funds, Citadel is therefore able to look for even greater discounts to intrinsic value (usually 50%) before investing. We are convinced of the importance of always having a big margin-of-safety.
In constructing the portfolio the Fund takes a two-fold approach; take larger more concentrated positions in the quality businesses available at cheap prices, and smaller positions in the lesser 'classic' value businesses. We prefer investing in the quality business where the business model is proven, management is decent, and cash flows and return on capital are high. Often these opportunities arise after a company’s stock has fallen due to recent uncertainty or problems, and which we judge to be temporary, not structural. A larger position in such companies is justified because the intrinsic values of these firms will steadily grow over time making them increasingly valuable. When market prices make it more difficult to find these sort of companies at value prices, we are not averse to investing in more 'classic' value stocks.
With 'classic' value stocks diversification is more important, and the positions will be much smaller. This is to protect both against the risk that a cheap stock remains cheap, as well as against firm-specific risks. Generally the 'classic' value stock is more controversial than its quality brethren; otherwise its valuation wouldn't be what it was. Results are sometimes weak, the business is often dull, and balance sheets can be stretched. Beyond spreading risk through diversification, we are always prudent in weeding out those with weak balance sheets. This is to avoid the risk that a company is tipped into serious problems (i.e. liquidity problems or worse) if results deteriorate. We are also careful to select only those companies where cash flows are positive or close to it, and which our analysis suggests will improve. When prices get too far out of line, split-ups and acquisitions at far higher prices can occur. Although nice if it happens (and it does with some regularity), we certainly don't build this into the investment case. With a basket of deeply undervalued 'classic' value stocks - even if held for several years - the Fund should earn a good return if even a couple of these holdings periodically move to our estimate of intrinsic value or close to it.
The Citadel Value Fund is ultimately all about bottom-up stock-picking - irrespective of index or sector composition.
The Fund is committed to maintaining a clear, consistent, and disciplined methodology. This means not wavering in strategy, or watering-down the investment criteria to suit the wisdom of the day. A basic principle is not to speculate on how and when stock markets will perform, which sectors will out- or underperform, or which themes will drive stock prices. Few if any investors have ever succeeded in the long-term by practising those approaches. We are firm believers that stock prices are always, (although sometimes it takes a while), driven by the values of the underlying businesses. Solid businesses acquired at very low prices are the best recipe for achieving superior long-term returns, and preserving investors' capital.
The investment process
1) Fundamental company research to find undervalued stocks
The key to identifying undervalued stocks is to thoroughly research and analyse companies, and carefully estimate their intrinsic value. We continuously search for stocks which appear to be very undervalued based on quantitative measures such as Enterprise Value to Sales, EBITDA, EBITA, and Free Cash Flow, Price-to-Book, etc., and then research them in-depth. Researching a company is highly time consuming, and involves analysing the financial statements, researching markets, products and competitors, interviewing management, etc.. It is crucial to reducing potential risks. Companies with very weak balance sheets, a poor track record of spending shareholders' money, or where we simply find it impossible to draw a well-reasoned conclusion are filtered out. We want to be able to layout, with a fair degree of conviction and at least in rough terms, how a company will be faring several years hence. The next important element of our work involves putting a price tag on a company. We do this by constructing detailed business and valuation models. We use a variety of valuation yardsticks (often sector specific), and pay keen attention to the prices paid by the most knowledgeable buyers of companies - other companies in comparable businesses. We attempt to err on the side of cautiousness in this process. The end result is our estimate of a company's intrinsic value, which becomes our target price.
2) Purchase shares at a big discount to their estimated intrinsic value
While research often throws up undervalued stocks, the vast majority are not sufficiently undervalued enough to invest in or have other problems. A select few do make the grade though. Buying at a large discount - as a rule we look for a price of 50% or less of estimated intrinsic value - offers two advantages. It provides a "margin of safety" to protect against unforeseeable risks, while simultaneously offering the potential for substantial share price appreciation.
3) Seek a balance between diversification and focus
Generally, the Fund will hold positions in between 20 and 40 individual stocks. This provides it with a sensible level of diversification to protect against potential disappointments in individual holdings. However, it also allows the Fund to build meaningful positions when our analysis turns up an undervalued gem. Were the number of holdings to be much higher, it would be virtually impossible to carry-out the painstaking research which is crucial to the Fund's investment process.
4) Invest for the long-term
We cannot predict when undervalued shares will rise to their intrinsic value, nor do we believe that others can, at least not consistently or with any degree of reliability. Consequently, we invest with a view to holding stocks for the long-term – often between 3 to 5 years or even longer. Short-term investment success is usually more a question of good luck than good judgement. However, in a portfolio of deeply undervalued stocks, held for the long-term, there is a reasonable probability that several will rise to their estimated intrinsic value on a regular basis, thereby generating attractive returns.
5) Sell holdings when they reach our estimate of intrinsic value
Just as we look to buy based on a careful appraisal of a stock's value, we sell based on the same hard analysis, and look to replace it with another undervalued stock. Speculating that a stock will move above our estimate of intrinsic value is not part of this strategy. When we can’t find a replacement that meets our criteria, we are happy to hold cash until such a time that we can.
More about value investing?
Investors can read more about the Citadel Value Fund's value investment philosophy in its brochure found under DOCS. We also encourage investors to explore the whole history of letters and updates to shareholders found in the NEWS section of the site to learn more about the Fund’s specific approach to value investing and how it is implemented.
For those interested in reading more about value investing in general we would recommend the following literature, although there are numerous other worthwhile books and periodicals:
Warren Buffett's letters to shareholders - These highly readable letters, stretching back decades, give an excellent overview on value investing. They can be found at the Berkshire Hathaway website.
Security Analysis, by Benjamin Graham & David Dodd - Available in several editions this is the 'bible' for value investors, but not an easy read.
The Intelligent Investor, by Benjamin Graham - This is a smaller and more readable book than Security Analysis, and contains several of the most ground-breaking ideas in investing.
Buffett: the making of an American capitalist, by Roger Lowenstein - A superb, well written biography of Buffett which also sheds considerable light on Buffett's approach to value investing.
Common stocks and uncommon profits, by Philip Fisher - A good companion work to Benjamin Graham which stresses a less mechanistic approach to value investing through its emphasis on growth and company quality.