Isenberg Professor's Book Advocates Value Approach to Investments
February 10, 2014
For Isenberg strategy professor Anurag Sharma, investing is both a science and an art and, most importantly, a deep discipline. In his recently published Book of Value, he notes that too many investors mistake in-the-moment prices of securities for their true economic worth. Those prevailing, in-the-moment prices, he says, do incorporate the collective wisdom of a very large number of investors. They also bring efficiency and liquidity to the market-facilitating buying and selling. But, he cautions, prices can just as readily reflect pure sentiment or crowd psychology, which can shift on a dime, often unexpectedly.
To get at the underlying value of an individual security, Book of Value recommends that each investor must be critically aware of his or her own emotions and psychology. To that end, the book's first half explores a history of mass psychology and individual vulnerabilities that value investors should deeply understand. Collective delusions and herd behavior, visceral urges and cognitive errors, seductions of persuasive discourses and clever marketing-Book of Value identifies these themes, and arms the reader with a conceptual framework with which to detect true value in a sea of noise.
The power of negative thinking. According to Sharma, subjecting an investment thesis to critical tests of falsification-a key aspect of scientific method-is central to countering the emotional/psychological distortions that lead to investment missteps. You must subject your investment ideas, he says, to a battery of quantitative and qualitative tests in an attempt to refute or disconfirm them. Doing so would help you sort fact from fiction and true value from pipe dream.
Book of Value's remaining sections detail Sharma's own systematic method for evaluating equities (i.e., valuing businesses). It subjects each potential investment to empirical tests for yield, stability, and strength. It advocates analysis of financial statements and mandatory filings with the Securities and Exchange Commission (SEC)-systematically scrutinizing operating leases, pension and post-retirement obligations, loan guarantees and other off-balance sheet arrangements, lawsuits and legal claims, and quality of assets. And it assesses a firm's economic performance through a battery of capital efficiency ratios and measures of cash flows.
Narrative Analysis. Then the book turns to largely qualitative measures by evaluating a firm's management team via its demographics, its performance track record, and its oversight by its board of directors. It asks: Are the managers good stewards of the resources entrusted to them? Do they create value by competently and creatively managing the company's resources? Do they understand their responsibility to the suppliers of capital at risk, i.e., the shareholders? Finally, the book advocates evaluation of the company's business model, which it describes as the company's economic narrative or story that articulates its overall game plan, the mechanism with which it makes money.
Value is as value does. "I encourage investors to try to refute or disconfirm their investment thesis," observes Sharma. "If the thesis stands up against genuine attempts to disconfirm it, then it might qualify for a place in the short list for a robust portfolio."
Sharma adds that value-focused approaches like his own are ignored by many financial academics and practitioners. But he proudly identifies with a vibrant lineage of value investors beginning with Graham and Dodd (authors of the classic Security Analysis ) and such stalwarts as Phil Fisher and Warren Buffett. Current value-oriented practitioners, he notes, include several hedge fund virtuosos. "Many in academic finance think that Buffett, for example, is a statistical anomaly," remarks Sharma. "But that is because they use an intellectual framework that only makes it seem so. My own focus is to go underneath the appearances and develop an alternate intellectual infrastructure that exposes the fundamentals of good value investing. Instead of asking where prices are going to go next, I encourage investors to ask different questions: Can you evaluate this security? How much is it worth? How much should you pay for it?"