Cover Story

TAKING STOCK
Professor Bruce Greenwald believes that value investing is all about buying
bargains as it’s difficult for investors to outperform the market

Professor Bruce C N Greenwald, pro-

fessor of finance and asset manage-
ment at Columbia Business School, is
the academic Director of the Heilbrunn
Center for Graham & Dodd Investing.
Described by the New York Times as “a
guru to Wall Street’s gurus,” Greenwald
is an authority on value investing.
Greenwald has been recognised for
his outstanding teaching abilities. He
has been the recipient of numerous
awards, including the Columbia Uni-
versity Presidential Teaching Award
which honors the best of Columbia’s
teachers. His classes are consistently
oversubscribed, with more than 650
students taking his courses every year
in subjects such as Value Investing,
Economics of Strategic Behavior, Glo-
balization of Markets, and Strategic
Management of Media. He has co-au-
thored the hugely popular “Value In-
vesting: From Graham to Buffett and
Beyond” (2001) and “Competition De-
mystified: A Radically Simplified Ap-
proach to Business Strategy” (2005).
In an interaction with Outlook
Profit, Greenwald talks about, among
other things, how a valuation model
used by value investors is far more re-
liable than the traditional discounted
cash-flow model used by most analysts.
Excerpts:

Can you tell us why value investing

can result in out performance?
Value investing, developed by Benja-
min Graham and David Dodd at Co-
lumbia University, and practised by
Warren Buffett and Gabelli among oth-
ers has historically outperformed the
market by 3-5 per cent. Value investing
is all about buying bargains.
The efficient market theory says that
investors can’t really do better than the
market, so it’s best to diversify, mini-
mise your transaction cost and not try
to guess which stocks are going to go
up. What people have discovered is
that there are, in fact, ways of statisti-
cally picking stocks that can outper-
form the market.
But when you go in the investment
business, notwithstanding the statisti-
cal evidence, there is an unavoidable
PHOTOS: SANJIT KUNDU
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13 June 2008 Outlook PROFIT
 Cover Story
way in which markets are efficient,
and it is this there are two sides to ev-
ery trade and one of us is always wrong.
Therefore, one way to think of efficien-
cy is to see what it is that makes your
portfolio decisions better the market.
Basically, what Ben Graham recog-
nised is that there were ways to look
at cheap stocks, many of which were
practically obscure. Statistics shows
these kinds of stocks ultimately out-
perform the market.
In every society, people buy lottery
tickets which have always been a crap-
py investment. People will overpay
for the dream and the reverse side of
that is something that looks ugly, so
people will irrationally sell off or shy
away from it. If, I am a fund manag-
er, I’m going to lose the funds under
management if I under-perform in a
significant way. So I copy everybody
and buy the same lottery-ticket stocks
which are going to get bid up more and
more. It is an echo chamber that am-
plifies these behavioral irrationalities
and people never learn.
Can you tell us about the method you
use to arrive at the correct value of a
stock?
When you buy a stock, when you think
you have found an opportunity, it’s
cheap, it’s ignored, and it’s a small-cap
stock. If you want to decide whether to
buy it or not, the conventional way to
go about it would be to do a discount-
ed cash flow for 6-7 years, by getting
a terminal value and calculating the
net present value of all future inflows.
Now in theory, if you know the right
numbers, this will give you the right
answers. In practice it is an incredibly
stupid way to value stocks. And I think
there three reasons for that -- two are
quite obvious and one, a little subtle.
The most obvious reason why it’s a
56
Outlook PROFIT 13 June 2008
bad way to value a stock is that to take
the sum of discounted cash flows, you
have to first estimate near-term cash
flows which is very good information;
then estimate the distant-year cash
flow; finally, you have to find out the
terminal value, which is very bad in-
formation because you don’t really
know what that value is. And when you
add bad information to good informa-
tion, you end up with bad information.
So what you want is a different proce-
dure where you can say ‘this is value
that I’m confident of’; the second piece
is intermediate quality information
that I have semi-confidence in; and the
third piece where there are mistakes
and on which I’m not going to rely on
that much. Discounted models don’t
do that.
The second thing is that there is one
very important piece of information
that this model throws away is the bal-
ance sheet information. The balance
sheet describes the company and any
asset it has. These are very important
elements to think about when you are
buying assets, yet DCF models ignore
the balance sheet.
The third reason is a little more sub-
tle and I will explain it in the context
of Tata Motors and their 1 lakh rupee
car. If you wanted to value that enter-
prise, you would have to estimate sales
over the next 15 years, estimate mar-
gins which is a number, estimate capi-
tal intensity which is a ratio, estimate
the cost of capital which you may not
be able to do accurately especially as
you go deep into the future.
A valuation procedure is a machine
into which you take assumptions like
that, put them and crank it up and wait
for it to throw out a valuation. Now if
the assumptions are bad, you won’t get
a good answer. If it was the best you
could do, that would be fine because
you got to put a number to it.
So how do you deal with it?
There are assumptions that we can
make with confidence about the future
of the Tata Motors’ car. For example,
will there be a market for the 1 lakh ru-
pee car 15 years from now? We think
there will be; this is an economically
viable market. The second question
is do we think that Tata Motors is the
only one who can do this? Bajaj just
announced that they are going to do it
as well, so has Honda. So Tata Motors
is going to have no competitive advan-
tage in that market and 15 years from
now everybody is going to be mak-
ing these cars. Those are strategic as-
sumptions we like to use.
So what Graham and Dodd devel-
oped although they were never explicit
about it is to organise the information
by way of a ‘reliability class’. You start
with the most reliable information that
is the balance sheet. For instance, in
the case of Tata Motors which is in a
viable industry, sooner or later those
assets will have to be reproduced or
replaced in the most efficient manner.
Just work down the balance sheet and
you can look at the reproduction value.
If the company is in a viable industry,
compute the asset value and if it’s in
an unviable industry, look at the liqui-
dation value.
 What I told you is our basic framework.
We haven’t talked about growth at all
because it a complicated question.
What you have to understand about
Then what you look at is the near- can’t copy. That is a barrier to entry, so growth is while everybody says growth
term earnings power of the business. the key research question is looking at is good, it is not. It is a two-edged
Let’s forget growth altogether and we the structure of competitive advantage sword. A growing income stream is
average out for the business cycle and in the market and finding out whether worth a lot more than a flat income
we undo all accounting fallacies, we get that gap is sustainable. stream. But usually to get the grow-
what is the real distributable cash flow. The other possibility is that the as- ing income stream you have to invest.
Rather than using accounting depreci- set reproduction value is 5 billion ru- And the more you invest, the smaller
ation we ask, what will we have to pay pees and the business earns 5 billion the distributable income is. Growth, in
in investment to return the company rupees. That’s exactly what you would cases where the asset value is greater
at the end of the year expect to see if there than the earnings power value, is ac-
to the state at which it were no barriers to tually bad. I don’t care if I’m in India
was in the beginning entry and Tata Motors or China. If it is a crappy management
of the year? That is a
If you want to decide didn’t enjoy any com- investing money in a stupid way or at
much better number whether to buy a petitive advantages. a competitive disadvantage, growth is
because that is what stock or not, the Now you have two your enemy.
you need to really re- conventional way to independent obser- Let us take the case of Tata Motors,
invest. vations on what that where there are no barriers to entry.
So you get a good go about it would be company is worth and I am going to invest 10 billion rupees
idea of what the after- to do a discounted that is going to be far and I have to pay 10 per cent to the peo-
tax earnings power of cash flow for 6-7 more reliable than ple who provided it. If competition is
the business is and years, by getting a DCF. out there, then basically it is not going
if it went on forever, The third possibil- to earn two billion a year because com-
what would the busi- terminal value and ity is the assets are petition will enter and eliminate that.
ness be worth? This calculating the net worth 10 billion ru- So I am going to earn a billion rupees
is your second piece present value pees and earnings are a year and I pay a billion to the people
of most reliable infor- 5 billion rupees. Well, who provided that capital. Growth has
mation. Two things assuming that it is not no value here. That’s the situation in
can happen: one is a dying industry and companies like Mittal Steel which are
the day the earning you have not over-es- expanding capacity in India while de-
power is 10 billion rupees (say for Tata timated the value of the assets, that’s mand is expected to grow by 12 per
Motors) and the assets are worth 5 bil- got to be crappy management because cent or so, which means they will not
lion rupees. Since there are no barriers they are taking 10 bn of assets and pro- make much money. So when you look
to entry in this industry, people could ducing 5 bn of earnings. In this case, at growth in India, you have to be very
create 10 billion in earnings for 5 bil- what you care about is whether you selective. There is also a lot of stuff that
lion rupees in investments and that’s can get rid of these guys. And so you’re Reliance Industries is doing by setting
when the Bajaj and the other foreign going to study the proxy statements; up retail all over India and this is also
car companies are going to come in. the activist investor will focus on that. going to destroy value.
If you saw that and if there was a Notice that in each case, it ties the ulti- The growth that creates value is only
discrepancy between earnings power mate valuation to a critical single ques- where you are protected by barriers to
value and asset value and the earnings tion. entry - where you pay 10 per cent and
power are higher, then Tata Motors get 20 per cent, where earnings pow-
better do something that other people How do you value growth? er value is decisively greater than as-
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13 June 2008 Outlook PROFIT
 Cover Story
set value. Take Hindustan Unilever
which enjoys economies of scale and
also commands the loyalty of custom-
ers. If you are 50 per cent of the mar-
ket and competition has only 10 per
cent of the market, you could kill them
and still make a ton of money. Unile-
ver India has got all powerful competi-
tive advantages and they are going to
make money out of the growing mar-
ket whereas Mittal Steel is a very dif-
ferent story.
Two prime drivers for Indian soft-
ware service companies have
been a depreciating currency
and cheap labour. Would you call
these competitive advantages?
Ask yourself what elements consti-
tute as barriers to entry and these are
the competitive advantages that an in-
cumbent enjoys. There are three types
of competitive advantage: custom-
er captivity; proprietary technology;
and economies of scale. The strength
or weakness of a currency cannot be a
competitive advantage. If a currency
is undervalued or overvalued, the sit-
uation will soon correct itself and the
advantage will go away. The low cost
you described is not an advantage. You
have to differentiate between what is
good for the country and an individual
company. Besides, competitive advan-
tage has to be measured against your
strongest competitors, not your weak-
est ones.
They do not have proprietary technol-
ogy or a cost advantage over the rest of
the Indian players. But what they do
have is customer captivity which is a
relatively useful competitive advan-
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Outlook PROFIT 13 June 2008
tage. These companies have long-term
customer relationships which are go-
ing to be hard to displace. But over
time, their customers would look to
source the same services more cheaply
from other service providers.
If you look at the top 10 Chinese
companies by market value (remem-
ber they all have got cheap labour
and great manufacturing capabilities)
none of them are manufacturing com-
panies – instead, they are natural re-
sources companies. There are only two
manufacturing companies in the top
25: Shanghai Motors and China FAW
and they make 2-4 per cent on equity.
They are not profitable as they have
to compete with other Chinese com-
panies. So China is doing great, wages
are rising and output is expanding but
are companies profitable? No, because
they have to compete.
Despite boasting powerful brands,
some consumer goods companies
compete fiercely in the market place.
Does that not destroy value?
Look at their margins and return on
capital -- it has been going up. People
tell that story because in some indus-
tries it matters but when it comes to
consumer goods, people are fanatically
loyal, for example, to their detergents.
P&G can work like crazy but they are
going to see stable market shares at
best.
So for these companies, you have
to look at each product segments and
consumer behaviour in that segment,
not the company as a whole. By the
way, consumer behaviour is surpris-
ingly uniform across the world. In ev-
ery country, the toothpaste segment
has a single dominant competitor, and
that’s because people use the same
toothpaste forever and ever. They don’t
switch their colas easily either: look at
Coca Cola – people have been drinking
it for a hundred years now.
Similarly, people don’t switch cig-
arettes easily. But shampoos, they
switch all the time. The shampoo busi-
ness is, therefore, more like steel!
The point here is that people who try
to compete without a competitive ad-
vantage will usually lose their shirts.
The famous example of that is AT&T,
which decided in 1982 to go after IBM
in the information processing busi-
ness. IBM had captive customers in the
business and enjoyed big economies
of scale. AT&T did not have either but
still it was considered a ‘strong com-
petitor’ because it had tons of money.
In the next fifteen years or so, AT&T
lost about $100 billion and it’s no lon-
ger even there.
So do you mean new companies can’t
challenge established players?
They can but they need to act smart.
The challenger has to attack the
incumbent where the latter is the
weakest. So if P&G was smart, they
would look at markets where Unilever
has the smallest share geographically
and would set up base there.
When Pepsi went up against Coke,
they targeted the new generation
– who had not taken to the drink yet.
They targeted the north-east and the
mid-west where Coke was the weak-
est. They targeted grocery stores
where Coke did not have a distri-
bution network. Smart companies
don’t run head-on with a competitive
disadvantage.
So these dominant companies are
safer bets?
It depends on what multiples they
trade at. But they are safer because
they have competitive advantages and
their growth is valuable. For the sec-
ondary companies trying to fight their
way in, growth, more often, has nega-
tive value because they are competing
with a disadvantage.
How do you factor in liquidity into
stock valuations?
We don’t! We ignore it completely. Li-
quidity gets built into the price, it
doesn’t get built into the value. Value
is concerned with what is this thing
going to earn? What does it cost to
reproduce the assets? These are the
fundamentals. For value investors, li-
quidity is not a concern and macro is
not a concern. p
 Cover Story

Valuable resources
BOOKS
The Intelligent
Investor –Ben-
jamin Graham’s
The Intelligent
Investor still con-
sidered the Bible
of value investing
– a book no value
investor can start
without.
Security Analysis – Comprises Ben-
jamin Graham’s courses in Columbia
University. Originally part of Dodd’s
notes that he transcribed during Gra-
ham’s classes.
Interpretation of Financial State-
ments – Graham’s first book for the
non- finance people. It instructs how
PAPERS AND LETTERS
The Original Graham and New-
man Letters brings alive the Graham
Newman Corporation, the stocks that
they bought, the times they operated
in and their performances.
Benjamin Graham: The Father of Fi-
nancial Analysis by Irving Kahn and
Robert D. Milne, 1977.
What has worked in Investing: Stud-
ies of Investment Approaches and
Characteristics Associated with Ex-
ceptional Returns by Tweedy, Browne
Company LLC – A study of various
approaches to investing and their re-
spective performances.
Testing Benjamin Graham’s Net
Current Asset Value Strategy in
London by Ying Xiao and Glen C
Arnold –Their study done for the pe-
GRAHAM’S DISCIPLES – VALUE
INVESTORS’ HALL OF FAME
to read the balance sheet and the in-
come statement. Warren Buffett
– The Undis-
Janet Lowe’s The Rediscovered puted succes-
Benjamin Graham – Treasure trove sor and most
of Graham’s articles, lectures and in- successful val-
terviews that he gave. Straight from ue investor ev-
the Master. Must Have! eryone knows
about. Read the
The Memoirs of the Dean of Wall Berkshire Ha-
Street by Benjamin Graham– Again thaway Annu-
straight from the Master himself. Con- al Letters if you
tains his memoirs as he traces back want to learn
his life through all its ups and downs. from the most
successful in-
Benjamin Graham on Value Invest- vestor of all times, straight from War-
ing: Lessons from the Dean of Wall ren at www.berkshirehathaway.com/
Street by Janet Lowe – A concise yet letters/letters.html
comprehensive coverage of Graham’s
life, his strategies and his key lessons. Christopher H Browne author of
“The Little Book of Value Invest-
ing”. Read the Tweedy, Browne Let-
ters and Articles resources avail-
able at www.tweedy.com/content.
riod 1981 to 2005 on stocks trading asp?pageref=reports
with net current assets/market value
greater than 1.5 found them giving an-
nualised return up to 19.7 per cent per Martin J Whit-
year over five holding years. man – Legendary
value investor.
The Superinvestors of Graham- Read his letters
and-Doddsville by Warren Buffett – to shareholders
Based on his 1984 presentation to the of Third Avenue
Columbia University – challenges the Funds to gain
Efficient market hypothesis and Gra- profitable insight
ham’s contribution to making money into value invest-
through market inefficiencies. ing at www.thir-
davenuefunds.
Grahams lectures from the series en- com/taf/aboutus-
titled Current Problems in Security shareholder-letters.html
Analysis that Graham presented at
the New York Institute of Finance Other famous value investors that you
from September 1946 to February must read up on include:
1947 available at www.wiley.com/ William Ruane of the Sequoia Fund,
legacy/products/subject/finance/ Jean-Marie Eveillard of First Eagle
bgraham/index.html Funds, Walter and Edwin Schloss

WEB RESOURCES AND BLOGS

The Heilbrunn Center for Graham &
Dodd Investing has a page on profiles
on various value investors at www.
gsb.columbia.edu/valueinvesting/
schlossarchives/public
www.gsb.columbia.edu/students/or-
ganizations/cima/newsletter.html
for the Graham and Doddsville news-
letters
www.gannononinvesting.com Val-
ue investing blog and value invest-
ing podcast influenced by Benjamin
Graham, Joel Greenblatt, and Warren
Buffett’s value investing model.
www.stocksbelowncav.blogspot.com
- Cheap stocks: Below net current as-
set value, real estate, and other value
strategies
www.grahaminvestor.com Value In-
vesting Benjamin Graham style
http://valueinvestingresource.
blogspot.com Value investing re-
sources
www.moderngraham.com Devoted
to the study and modernisation of the
theories of Graham and Buffett.

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13 June 2008 Outlook PROFIT