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1 June 2014 CFA Institute Journal Review

A Novel Equity Valuation and Capital Allocation Model for Use by Long-Term Value-Investors (Digest Summary)

  1. Isaac T. Tabner, CFA

To capture the investment wisdom and stock-selection approach of Benjamin Graham and Warren Buffett, the authors derive a valuation model. Their model is distinguished from other valuation models by its treatment of the expected competitive advantage period (ECAP). Each year, the ECAP is assigned a subjective probability of termination that is independent of the business cycle.

What’s Inside?

Through their valuation model, the authors provide a structure for analyzing the success of long-term value investment strategies applied by Warren Buffett and Benjamin Graham in a two-asset setting that includes cash and stocks. Assumptions underpinning the efficient market hypothesis (EMH) and the capital asset pricing model (CAPM) are relaxed, and the authors aim to reconcile the wisdom of Graham and Buffett with mainstream financial economics. Tiger Brands and Campbell Soup Company are used to illustrate the model, and a comparison between Apple and Coke illustrates the rationale for allocating different expected competitive advantage periods (ECAPs) when valuing these two firms.

How Is This Research Useful to Practitioners?

Determining a sustainable level, growth rate, and lifespan of competitive advantage is challenging when valuing growth companies. The authors present a useful—albeit subjective—framework for determining this valuation by incorporating an ECAP into their model and illustrating how the ECAP might arguably differ between such different categories of firms as Coke in branded goods and Apple in consumer technology. As with other absolute valuation models, application of the authors’ approach does not require the existence of a market; thus, it is suitable for many kinds of enterprise, including private firms.

The authors’ findings emphasize that value and growth should be viewed synonymously, rather than as the discrete and diametrically opposed strategies implicit in such settings as the Fama–French three-factor model. Furthermore, the authors argue (1) that Benjamin Graham’s margin of safety is the only tool that works when investors are faced with Knightian uncertainty, where the probability distribution of outcomes, or even the existence of some possible outcomes, is not known; (2) that valuation techniques are most useful when used to produce range estimates (i.e., probability distributions) rather than point estimates of value; and (3) that contrary to the assumptions of the EMH, value gained does not always coincide with the price paid.

When judging the ECAP, the authors argue that it is best to think in terms of the business moat, its durability, and the extent to which management efforts of the investee firm can be productively used to reinforce it. Finally, they argue that successful evaluation of the margin of safety—and hence, mitigation of Knightian uncertainty—requires identification of resilient business moats and that investors are most likely to achieve this result when remaining within their spheres of competence.

Overall, the greatest benefit to practitioners lies in the provision of a disciplined framework within which to formulate inputs to conventional valuation models.

How Did the Authors Conduct This Research?

This article is theoretical rather than empirical, and only four companies are used to illustrate the arguments underpinning the authors’ approach. Their intuition and contribution are supported by citations from Buffett and Graham as well as by mainstream financial economics. The valuation model is then developed together with a list of assumptions and conditions, followed by the model’s formal derivation from a standard present value model.

The relationship between model value and ECAP is illustrated using the South African firm Tiger Brands as an example. Tiger Brands and Campbell’s Soup Company are then used to demonstrate the evolution of model outputs for each firm over the periods of September 2006–September 2013 and July 2004–July 2013, respectively, and the authors highlight sustained periods of under- and overvaluation. A trading strategy composed of concentrated portfolios invested in stocks during periods of undervaluation and of an all-cash allocation during periods of overvaluation is suggested. No empirical tests, however, are provided for this strategy.

Abstractor’s Viewpoint

The authors provide a helpful framework within which to judge the plausibility of assumptions required for analysis and valuation. It is one of only a few articles that seek to reconcile growth and value investing by developing the insights of Graham and Buffett within a rigorous theoretical framework. Further research could be directed at empirical tests of the model. As in all models, overapplication will result in excess returns being arbitraged away, although the necessity of holding only cash for extended periods may delay this process in cases with a prevailing institutional focus on short-term results.

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