CHAPTER 8
Graham’s Disciples: 
Value Investing
KEY POINTS
Value investors are bargain hunters and many investors describe them-
selves as such. But who is a value investor? In this chapter, we begin by
addressing this question and argue that value investors come in many
forms. Some value investors use specific criteria to screen for what they
categorize as undervalued stocks and invest in these stocks for the long
term. Other value investors believe that bargains are best found in the
aftermath of a sell-off and that the best time to buy a stock is when it
is down. Still others adopt a more activist approach, where they buy
large stakes in companies that they believe are undervalued and push
for changes that they believe will unleash this value.
Value investing is backed by empirical evidence from financial theo-
rists and by anecdotal evidence—the success of value investors like Ben
Graham and Warren Buffett are part of investment mythology—but it is
not for all investors. We will consider what investors need to bring to the
table to succeed at value investing.
WHO IS A VALUE INVESTOR?
Morningstar is a widely used source of mutual fund information, and it
categorized 38 percent of mutual funds as value funds in 2001. But how
did it make this categorization? While it did look at the way these funds
described themselves in their prospectus, the ultimate categorization was
based on a far simpler measure. Any fund that invested in stocks with low
219

price-to-book value ratios or low price earnings ratios, relative to the mar-
ket, was categorized as a value fund. This categorization is fairly conven-
tional, but we believe that it is too narrow a definition and misses the
essence of value investing.
Another widely used definition of value investors suggests that they are
investors interested in buying stocks for less than what they are worth. But
that is too broad a definition, because you could potentially categorize
most active investors as value investors on this basis. After all, growth
investors (who are often viewed as competing with value investors) also
want to buy stocks for less than what they are worth. So, what is the
essence of value investing? To understand value investing, we have to begin
with the proposition that the value of a firm is derived from two sources—
investments that the firm has already made (assets in place) and expected
future investments (growth opportunities). What sets value investors apart
is their desire to buy firms for less than what their assets-in-place are
worth. Consequently, value investors tend to be leery of large premiums
paid by markets for growth opportunities and try to find their best bar-
gains in more mature companies that are out of favor.
Even with this definition of value investing, there are three distinct
strands that we see in value investing. The first and perhaps simplest form
of value investing is passive screening, where companies are put through a
number of investment screens—for example, low PE ratios, marketability,
and low risk—and those that pass the screens are categorized as good
investments. In its second form, you have contrarian value investing, where
you buy assets that are viewed as untouchable by other investors because
of poor past performance or bad news about them. In its third form, you
become an activist value investor who buys equity in undervalued or
poorly managed companies but then uses the power of your position
(which has to be a significant one) to push for change that will unlock this
value.
THE PASSIVE SCREENER
There are many investors who believe that stocks with specific 
characteristics—good management, low risk, and high quality earnings,
for example—outperform other stocks and that the key to investment
success is to identify what these characteristics are. While investors have
always searched for these characteristics, it was Ben Graham in his clas-
sic books on security analysis (with David Dodd) who converted these
qualitative factors into quantitative screens that could be used to find
220 INVESTMENT PHILOSOPHIES

promising investments. In recent years, as data has become more easily
accessible and computing power has expanded, these screens have been
refined and extended, and variations are used by many portfolio man-
agers and investors to pick stocks.
Ben Graham: The Father of Screening
Many value investors claim to trace their antecedents to Ben Graham and to
use the book on security analysis that he co-authored with David Dodd in
1934 as their investment bible. But who was Ben Graham, and what were his
views on investing? Did he invent screening, and do his screens still work?
Graham’s Screens Ben Graham started life as a financial analyst and later
was part of an investment partnership on Wall Street. While he was suc-
cessful on both counts, his reputation was made in the classroom. He
taught at Columbia and the New York Institute of Finance for more than
three decades and during that period developed a loyal following among
his students. In fact, much of Mr. Graham’s fame comes from the success
enjoyed by his students in the market.
It was in the first edition of Security Analysis that Ben Graham put his
mind to converting his views on markets to specific screens that could be
used to find undervalued stocks. While the numbers in the screens did
change slightly from edition to edition, they preserved their original form
and are as follows:
1. Earnings to price ratio that is double the AAA bond yield
2. PE of the stock has to be less than 40 percent of the average PE for all
stocks over the past five years
3. Dividend Yield > Two-thirds of the AAA Corporate Bond Yield
4. Price <> Twice Current Liabilities
8. Debt <> 7%
10. No more than two years of declining earnings over the previous 10
years
Graham’s Disciples: Value Investing 221
1 
Tangible book value is computed by subtracting the value of intangible assets, such as
goodwill, from the total book value.

Any stock that passes all 10 screens, Graham argued, would make a
worthwhile investment. It is worth noting that while there have been a
number of screens that have been developed by practitioners since these
first appeared, many of them are derived from or are subsets of these
original screens.
The Performance How well do Ben Graham’s screens work when it comes to
picking stocks? Henry Oppenheimer studied the portfolios obtained from
these screens from 1974 to 1981 and concluded that you could have made
an annual return well in excess of the market. As we will see later in this sec-
tion, academics have tested individual screens—low PE ratios and high-
dividend yields to name two—in recent years and have found that they
indeed yield portfolios that deliver higher returns. Mark Hulbert, who evalu-
ates the performance of investment newsletters, found newsletters that
espoused to follow Graham did much better than other newsletters.
222 INVESTMENT PHILOSOPHIES
NUMBER WATCH
Stocks that pass the Graham screens: Take a look at the stocks that currently pass
the Graham screens.
The only jarring note is that an attempt to convert the screens into a
mutual fund that would deliver high returns did fail. In the 1970s, an
investor named James Rea was convinced enough of the value of these
screens that he founded a fund called the Rea-Graham Fund, which
would invest in stocks based upon the Graham screens. While it had
some initial successes, the fund floundered during the 1980s and early
1990s and was ranked in the bottom quartile for performance.
The best support for Graham’s views on value investing do not
come from academic studies or the Rea-Graham fund but from the suc-
cess of many of his students at Columbia. While they chose diverse
paths, many of them ended up managing money and posting records of
extraordinary success. In the section that follows, we will look at the
most famous of his students—Warren Buffett.
Warren Buffett: Sage from Omaha
No investor is more lionized or more relentlessly followed than Warren
Buffet. The reason for the fascination is not difficult to fathom. He has
risen to become one of the wealthiest men in the world with his investment

Graham’s Disciples: Value Investing 223
GRAHAM’S MAXIMS ON INVESTING
Janet Lowe, in her biography of Ben Graham, notes that while his lectures
were based upon practical examples, he had a series of maxims that he empha-
sized on investing. Because these maxims can be viewed as the equivalent of
the 10 commandments of value investing, they are worth revisiting:
1. Be an investor, not a speculator. Graham believed that investors bought
companies for the long term, but speculators looked for short-term profits.
2. Know the asking price. Even the best company can be a poor investment at
the wrong (too high) price.
3. Rake the market for bargains. Markets make mistakes.
4. Stay disciplined and buy the formula:
E (2g + 8.5) (T.Bond rate/Y)
where E = Earnings per share, g = Expected growth rate in earnings, Y is the
yield on AAA-rated corporate bonds, and 8.5 is the appropriate multiple for
a firm with no growth. For example, consider a stock with $2 in earnings in
2002 and 10 percent growth rate when the Treasury bond rate was 5 per-
cent and the AAA bond rate was 6 percent. The formula would have yielded
the following price:
Price = $2.00 (2 (10)+8.5)* (5/6) = $47.5
If the stock traded at less than this price, you would buy the stock.
5. Regard corporate figures with suspicion (advice that carries resonance in the
aftermath of recent accounting scandals).
6. Diversify. Do not bet it all on one or a few stocks.
7. When in doubt, stick to quality.
8. Defend your shareholder’s rights. This topic was another issue on which
Graham was ahead of his time. He was one of the first advocates of strong
corporate governance.
9. Be patient. This follows directly from the first maxim.
It was Ben Graham who created the figure of Mr. Market, which was later
much referenced by Warren Buffett. As described by Mr. Graham, Mr. Market
was a manic-depressive who did not mind being ignored and was there to serve
and not to lead you. Investors, he argued, could take advantage of Mr.
Market’s volatile disposition to make money.
acumen, and the pithy comments on the markets that he makes at stock-
holder meetings and in annual reports for his companies are widely read.
In this section, we will consider briefly Buffett’s rise to the top of the
investment world.
Buffett’s History How does one become an investment legend? Warren
Buffett started a partnership with seven limited partners in 1956, when he
was 25, with $105,000 in funds. He generated a 29 percent return over
the next 13 years, developing his own brand of value investing during
the period. One of his most successful investments during the period
was an investment in American Express after the company’s stock price
tumbled in the early 1960s. Buffett justified the investment by pointing
out that the stock was trading at far less than what the American
Express card generated in cash flows for the company for a couple of
years. By 1965, the partnership was at $26 million and was widely
viewed as successful.
The moment that made Buffett’s reputation was his disbanding of the
partnership in 1969 because he could not find any stocks to buy with his
value investing approach. At the time of the disbanding, he said, “On one
point, I am clear. I will not abandon a previous approach whose logic I
understand, although I might find it difficult to apply, even though it may
mean foregoing large and apparently easy profits to embrace an approach
which I don’t fully understand, have not practiced successfully and which
possibly could lead to substantial permanent loss of capital.” The fact that
a money manager would actually put his investment philosophy above
short-term profits, and the drop in stock prices in the years following this
action, played a large role in creating the Buffett legend.
Buffett then put his share of the partnership (about $25 million) into
Berkshire Hathaway, a textile company whose best days seemed to be in
the past. He used Berkshire Hathaway as a vehicle to acquire companies
(GEICO in the insurance business and non-insurance companies such as
See’s Candy, Blue Chip Stamps, and Buffalo News) and to make invest-
ments in other companies (Am Ex, The Washington Post, Coca-Cola, and
Disney). His golden touch seemed to carry over, and Berkshire Hathaway’s
stock price reflected his success (see Figure 8.1).
An investment of $100 in Berkshire Hathaway in December 1988
would have outstripped the S&P 500 four-fold over the next 13 years.
As CEO of the company, Buffett broke with the established practices
of other firms in many ways. He refused to fund the purchase of expen-
sive corporate jets and chose to keep the company in spartan offices in
Omaha, Nebraska. He also refused to split the stock as the price went
ever higher to the point that relatively few individual investors could
afford to buy a round lot in the company. On December 31, 2001, a
share of Berkshire Hathaway stock was trading at $75,600, making it
by far the highest-priced listed stock in the United States. He insisted on
releasing annual reports that were transparent and included his views on
investing and the market, stated in terms that could be understood by all
investors.
224 INVESTMENT PHILOSOPHIES
Graham’s Disciples: Value Investing 225
$0.00
$200.00
$400.00
$600.00
$800.00
$1,000.00
$1,200.00
$1,400.00
$1,600.00
$1,800.00
Value of $ 100 invested 12/88
Berkshire Hathaway
S&P 500
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Year
FIGURE 8.1 Berkshire Hathaway. 
(Source: Raw data from Bloomberg)
BUFFETT’S TENETS
Roger Lowenstein, in his excellent book on Buffett, suggests that Buffett’s suc-
cess can be traced to his adherence to the basic notion that when you buy a
stock, you are buying an underlying business.
Business Tenets:
 The business the company is in should be simple and understandable. In
fact, one of the few critiques of Buffett was his refusal to buy technology
companies, whose business he said was difficult to understand.
 The firm should have a consistent operating history, manifested in operat-
ing earnings that are stable and predictable.
 The firm should be in a business with favorable long-term prospects.
Management Tenets:
 The managers of the company should be candid. As evidenced by the way
he treated his own stockholders, Buffett put a premium on managers he
trusted. Part of the reason he made an investment in The Washington Post
was the high regard that he had for Katherine Graham, who inherited the
paper from her husband.
Assessing Buffett It might be presumptuous of us to assess an investor who
has acquired mythic status, but is Warren Buffett worthy of his reputation?
If so, what accounts for his success, and can it be replicated? We believe that
his reputation is well deserved and that his extended run of success cannot
be attributed to luck. While he has had his bad years, he has always
bounced back in subsequent years. The secret to his success seems to rest on
the long view he brings to companies and his discipline—the unwillingness
to change investment philosophies even in the midst of short-term failure.
Much has been made of the fact that Buffett was a student of Graham at
Columbia University and their adherence to value investing. Warren Buffett’s
investment strategy is more complex than Graham’s original passive screening
approach. Unlike Graham, whose investment strategy was inherently conserv-
226 INVESTMENT PHILOSOPHIES
(Continued)
 The managers of the company should be leaders and not followers. In prac-
tical terms, Buffett was looking for companies that mapped out their own
long-term strategies rather than imitating other firms.
Financial Tenets:
 The company should have a high return on equity, but rather than base the
return on equity on accounting net income, Buffett used a modified version
of what he called owner earnings:
Owner Earnings  Net income  Depreciation and Amortization – Capital
Expenditures
Harking back to Chapter 4, where we looked at valuation, note that this
concept is very close to a free cash flow to equity.
 The company should have high and stable profit margins and a history of
creating value for its stockholders.
Market Tenets:
 In determining value, much has been made of Buffett’s use of a risk-free rate to
discount cash flows. Because he is known to use conservative estimates of earn-
ings and because the firms he invests in tend to be stable firms, it looks to us like
he makes his risk adjustment in the cash flows rather than the discount rate.2
 In keeping with Buffett’s views of Mr. Market as capricious and moody,
even valuable companies can be bought at attractive prices when investors
turn away from them.
2 
In traditional capital budgeting, this approach is called the certainty equivalent approach,
where each expected cash flow is replaced with a lower cash flow, representing its certainty
equivalent.

ative, Buffett’s strategy seems to extend across a far more diverse range of
companies, from high-growth firms like Coca-Cola to staid firms such as Blue
Chip Stamps. While Graham and Buffett both might use screens to find
stocks, the key difference as we see it between the two men is that Graham
strictly adhered to quantitative screens whereas Buffett has been more willing
to consider qualitative screens. For instance, Buffett has always put a signifi-
cant weight on both the credibility and the competence of top managers when
investing in a company.
In more recent years, he has had to struggle with two byproducts of his
success. Buffett’s record of picking winners has attracted a crowd of imita-
tors who follow his every move and buy everything be buys, making it dif-
ficult for him to accumulate large positions at attractive prices. At the same
time, the larger funds at his disposal imply that he is investing far more
than he did two or three decades ago in each of the companies that he
takes a position in, which makes it more difficult for him to be a passive
investor. It should come as no surprise, therefore, that he is a much more
activist investor than he used to be, serving on boards of The Washington
Post and other companies and even operating as interim chairman of
Salomon Brothers during the early 1990s.
Be Like Buffett? Warren Buffett’s approach to investing has been examined in
detail, and it is not a complicated one. Given his track record, you would expect
a large number of imitators. Why, then, do we not see other investors using his
approach to replicate his success? There are three reasons:
 Markets have changed since Buffett started his first partnership. His
greatest successes occurred in the 1960s and the 1970s, when relatively
few investors had access to information about the market and
institutional money management was not dominant. Even Warren
Buffett would have difficulty replicating his success in today’s market,
where information on companies is widely available and dozens of
money managers claim to be looking for bargains in value stocks.
 In recent years, Buffett has adopted a more activist investment style and
has succeeded with it. To succeed with this style as an investor, though,
you would need substantial resources and have the credibility that comes
with investment success. There are few investors, even among successful
money managers, who can claim this combination.
 The third ingredient of Buffett’s success has been patience. As he has
pointed out, he does not buy stocks for the short term but businesses
for the long term. He has often been willing to hold stocks that he
believes to be undervalued through disappointing years. In those same
years, he has faced no pressure from impatient investors because
stockholders in Berkshire Hathaway have such high regard for him.
Graham’s Disciples: Value Investing 227

Many money managers who claim to have the same long-time horizon
that Buffett has come under pressure from investors wanting quick
results.
In short, it is easy to see what Warren Buffett did right over the last half
century, but it will be very difficult for an investor to replicate that success.
In the sections that follow, we will examine both the original value invest-
ing approach that brought him success in the early part of his investing life
and the more activist value investing that has brought him success in recent
years.
Value Screens
The Graham approach to value investing is a screening approach, where
investors adhere to strict screens (like the ones described earlier in the
chapter) and pick stocks that pass those screens. Because the data needed
to screen stocks is widely available today, the key to success with this strat-
egy seems to be picking the right screens. In this section, we will consider a
number of screens used to pick value stocks and the efficacy of these
screens.
Book Value Multiples The book value of equity measures what accountants
consider to be the value of equity in a company. The market value of equity
is what investors attach as a value to the same equity. Investors have used
the relationship between price and book value in a number of investment
strategies, ranging from the simple to the sophisticated. In this section, we
will begin by looking at a number of these strategies and the empirical evi-
dence on their success.
Buy Low Price-to-Book Value Companies Some investors argue that stocks
that trade at low price-book value ratios are undervalued, and there are
several studies that seem to back this strategy. Rosenberg, Reid, and
Lanstein looked at stock returns in the United States between 1973 and
1984 found that the strategy of picking stocks with high book-price
ratios (low price-book values) would have yielded an excess return of
about 4.5 percent a year. In another study of stock returns between
1963 and 1990,3 firms were classified on the basis of book-to-price
ratios into 12 portfolios, and firms in the lowest book-to-price (higher
P/BV) class earned an average annual return of 3.7 percent a year while
228 INVESTMENT PHILOSOPHIES
3 
This study was done by Fama and French in 1992 in the course of an examination of the
effectiveness of different risk and return models in finance. They found that price-to-book
explained more of the variation across stock returns than any other fundamental variable,
including market capitalization.

firms in the highest book-to-price (lowest P/BV) class earned an average
annual return of 24.31 percent for the 1963–1990 period. We updated
these studies to consider how well a strategy of buying low price-to-
book value stocks would have done from 1991 to 2001 and compared
these returns to returns in earlier time periods. The results are summa-
rized in Figure 8.2.
The lowest price-to-book value stocks continued to earn higher
annual returns than the high price-to-book value stocks during the
1990s.
These findings are not unique to the United States. A 1991 study found
that the book-to-market ratio had a strong role in explaining the cross-
section of average returns on Japanese stocks.4 Another study extended the
analysis of price-book value ratios across other international markets, and
found that stocks with low price-book value ratios earned excess returns in
every market analyzed between 1981 and 1992.5 The annualized estimates of
Graham’s Disciples: Value Investing 229
Lowest
2 3 4 5 6 7 8 9 Highest
1927-1960
1961-1990
1991-2001
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
PBV Class
1927-1960 1961-1990 1991-2001
Average Annual Return
FIGURE 8.2 PBV classes and returns—1927–2001.
(Source: Raw data from French)
4 
Chan, Hamao, and Lakonishok (1991) did this study and concluded that low price-to-book
value stocks in Japan earned a considerable premium over high price-to-book value stocks.
5 
Capaul, Rowley, and Sharpe (1993) did this study on international markets.

the return differential earned by stocks with low price-book value ratios,
over the market index, are shown in Table 8.1 in each of the markets studied:
Thus, a strategy of buying low price-to-book value stocks seems to hold
out much promise. Why don’t more investors not use it then, you might
ask? We will consider some of the possible problems with this strategy 
in the next section and screens that can be added on to remove these
problems.
230 INVESTMENT PHILOSOPHIES
TABLE 8.1 Annualized Estimates of the Return Differential
Country Added Return to Low P/BV Portfolio
France 3.26%
Germany 1.39%
Switzerland 1.17%
U.K. 1.09%
Japan 3.43%
U.S. 1.06%
Europe 1.30%
Global 1.88%
NUMBER WATCH
Stocks with lowest price-to-book ratios: Take a look at the stocks with the lowest
price-to-book value ratios in the U.S.
What Can Go Wrong? Stocks with low price-to-book value ratios earn
excess returns relative to high price-to-book stocks if we use conventional
measures of risk and return, such as betas. But, as noted in earlier chap-
ters, these conventional measures of risk are imperfect and incomplete.
Low price-book value ratios might operate as a measure of risk, because
firms with prices well below book value are more likely to be in financial
trouble and go out of business. Investors therefore have to evaluate
whether the additional returns made by such firms justifies the additional
risk taken on by investing in them.
The other limitation of a strategy of buying low price-to-book
value stocks is that the low book value multiples might be well
deserved if companies earn and are expected to continue earning low
returns on equity. In fact, we considered the relationship between

price-to-book value ratios and returns on equity in Chapter 4. For a
stable growth firm, for instance, the price-to-book value ratio can be
written as follows:
Price/Book 
Stocks with low returns on equity should trade at a low price-to-book
value ratio. In fact, a firm that is expected to earn a return on equity that
is less than its cost of equity in the long term should trade at a discount
on book value. In summary, then, as an investor you would want stocks
with low price-to-book ratios that also had reasonable (if not high)
returns on equity and limited exposure to risk.
Composite Screens If low price-to-book value ratios might yield riskier
stocks than average or stocks that have lower returns on equity, a more dis-
cerning strategy would require us to find mismatches—stocks with low price-
to-book ratios, low default risk, and high returns on equity. If we used debt
ratios as a proxy for default risk and the accounting return on equity in the
past year as the proxy for the returns that will be earned on equity in the
future, we would expect companies with low price-to-book value ratios, low
default risk, and high return on equity to be undervalued. This proposition
was partially tested by screening all NYSE stocks from 1981 to 1990 on the
basis of price-book value ratios and returns on equity at the end of each year
and creating two portfolios—an undervalued portfolio with low price-book
value ratios (in the bottom quartile of all stocks) and high returns on equity
(in the top quartile of all stocks) and an overvalued portfolio with high price-
book value ratios (in the top quartile of all stocks) and low returns on equity
(in the bottom quartile of all stocks)—each year and then estimating excess
returns on each portfolio in the following year. Table 8.2 summarizes returns
on these two portfolios for each year from 1982 to 1991.
 1Return on Equity  Expected Growth Rate2
1Return on Equity  Cost of Equity2
Graham’s Disciples: Value Investing 231
NUMBER WATCH
Stocks with low price-to-book ratios and high returns on equity: Take a look at the
stocks that are in the bottom quartile for price to book and the top for ROE.
The undervalued portfolios significantly outperformed the overvalued
portfolios in eight out of 10 years, earning an average of 14.99 percent more
per year between 1982 and 1991, and also had an average return signifi-
cantly higher than the S&P 500. While we did not adjust for default risk in
this test, you could easily add it as a third variable in the screening process.

232 INVESTMENT PHILOSOPHIES
TABLE 8.2 Returns on Mismatched Portfolios: Price to Book and ROE
Year Undervalued Portfolio Overvalued Portfolio S & P 500
1982 37.64% 14.64% 40.35%
1983 34.89% 3.07% 0.68%
1984 20.52% –28.82% 15.43%
1985 46.55% 30.22% 30.97%
1986 33.61% 0.60% 24.44%
1987 –8.80% –0.56% –2.69%
1988 23.52% 7.21% 9.67%
1989 37.50% 16.55% 18.11%
1990 –26.71% –10.98% 6.18%
1991 74.22% 28.76% 31.74%
1982–91 25.60% 10.61% 17.49%
Market Value to Replacement Cost—Tobin’s Q Tobin’s Q provides an alternative to
the price-book value ratio by relating the market value of the firm to the
replacement value of the assets in place. When inflation has pushed up the
price of the assets or where technology has reduced the price of the assets,
this measure might provide a better measure of undervaluation:
Tobin’s Q = Market value of assets / Replacement Value of Assets in place
While this measure has some advantages in theory, it does have practical
problems. The first is that the replacement value of some assets might be diffi-
cult to estimate, largely because they are so specific to each firm. The second is
that even where replacement values are available, substantially more informa-
tion is needed to construct this measure than the traditional price-book value
ratio. In practice, analysts often use shortcuts to arrive at Tobin’s Q, using
book value of assets as a proxy for replacement value. In these cases, the only
distinction between this measure and the price/book value ratio is that this
ratio is stated in terms of the entire firm (rather than just the equity).
The value obtained from Tobin’s Q is determined by two variables—
the market value of the firm and the replacement cost of assets in place. In
inflationary times, where the cost of replacing assets increases significantly,
Tobin’s Q will generally be lower than the unadjusted price-book value
ratio. Conversely, if the cost of replacing assets declines much faster than

the book value, Tobin’s Q will generally be higher than the unadjusted
price-book value ratio.
Many studies in recent years have suggested that a low Tobin’s Q is
indicative of an undervalued or a poorly managed firm, which is more
likely to be taken over. One study concludes that firms with a low Tobin’s
Q are more likely to be taken over for purposes of restructuring and
increasing value.6 That study also found that shareholders of high Q bid-
ders gain significantly more from successful tender offers than shareholders
of low Q bidders.
Earnings Multiples Investors have long argued that stocks with low price-
earnings ratios are more likely to be undervalued and earn excess returns.
In fact, it was the first of Ben Graham’s 10 screens for undervalued stocks.
In this section, we will examine whether it stands up to the promises made
by its proponents.
Empirical Evidence on Low PE Stocks Studies that have looked at the rela-
tionship between PE ratios and excess returns have consistently found that
stocks with low PE ratios earn significantly higher returns than stocks with
high PE ratios over long-time horizons. Figure 8.3 summarizes annual
returns by PE ratio classes for stocks from 1952 to 2001. The classes were
created based upon PE ratios at the beginning of each year and returns
were measured during the course of the year.
Graham’s Disciples: Value Investing 233
NUMBER WATCH
Stocks with highest low PE ratios: Take a look at the stocks with the lowest PE
ratios in the U.S.
Firms in the lowest PE ratio class earned 10 percent more each year
than those in the highest PE class between 1952 and 1971, about 9 percent
more each year between 1971 and 1990, and about 12 percent more each
year between 1991 and 2001.
The excess returns earned by low PE ratio stocks also persist in other
international markets. Table 8.3 summarizes the results of studies looking
at this phenomenon in markets outside the United States.
6 
Lang, Stulz and Walkling (1989) looked at the relationship between Tobin’s Q and
acquisitions.

234 INVESTMENT PHILOSOPHIES
Highest
Lowest
2 3 4 5 6 7 8 9
1952-71
1971-90
1991-2001
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
Average Annual Return
PE Ratio Class
FIGURE 8.3 Returns on PE ratio classes—1952–2001. 
(Source: Raw data from French)
TABLE 8.3 Excess Returns on Low P/E Ratio Stocks by Country: 1989–1994
Annual Premium Earned by Lowest P/E Stocks 
Country (Bottom Quintile) over Market
Australia 3.03%
France 6.40%
Germany 1.06%
Hong Kong 6.60%
Italy 14.16%
Japan 7.30%
Switzerland 9.02%
U.K. 2.40%
Annual premium: Premium earned over an index of equally weighted stocks in that market
between January 1, 1989 and December 31, 1994. These numbers were obtained from a
Merrill Lynch Survey of Proprietary Indices.

Thus, the results seem to hold up as we go across time and markets,
notwithstanding the fact that the findings have been widely disseminated
for more than 20 years.
What Can Go Wrong? Given the types of returns that low PE ratio stocks
earn, should we rush out and buy such stocks? While such a portfolio
might include a number of undervalued companies, it can also contain
other less desirable companies.
(a) Companies with high-risk earnings: The excess returns earned by
low price-earnings ratio stocks can be explained using a variation of
the argument used for low price to book companies—that is, the
risk of low PE ratios stocks is understated in the CAPM. It is
entirely possible that a portfolio of low PE stocks will include stocks
where there is a great deal of uncertainty about future operating
earnings. A related explanation, especially in the aftermath of the
accounting scandals of recent years, is that accounting earnings are
susceptible to manipulation. If earnings are high not because of a
firm’s operating efficiency but because of one-time items such as
gains from divestiture or questionable items such as income from
pension funds, you might discount these earnings more (leading to a
lower PE ratio).
(b) Tax costs: A second possible explanation that can be given for this
phenomenon, which is consistent with an efficient market, is that low
PE ratio stocks generally have large dividend yields, which would have
created a larger tax burden for investors because dividends were taxed
at higher rates during much of this period.
(c) Low growth: A third possibility is that the price earnings ratio is low
because the market expects future growth in earnings to be low or
even negative. Many low PE ratio companies are in mature businesses
where the potential for growth is minimal. As an investor, therefore,
you have to consider whether the tradeoff of a lower PE ratio for lower
growth works in your favor.
Finally, many of the issues we raised about how accountants measure
earnings will also be issues when you use PE ratios. For instance, the fact
that research and development is expensed at technology firms rather than
capitalized might bias their earnings down (and their PE ratios upwards).
Modified Earnings Multiples The price earnings ratio is computed by divid-
ing the current price by the current earnings per share. The latter is both
Graham’s Disciples: Value Investing 235
volatile and subject to measurement error. Are there ways in which we can
modify the ratio to make it a better tool for investment analysis? There are
several variations that may yield more reliable values:
1. Price to normalized earnings: When your primary concern is volatility
in earnings, as is often the case with cyclical and commodity
companies, you can average earnings across a cycle (an economic cycle
for a cyclical firm or a price cycle for a commodity firm) and use it as a
measure of normalized earnings. Only firms that have low price to
normalized earnings would be considered cheap.
2. Price to adjusted earnings: When your concern is with accounting
standards and measurement issues, you may need to restate earnings to
reflect your concerns. For instance, Standard and Poor’s recently came
up with a measure of operating earnings for companies where they
adjust the earnings for the option grants (to management) and remove
earnings from pension funds.
3. Price to cash earnings: When you have non-cash items (such as
depreciation and amortization) significantly affecting measured
earnings, you could argue that looking at the price as a multiple of
cash earnings might give you a better measure of value. In the simplest
form, you add back non-cash charges to earnings:
Price/ Cash Earnings = Price / (Earnings + Depreciation & Amortization)
In its more complex forms, you adjust for changes in non-cash
working capital to convert accrual earnings to cash earnings.
Once you have the modified earnings multiples for firms, you can screen to
find the stocks with the lowest multiples of earnings. There are two final
tests that you need to run on this list to ensure that your portfolio is not
composed of low growth, high-risk companies:
(a) Check for risk: You might want to introduce a screen for risk, using
either market variables (such as standard deviation in stock prices) or
accounting variables (such as debt to equity ratios), and only invest in
stocks with below-average risk.
(b) Assess growth: While it would be unrealistic to expect low PE stocks
to have high growth, you can still apply minimal screens for growth.
For instance, you might want to eliminate firms where earnings have
been declining for the past few years (with no end in sight) or are
growing at rates lower than their sector averages.
236 INVESTMENT PHILOSOPHIES
Revenue Multiples As investors have become more wary about trusting
accounting earnings, an increasing number have started moving up the
income statement looking for numbers that are less susceptible to account-
ing decisions. Not surprisingly, many have ended up screening for stocks
that trade at low multiples of revenues. But how well have revenue multi-
ples worked at picking under valued stocks? In this section, we will begin
by looking at that evidence and then consider some of the limitations of
this strategy.
Graham’s Disciples: Value Investing 237
ENTERPRISE VALUE TO EBITDA MULTIPLES
The earnings per share of a firm reflect not just the earnings from operations
of a firm but all other income as well. Thus, a firm with substantial holdings of
cash and marketable securities might generate enough income on these invest-
ments to push up earnings. In addition, earnings per share and equity multiples
are affected by how much debt a firm has and what its interest expenses are.
These concerns, in conjunction with the volatility induced in earnings by non-
cash expenses (such as depreciation) and varying tax rates has led some
investors to seek a more stable, cash-based measure of pre-debt earnings. One
measure that has acquired a following is called the enterprise value to EBITDA
multiple and is defined as follows:
Enterprise Value to EBITDA =
Why, you might wonder, do we add back debt and subtract out cash?
Because EBITDA is before interest expenses, you would be remiss if you did
not add back debt. Analysts who look at Price/EBITDA will conclude, for
instance, that highly levered firms are cheap. Because we do not count the
income from the cash and marketable securities in EBITDA, we net it out of
the numerator as well.
The sectors where this multiple makes the most sense tend to be heavy
infrastructure businesses—steel, telecommunications, and cable are good
examples. In these sectors, you can screen for stocks with low enterprise value
to EBITDA. As a note of caution, though, in many cases firms that look cheap
on an enterprise value to EBITDA basis often have huge reinvestment needs—
capital expenditures eat up much of the EBITDA—and poor returns on capi-
tal. Thus, we would recommend adding two more screens when you use this
multiple—low reinvestment needs and high return on capital.
1Market Value of Equity  Market Value of Debt  Cash & Marketable Securities
Earnings before interest, taxes, depreciation, and amortization

Empirical Evidence on Price to Sales Ratios There is far less empirical evi-
dence, either for or against, on price to sales ratios than there is 
on price earnings or price-to-book value ratios. In one of the few 
direct tests of the price-sales ratio, Senchack and Martin in 1987 com-
pared the performance of low price-sales ratio portfolios with low price-
earnings ratio portfolios and concluded that the low price-sales ratio
portfolio outperformed the market but not the low price-earnings 
ratio portfolio. They also found that the low price-earnings ratio strategy
earned more consistent returns than a low price-sales ratio strategy, and
that a low price-sales ratio strategy was more biased towards picking
smaller firms. In 1988, Jacobs and Levy tested the value of low price-
sales ratios (standardized by the price-sales ratio of the industries in
which the firms operated) as part of a general effort to disentangle the
forces influencing equity returns. They concluded that low price-sales
ratios, by themselves, yielded an excess return of about 2 percent a year
between 1978 and 1986. Even when other factors were thrown into the
analysis7, the price-sales ratios remained a significant factor in explaining
excess returns (together with price-earnings ratio and size).
238 INVESTMENT PHILOSOPHIES
NUMBER WATCH
Stocks with lowest price to sales ratios: Take a look at the stocks with the lowest
price to sales ratios.
We examined how a portfolio of low price to sales ratios would
have done relative to a portfolio of high price to sales ratios from 1991
to 2001. We found that the returns on the low price to sales ratio port-
folio were no greater than the returns earned on a high price to sales
ratio portfolio over this decade, reflecting the surge of new economy
companies that entered the market during the period with huge price to
sales ratios.
What Can Go Wrong? While firms with low price to sales ratios may
deliver excess returns over long periods, it should be noted, as with low
price to book and price earnings ratios, that there are firms that trade
7 
Jacobs and Levy considered 25 different anomaly measures based upon past studies,
including size, PE, P/BV, earnings momentum measures, relative strength, and neglect.

Composite Revenue Multiples The significance of profit margins in
explaining price-sales ratios suggests that screening on the basis of both
price-sales ratios and profit margins should be more successful at identi-
fying undervalued securities. To test this proposition, the stocks on the
New York Stock Exchange were screened on the basis of price-sales
ratios and profit margins to create undervalued portfolios (price-sales
ratios in the lowest quartile and profit margins in the highest quartile)
and overvalued portfolios (price-sales ratios in the highest quartile and
profit margins in the lowest quartile) at the end of each year from 1981
to 1990. The returns on these portfolios in the following year are sum-
marized in Table 8.4.
Graham’s Disciples: Value Investing 239
NUMBER WATCH
Stocks with highest low price to sales and high margins: Take a look at the stocks
that are in the bottom quartile for price to sales and the top quartile for margin.
at low price to sales ratios that deserve to trade at those values. In
addition to risk being the culprit again—higher risk companies should
have lower price to sales ratios—there are other possible explanations. 
1. High leverage: One of the problems with using price to sales ratios
is that you are dividing the market value of equity by the revenues
of the firm. When a firm has borrowed substantial amounts, it is
entirely possible that its equity will trade at a low multiple of
revenues. If you pick stocks with low price to sales ratios, you might
very well end up with a portfolio of the most highly levered firms in
each sector.
2. Low margins: Firms that operate in businesses with little pricing
power and poor net profit margins will trade at low multiples of
revenues. The reason is intuitive. Ultimately, your value comes not
from your capacity to generate revenues but from the earnings that
you have on those revenues.
The simplest way to deal with the first problem is to redefine the rev-
enue multiple. If you use enterprise value (which adds debt to the numera-
tor and subtracts out cash) instead of market value of equity in the
numerator, you will remove the bias towards highly levered firms. For the
second problem, you would need to screen stocks for reasonable margins.

During the period, the undervalued portfolios outperformed the overval-
ued portfolios in six out of the 10 years, earning an average of 8.28 percent
more per year, and averaged a significantly higher return than the S&P
500.
Dividend Yields While PE ratios, price-to-book ratios, and price to sales ratios
might be the most widely used value screens, there are some investors who
view the dividend yield as the only secure measure of returns. Earnings,
they argue, are not only illusory but are also out of reach for most investor
in stocks because a significant portion might get reinvested. Following up
on this logic, stocks with high dividend yields should be better investments
than stocks with low dividend yields.
Does this approach yield positive results? Between 1952 and 2001, for
instance, stocks with high dividend yields earned higher annual returns
than stocks with low dividend yields, but the relationship is neither as
strong or as consistent as the results obtained from the PE ratio or the PBV
ratio screens. Figure 8.4 summarizes returns earned by dividend yield class
from 1952 to 2001, broken down by sub-periods.
The highest dividend yield stocks earned higher returns than lower div-
idend yield stocks in the 1952–1971 and the 1991–2001 time periods, but
the stocks with the lowest returns were the stocks with average dividends.
240 INVESTMENT PHILOSOPHIES
TABLE 8.4 Returns on Mismatched Portfolios—PS and Net Margins
Year Undervalued Portfolio Overvalued Portfolio S & P 500
1982 50.34% 17.72% 40.35%
1983 31.04% 6.18% 0.68%
1984 12.33% –25.81% 15.43%
1985 53.75% 28.21% 30.97%
1986 27.54% 3.48% 24.44%
1987 –2.28% 8.63% –2.69%
1988 24.96% 16.24% 9.67%
1989 16.64% 17.00% 18.11%
1990 –30.35% –17.46% 6.18%
1991 91.20% 55.13% 31.74%
1982–91 23.76% 15.48% 17.49%

In the 1971–1990 time period, stocks with lower dividend yields outper-
formed stocks with higher dividend yields.
An extreme version of this portfolio is the strategy of investing in the
“Dow Dogs,” the ten stocks with the highest dividend yields in the Dow
30. Proponents of this strategy claim that they generate excess returns from
it, but they compare the returns to what you would have made on the Dow
30 and the S&P 500, and do not adequately adjust for risk. A portfolio
with only 10 stocks in it is likely to have a substantial amount of firm-
specific risk. A study by McQueen, Shields and Thorley in 1997 examined
this strategy and concluded that while the raw returns from buying the top
dividend paying stocks are higher than the returns on the rest of the index,
adjusting for risk and taxes eliminates all the excess returns. A study by
Hirschey in 2000 confirmed this finding.
Graham’s Disciples: Value Investing 241
Highest
Lowest
2 3 4 5 6 7 8 9
1952-71
1971-90
1991-2001
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
Average Annual Return
Dividend yield class
FIGURE 8.4 Returns on dividend yield classes—1952–2001. 
(Source: Raw data from French)
NUMBER WATCH
Stocks with highest dividend yields: Take a look at the stocks with the highest divi-
dend yields in the United States.

There are three final considerations in a high-dividend strategy. The
first is that you will have a much greater tax cost on this strategy, because
dividends are taxed at a higher rate than capital gains. The second is that
some stocks with high dividend yields might currently be paying much
more in dividends than they can afford. It is only a matter of time, then,
before the dividends are cut. The third is that any stock that pays a sub-
stantial portion of its earnings as dividends is reinvesting less and can
therefore expect to grow at a much lower rate.
Determinants of Success
If all we have to do to earn excess returns is invest in stocks that trade at
low multiples of earnings, book value, or revenues, more investors should
employ these screens to pick their portfolios, right? And assuming that they
do, should they not beat the market by a healthy amount?
To answer the first question, there are a large number of portfolio
managers and individual investors who employ either the screens we have
referred to in this section or variants of these screens to pick stocks.
Unfortunately, their performance does not seem to match up to the returns
that we see earned on the hypothetical portfolios. Why might that be? We
can think of several reasons:
 Time horizon: All the studies quoted earlier look at returns over
time horizons of five years or greater. In fact, low price-book value
stocks have underperformed high price-book value stocks over
shorter time periods. The same can be said about PE ratios and price
to sales ratios.
 Dueling screens: If one screen earns you excess returns, three should
do even better seems to be the attitude of some investors who
proceed to multiply the screens they use. They are assisted in this
process by the easy access to both data and screening technology.
There are Web sites (many of which are free) that allow you to
screen stocks (at least in the United States) using multiple criteria.8
The problem, though, is that the use of one screen seems to
undercut the effectiveness of others, leading to worse rather than
better portfolios.
 Absence of diversification: In their enthusiasm for screens, investors
sometimes forget the first principles of diversification. For instance,
242 INVESTMENT PHILOSOPHIES
8 
Stockscreener.com, run by Hoover, is one example. You can screen all listed stocks in the
United States using multiple criteria, including all of the criteria discussed in this chapter.

it is not uncommon to see stocks from one sector disproportionately
represented in portfolios created using screens. A screen from low
PE stocks might deliver a portfolio of banks and utilities, whereas a
screen of low price to book ratios might deliver stocks from a sector
with high infrastructure investments. In 2001, for instance, many
telecom stocks traded at a discount on their book value.
 Taxes and transactions costs: As in any investment strategy, taxes and
transactions costs can take a bite out of returns, although the effect
should become smaller as your time horizon lengthens. Some screens,
though, can increase the effect of taxes and transactions costs. For
instance, screening for stocks with high dividends and low PE ratios
will yield a portfolio that has much higher tax liabilities (because of
the dividends).
 Success and imitation: In some ways, the worst thing that can occur to
a screen (at least from the viewpoint of investors using the screen) is
that its success is publicized and that a large number of investors begin
using that same screen at the same time. In the process of creating
portfolios of the stocks they perceive to be undervalued, they might
very well eliminate the excess returns that drew them to the screen in
the first place.
To be a successful screener, you would need to be able to avoid or manage
these problems. In particular, you need to have a long time horizon, pick
your combination of screens well, and ensure that you are reasonably
diversified. If a screen succeeds, you will probably need to revisit it at regu-
lar intervals to ensure that market learning has not reduced the efficacy of
the screen.
THE CONTRARIAN VALUE INVESTOR
The second strand of value investing that we will examine is contrarian
value investing. In this manifestation of value investing, you begin with the
belief that stocks that are beaten down because of the perception that they
are poor investments (because of poor projects, default risk or bad man-
agement) tend to get punished too much by markets just as stocks that are
viewed as good investments get rewarded too much. Within contrarian
investing, we would include several strategies ranging from relatively unso-
phisticated ones like buying the biggest losers in the market in the prior
period to vulture and distressed security investing, where you use sophisti-
cated quantitative techniques to highlight securities (both stocks and
bonds) issued by troubled firms that may be undervalued.
Graham’s Disciples: Value Investing 243

Basis for Contrarian Investing
Do markets overreact to new information and systematically over price
stocks when the news is good and under price stocks when the news is
bad? There is some evidence that suggests that markets do overreact to
both good and bad news, especially in the long term, and that stocks that
have done exceptionally well or poorly in a period tend to reverse course in
the following period, but only if the period is defined in terms of years
rather than weeks or months.
Strategies and Evidence
While contrarian investing takes many forms, we will consider three strate-
gies in this section. We will begin with the simple strategy of buying stocks
that have gone down the most over the previous period, move on to a
slightly more sophisticated process of playing the expectations game, buy-
ing stocks where expectations have been set too low and selling stocks
where expectations are too high and end the section by looking at a strat-
egy of investing in securities issued by firms in significant operating and
financial trouble.
Buying the Losers In Chapter 7, we presented evidence that stocks reverse
themselves over long periods in the form of negative serial correlation—
that is, stocks that have gone up the most over the past five years are more
likely to go down over the next five years than other stocks. Conversely,
stocks that have gone down the most over the past five years are more
likely to go up than other stocks. In this section, we will consider a strategy
of buying the latter and selling or avoiding the former.
The Evidence How would a strategy of buying the stocks that have gone
down the most over the past few years perform? To isolate the effect of price
reversals on the extreme portfolios, DeBondt and Thaler constructed a win-
ner portfolio of 35 stocks, which had gone up the most over the prior year,
and a loser portfolio of 35 stocks, which had gone down the most over the
prior year, each year from 1933 to 1978, They examined returns on these-
portfolios for the sixty months following the creation of the portfolio. Figure
8.5 graphs the returns on both the loser and winner portfolios.
This analysis suggests that an investor who bought the 35 biggest
losers over the previous year and held for five years would have generated
a cumulative abnormal return of approximately 30 percent over the mar-
ket and about 40 percent relative to an investor who bought the winner
portfolio.
244 INVESTMENT PHILOSOPHIES
This evidence is consistent with market overreaction and suggests that a
simple strategy of buying stocks that have gone down the most over the last
year or years might yield excess returns. Because the strategy is based entirely
on past prices, you could argue that this strategy shares more with charting—
consider it a long term contrarian indicator—than it does with value investing.
Caveats There are many academics as well as practitioners who suggest
that these findings might be interesting but that they overstate potential
returns on loser portfolios for several reasons:
 There is evidence that loser portfolios are more likely to contain low-
priced stocks (selling for less than $5) that generate higher transactions
Graham’s Disciples: Value Investing 245
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
1
4
7
10
13
16
19
22
25
28
31
34
37
40
43
46
49
52
55
58
Cumulative Abnormal Return
Winner stocks
Loser stocks
Month after portfolio formation
FIGURE 8.5 Cumulative abnormal returns—winners versus losers. 
(Source: DeBondt & Thaler)
NUMBER WATCH
Loser stocks: Take a look at the stocks that went down the most over the past
year.
costs and are also more likely to offer heavily skewed returns; that is,
the excess returns come from a few stocks making phenomenal returns
rather than from consistent performance.
 Studies also seem to find loser portfolios created every December earn
significantly higher returns than portfolios created every June. This
statement suggests an interaction between this strategy and tax loss
selling by investors. Because stocks that have gone down the most are
likely to be sold towards the end of each tax year (which ends in
December for most individuals) by investors, their prices might be
pushed down by the tax loss selling.
 There seems to be a size effect when it comes to the differential returns.
When you do not control for firm size, the loser stocks outperform the
winner stocks, but when you match losers and winners of comparable
market value, the only month in which the loser stocks outperform the
winner stocks is January.9
 The final point to be made relates to time horizon. As we noted in the last
chapter, while there may be evidence of price reversals in long periods
(three to five years), there is evidence of price momentum—losing stocks
are more likely to keep losing and winning stocks to keep winning—if
you consider shorter periods (six months to a year). An earlier study that
we referenced, by Jegadeesh and Titman tracked the difference between
winner and loser portfolios10 by the number of months that you held the
portfolios. Their findings are summarized in Figure 8.6.
There are two interesting findings in this graph. The first is that the
winner portfolio actually outperforms the loser portfolio in the first 12
months. The second is that while loser stocks start gaining ground on
winning stocks after 12 months, it took them 28 months in the
1941–1964 time period to get ahead of them and the loser portfolio
does not start outperforming the winner portfolio even with a 36-
month time horizon in the 1965–1989 time period. The payoff to
buying losing companies might depend very heavily on whether you
have the capacity to hold these stocks for long time periods.
Playing the Expectations Game A more sophisticated version of contrarian
investing is to play the expectations game. If you are right about markets
overreacting to recent events, expectations will be set too high for stocks
that have been performing well and too low for stocks that have been
246 INVESTMENT PHILOSOPHIES
9 
See “Size, Seasonality and Stock Market Overreaction” by Zarowin 1990.
10 
The definition of winner and loser portfolios is slightly different in this study. The
portfolios were created based upon returns over the previous six months.
doing badly. If you can isolate these companies, you can buy the latter and
sell the former. In this section, we will consider a couple of ways in which
you can invest on expectations.
Bad Companies Can Be Good Investments Any investment strategy that is based
upon buying well-run companies and expecting the growth in earnings in
these companies to carry prices higher is dangerous, since it ignores the possi-
bility that the current price of the company already reflects the quality of the
management and the firm. If the current price is right (and the market is pay-
ing a premium for quality), the biggest danger is that the firm loses its luster
over time and that the premium paid will dissipate. If the market is exaggerat-
ing the value of the firm, this strategy can lead to poor returns even if the firm
delivers growth. It is only when markets underestimate the value of firm qual-
ity that this strategy stands a chance of making excess returns.
There is some evidence that well managed companies do not always
make good investments. Tom Peters, in his widely read book on excellent
companies a few years ago, outlined some of the qualities that he felt sepa-
rated excellent companies from the rest of the market. Without contesting
his standards, a study went through the perverse exercise of finding compa-
nies that failed on each of the criteria for excellence—a group of unexcellent
Graham’s Disciples: Value Investing 247
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
Cumulative abnormal return (Winner - Loser)
Winners – Losers 1961–64
Winners – Losers 1965–89
Month after portfolio formation
FIGURE 8.6 Differential returns—winner minus loser portfolios. 
(Source: Jegadeesh & Titman)
248 INVESTMENT PHILOSOPHIES
TABLE 8.5 Excellent Versus Unexcellent Companies—Financial Comparison
Excellent Companies Unexcellent Companies
Growth in assets 10.74% 4.77%
Growth in equity 9.37% 3.91%
Return on capital 10.65% 1.68%
Return on equity 12.92% –15.96%
Net margin 6.40% 1.35%
0
50
100
150
200
250
300
350
1
3
5
7
9
11
13
15
17
19
21
23
25
27
29
31
33
35
37
39
41
43
45
47
49
51
53
55
57
59
Months after portfolio formation
Value of $ 100 invested in
 January 1981
Excellent Companies
Unexcellent Companies
FIGURE 8.7 Excellent versus unexcellent companies. 
(Source: Clayman)
companies and contrasting them with a group of excellent companies. Table
8.5 provides summary statistics for both groups.11
The excellent companies clearly are in much better financial shape and
are more profitable than the unexcellent companies (to coin an awkward
phrase), but are they better investments? Figure 8.7 contrasts the returns
that would have been made on these companies versus the excellent ones.
11 
See “Excellence Revisited” by Michelle Clayman, Financial Analysts Journal, May/June
1994, p. 61–66.
The excellent companies might be in better shape financially but the
unexcellent companies would have been much better investments at least
over the time period considered (1981–1985). An investment of $100 in
unexcellent companies in 1981 would have grown to $298 by 1986,
whereas $100 invested in excellent companies would have grown to only
$182. While this study did not control for risk, it does present some evi-
dence that good companies are not necessarily good investments, whereas
bad companies can sometimes be excellent investments.
The second study used a more conventional measure of company qual-
ity. Standard and Poor’s, the ratings agency, assigns quality ratings to stocks
that resemble its bond ratings. Thus, an A rated stock, according to S&P, is a
higher quality investment than a B+ rated stock, and the ratings are based
upon financial measures (such as profitability ratios and financial leverage).
Figure 8.8 summarizes the returns earned by stocks in different ratings
classes, and as with the previous study, the lowest-rated stocks had the high-
est returns and the highest-rated stocks had the lowest returns.
Again, the study is not definitive because it might well reflect the dif-
ferences in risk across these companies, but it indicates that investors who
bought the highest ranked stocks, expecting to earn higher returns, would
have been sorely disappointed.
One version, perhaps an extreme one, of contrarian investing is vulture
investing. In vulture investing, you buy the equity and bonds of companies
that are in bankruptcy and bet either on a restructuring or a recovery. This
Graham’s Disciples: Value Investing 249
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
A+ A A- B+ B B- C/D
Average Annual Return (1986-94) 
S&P Common Stock Rating
FIGURE 8.8 S & P ratings and stock returns.
method is a high-risk strategy where you hope that a few big winners offset
the many losers in your portfolio.
Caveats As with the previous strategy of buying losers, a strategy of buying
companies that rank low on financial criteria is likely to require a long
time horizon and expose you to more risk, both from financial default and
volatility. In addition, the following factors should be kept in mind while
putting together a portfolio of “bad” companies.
The first is that not all companies that are poor performers are badly
managed. Many are in sectors that are in long-term decline and have no
turn-around in sight. It is entirely possible that these companies will con-
tinue to be poor performers in the future. Your odds of success are usually
higher if you buy a poorly performing company in a sector where other
companies are performing well. In other words, you are more likely to get
the upside if there is potential for improvement.
Even if companies have potential for improvement in their sectors, part
of the reason for the poor performance of the companies may be poor
management. If the management of the company is entrenched, either
because the managers hold a significant portion of the equity—at least the
voting shares—or because of anti-takeover amendments in place, there
may be little chance of improved performance in the future. You might
have a better chance of succeeding at your portfolio, if you direct your
investments to poorly managed firms, where there is a high (or at least rea-
sonable) chance of removing incumbent management. You would, for
instance, avoid poorly managed companies with unequal voting rights
(voting and non-voting shares), substantial holdings by incumbent man-
agers or anti-takeover amendments in place.
Finally, risk averse investors who wait for the absolute bottom before
they will invest often fail at this strategy because timing it is just about
impossible. You will have to accept the fact that bad companies will some-
times (or often) become worse before they become better and that this situ-
ation might create some short term damage to your portfolio.
Determinants of Success
The caveats presented in the previous section suggest that success from
buying losers or bad companies is not guaranteed and may prove illusive.
In particular, you need the following:
(a) Long-time horizon: To succeed by buying these companies, you need
to have the capacity to hold the stocks for several years. This
capacity is necessary not only because these stocks require long time
250 INVESTMENT PHILOSOPHIES
periods to recover, but also to allow you to spread the high
transactions costs associated with these strategies over more time.
Note that having a long time horizon as a portfolio manager might
not suffice if your clients can put pressure on you to liquidate
holdings at earlier points. Consequently, you either need clients who
think like you do or clients that have made enough money with you
in the past that their greed overwhelms any trepidation they might
have in your portfolio.
(b) Diversification: Because poor stock price performance is often
precipitated or accompanied by operating and financial problems, it is
very likely that quite a few of the companies in the loser portfolio will
cease to exist. If you are not diversified, your overall returns will be
extremely volatile as a result of a few stocks that lose all their value.
Consequently, you will need to spread your bets across a large number
of stocks in a large number of sectors. One variation that may
accomplish this is to buy the worst performing stock in each sector,
rather than the worst performing stocks in the entire market.
(c) Personal qualities: This strategy is not for investors who are easily
swayed or stressed by bad news about their investments or by the views
of others (analysts, market watchers and friends). Almost by definition,
you will read little that is good about the firms in your portfolio. Instead,
there will be bad news about potential default, management turmoil and
failed strategies at the companies you own. In fact, there might be long
periods after you buy the stock, where the price continues to go down
further, as other investors give up on its future. Many investors who
embark on this strategy find themselves bailing out of their investments
early, unable to hold on to these stocks in the face of the drumbeat of
negative information. In other words, you need both the self-confidence
to stand your ground as others bail out and a stomach for short-term
volatility (especially the downside variety) to succeed with this strategy.
ACTIVIST VALUE INVESTING
One of the more frustrating aspects of passive contrarian investing is that
you, as an investor, do not control your destiny. Thus, you could invest in a
poorly managed company, expecting management to change, but it might
never happen, leaving you with an investment that wilts over time. In activist
value investing, you acquire a large stake in an undervalued or poorly man-
aged company, and then use your position as a large stockholder to push for
changes that will release this value. In other words, you act as the catalyst for
change, and enrich yourself in the process.
Graham’s Disciples: Value Investing 251
Strategies and Evidence
The strategies used by you as an activist value investor will be diverse, and
will reflect why the firm is undervalued in the first place. With a conglomerate
or multi-business firm that sells for less than the sum of its parts, you may
push for divestitures or spin offs of the parts. When investing in a firm that is
being far too conservative in its use of debt, you may push for a recapitaliza-
tion (where the firm borrows money and buys back stock). Investing in a firm
that could be worth more to another firm because of synergy, you may push
for it to become the target of an acquisition. When a company’ s value is
weighted down because it is perceived as having too much cash, you may
demand higher dividends or stock buybacks. In each of these scenarios, you
will have to confront incumbent managers who are reluctant to make these
changes. In fact, if your concerns are broadly about management competence,
you might even push for a change in the top management of the firm.
Breaking up Is Hard to Do There are cases where large firms that operate in
multiple businesses are penalized by the market, either because they are too
complex to value or because of a perceived lack of efficiency that comes
from being unfocused. In these cases, you could argue that pushing the
firm to break up might create value for the component parts. In this sec-
tion, we will first consider the overall evidence on how the market values
multi-business firms, and then consider ways in which you might be able to
release value at these firms.
The Conglomerate Discount For the past few decades, strategists have gone
back and forth on whether becoming a conglomerate creates or destroys
value. In the 1960s and through much of the 1970s, the view was that con-
glomerates created value, relative to their individual pieces, because you could
pool the strengths of the pieces to create a more powerful firm. A hidden sub-
text to many of these arguments was the premise that conglomerates were
somehow less risky and more valuable than their individual components
because they were able to diversify away risk. Financial theorists pointed out
the fallacy in this argument by noting that individual investors could have
accomplished the same diversification at far lower cost. Later, the argument
shifted to one of superior management transferring its skills to poorly man-
aged firms in different businesses, and creating often unnamed synergies.
Empiricists have approached this question from a different perspective.
They have looked at the question of whether conglomerates trade at a pre-
mium or discount to their parts. To make this judgment, they value the pieces
of a conglomerate, using the typical multiple at which independent firms in
the business trade. Thus, you could break GE down into nine parts, and value
each part based upon the enterprise value to EBITDA or PE ratio at which
252 INVESTMENT PHILOSOPHIES
other firms in each business trade. You can then add up the values of the parts
and compare it to the value of the conglomerate. In this comparison, the evi-
dence12 seems to indicate that conglomerates trade at significant discounts
(ranging from 5–10 percent, depending upon the study) to their piecewise val-
ues. While one can contest the magnitude of these discounts on estimation
grounds—it is difficult to estimate the true earnings of GE Capital, given allo-
cations and other pooled costs—it is clear that some multi-business firms
would be worth more as individual businesses.
So what can an activist investor who buys stock in such a company do to
claim this surplus value? The most drastic step, in terms of separation from
the parent company and existing management, is a divestiture of the individ-
ual pieces. There are less drastic alternatives as well, such as spinoffs and
split-offs of independent businesses, that might accomplish the separation
while preserving some of the benefits generated by having a linkage.
Divestitures In a divestiture, a firm sells assets or a division to the highest
bidder. On the sale, it receives cash that is either reinvested in new assets or
returned to stockholders as dividends or stock buybacks. It is the most
drastic of the actions described in this section, since the divested assets will
belong to a new buyer and any connections with the parent company will
be severed.
Process and Effect on Value A divestiture can be initiated either by the
divesting firm or by an interested buyer. In the first case, the divesting firm
will offer assets for sale and invite potential bids. If the assets have substan-
tial value, it will use the services of an investment banker in seeking out
bidders. In the second case, the process starts with an interested buyer
approaching the firm and offering to buy a division or assets. While this
buyer cannot force the divestiture, it can elicit interest if it offers a high
enough price. The final price will then be determined by negotiations
between the two sides.
How does a divestiture affect a firm’s value? To answer, you would
need to compare the price received on the divestiture to the present value
of the expected cash flows that the firm would have received from the
divested assets. There are three possible scenarios:
1. If the proceeds from the divestiture are equal to the present value of
the expected cash flows, the divestiture will have no effect on the
divesting firm’s value.
Graham’s Disciples: Value Investing 253
12 
See Berger and Ofek, 1995, “Diversification’s Effect on Firm Value” and Lang & Stulz,
1994, Tobin’s Q, Corporate Diversification and Firm Performance.
2. If the proceeds from the divestiture are greater than the present value
of the expected cash flows, the value of the divesting firm will increase
on the divestiture.
3. If the proceeds from the divestiture are less than the present value of the
expected cash flows, the value of the firm will decrease on the divestiture.
The divesting firm receives cash in return for the assets and can choose to
retain the cash and invest it in marketable securities, invest the cash in
other assets or new investments, or return the cash to stockholders in the
form of dividends or stock buybacks. This action, in turn, can have a sec-
ondary effect on value.
Reasons for Divestitures Why would a firm sell assets or a division? There
are at least three reasons. The first is that the divested assets may have a
higher value to the buyer of these assets. For assets to have a higher value,
they have to either generate higher cash flows for the buyers or result in
lower risk (leading to a lower discount rate). The higher cash flows can
occur because the buyer is more efficient at utilizing the assets, or because
the buyer finds synergies with its existing businesses. The lower discount
rate might reflect the fact that the owners of the buying firm are more
diversified than the owners of the firm selling the assets. In either case,
both sides can gain from the divestiture and share in the increased value.
The second reason for divestitures is less value-driven and more a
result of the immediate cash flow needs of the divesting firm. Firms that
find themselves unable to meet their current operating or financial
expenses might have to sell assets to raise cash. For instance, many lever-
aged acquisitions in the 1980s were followed by divestitures of assets. The
cash generated from these divestitures was used to retire and service debt.
The third reason for divestitures relates to the assets not sold by the firm,
rather than the divested assets. In some cases, a firm might find the cash
flows and values of its core businesses affected by the fact that it has diversi-
fied into unrelated businesses. This lack of focus can be remedied by selling
assets or businesses that are peripheral to the main business of a firm.
Market Reaction to Divestitures A number of empirical questions are worth
asking about divestitures. What types of firms are most likely to divest
assets? What happens to the stock price when assets are divested? What
effect do divestitures have on the operating performance of the divesting
firm? Let us look at the evidence on each of these questions.
There are three scenarios in which firms divest assets. In the first, the firms
are forced by the government to divest because of antitrust laws. The second
occurs when financially distressed firms need the cash to meet their financial
254 INVESTMENT PHILOSOPHIES
obligations. In the third scenario, divestitures are part of a major restructuring
effort, designed to return a firm to its core businesses. In some cases this
process is initiated by the existing management, and in some cases by an
acquirer. One study13 looked at firms that were targets of hostile acquisitions,
and noted that there were substantial asset divestitures in 60 percent of them;
more than half the assets of the firms were divested in these cases. The divesti-
tures were of units that were distinct from the rest of the firm’s business and
often had been acquired as part of an earlier diversification effort.
In a study in 1984, Linn and Rozeff examined the price reaction to
announcements of divestitures by firms and reported an average excess
return of 1.45 percent for 77 divestitures between 1977 and 1982. They
also noted an interesting contrast between firms that announce the sale
price and motive for the divestiture at the time of the divestiture, and those
that do not: in general, markets react much more positively to the first
group than to the second, as shown in Table 8.6.
It appears that financial markets view firms that are evasive about the
reasons for and the proceeds from divestitures with skepticism. This find-
ing was confirmed by Klein in 1996, who noted that the excess returns are
positive only for those divestitures where the price is announced at the
same time as the divestiture. She extended the study and concluded that the
magnitude of the excess return is a function of the size of the divestiture.
For example, when the divestiture is less than 10 percent of the equity of
the firm, there is no significant price effect, whereas if it exceeds 50 per-
cent, the stock price increases by more than 8 percent.
Studies that have looked at the performance of parent firms after
divestitures report improvements in a number of operating measures: oper-
ating margins and returns on capital increase, and stock prices tend to out-
perform the rest of the sector. In summary, firms that have lost focus often
are more likely to divest; markets react positively to these divestitures if
Graham’s Disciples: Value Investing 255
TABLE 8.6 Stock Price Reaction to Divestiture Announcements
Price Announced Motive Announced
Yes No
Yes 3.92% 2.30%
No 0.70% 0.37%
(Source: Linn & Rozeff (1984))
13 
See Bhide, 1989.
information is provided at the time of the divestiture and operating perfor-
mance tends to improve after divestitures.
Spinoffs, Split-Offs, and Split-Ups In a spinoff, a firm separates out assets
or a division and creates new shares with claims on this portion of the
business. Existing stockholders in the firm receive these shares in pro-
portion to their original holdings. They can choose to retain these shares
or sell them in the market. In a split-up, which can be considered an
expanded version of a spin off, the firm splits into different business
lines, distributes shares in these business lines to the original stockhold-
ers in proportion to their original ownership in the firm, and then ceases
to exist. A split-off is similar to a spin off, insofar as it creates new
shares in the undervalued business line. In this case, however, the exist-
ing stockholders are given the option to exchange their parent company
stock for these new shares, which changes the proportional ownership
in the new structure.
Process and Follow-up Spinoffs, split-offs, and split-ups require far more
procedural steps than a typical divestiture. Miles and Woolridge (1999) lay
out the following steps in a typical spinoff; they are similar for a split-off
or split-up.
The process begins when the firm announces its intention to spin off a
subsidiary or division. The market reaction to a spinoff usually occurs on
this announcement. Once the announcement has been made, the firm
approaches the Internal Revenue Service or obtains a professional tax
opinion on the tax status of the spinoff. While the tax code in the United
States treats a spin off as a dividend, the spinoff is tax exempt if the firm
fulfils the following requirements:
1. Both the parent and the subsidiary have been in active operations for
at least five years prior to the spinoff distribution date.
2. The parent company had control of the subsidiary before the spinoff
and gives up this control after the spinoff. In general, the spun off
shares have to represent at least 80 percent of the outstanding value of
the unit, and the parent company must not be able to maintain
effective control with the remaining shares. In other words, the
subsidiary has to become independent of the parent company.
3. There must be a business reason for the spinoff, and the objective
cannot be purely distribution of profits. Legitimate business reasons
are usually broadly defined to include giving managers a stake in
ownership of the unit, complying with antitrust laws and enhancing
access to capital markets.
256 INVESTMENT PHILOSOPHIES
After obtaining a legal opinion, the firm will have to file Form 10 with the
SEC. This form, which resembles the prospectus in an initial public offer-
ing, contains information about the unit being spun off and supporting
financial statements. If the spin off is a large portion of the firm (as a per-
cent of firm value) or if the corporate charter requires it, the firm must
obtain stockholder approval for the action.
The firm will then either apply for stock exchange listing of the shares
in the spun off unit or arrange for over-the-counter trading. Often, institu-
tional investors will begin trading these units before they are actually
issued; such trading is said to occur on a “when issued” basis. Thus, by the
time the distribution of shares to existing stockholders occurs, the shares
already have been priced in the market. Shareholders are then free to hold
on to the shares or sell them in the market. The steps in the process are
summarized in Figure 8.9.
Reasons for Spin Offs There are two primary differences between a divesti-
ture and a spin off. The first is that there is often no cash generated for the
parent firm in a spin off. The second is that the division being spun off 
Graham’s Disciples: Value Investing 257
Firm announces intention to spin off a subsidiary or division and provide
a proportional distribution of shares to its stockholders
Firm seeks a ruling from the Internal Revenue Service on tax status of spin-off
Firm files Form 10 with the SEC, providing information on the division or 
assets to be spun off
If necessary, firm seeks stockholder approval for spin off
Firm applies for exchange listing for spun off unit’s shares or provides for 
trading over the counter
Trading begins before the actual distribution on a when-issued basis
Spin off occurs; stockholders receive shares in spun off unit, and are free to 
trade these shares
FIGURE 8.9 Steps in a spinoff. 
(Source: Miles & Woolridge)
usually becomes an independent entity, often with existing management in
place. As a consequence, the first two reasons given for divestitures—a
buyer who generates higher value from the assets than the divesting firm
and the need to meet cash flow requirements—do not apply to spinoffs.
Improving the focus of the firm and returning to core businesses, which we
offered as reasons for divestitures, can be arguments for spinoffs as well.
There are four other reasons:
 A spinoff can be an effective way of creating value when subsidiaries
or divisions are less efficient than they could be and the fault lies with
the parent company, rather than the subsidiaries. For instance, Miles
and Woolridge present the case of Cyprus Minerals, a firm that was a
mining subsidiary of Amoco in the early 1980s. Cyprus was never
profitable as an Amoco subsidiary. In 1985, it was spun off after losing
$95 million in the prior year. Cyprus cut overhead expenses by 30
percent and became profitable within six months of the spin off.
Because the management of Cyprus remained the same after the
spinoff, the losses prior to it can be attributed to the failures of
Amoco’s management. When a firm has multiple divisions, and the
sum of the divisional values is less than what the parent company is
valued at, we have a strong argument for a split off, with each division
becoming an independent unit.
 The second advantage of a spinoff or split-off, relative to a divestiture, is
that it might allow the stockholders in the parent firm to save on taxes. If
spinoffs and split-offs meet the tax tests described in the last section, they
can save stockholders significant amounts in capital gains taxes. In 1992,
for instance, Marriott spun off its hotel management business into a
separate entity called Marriott International; the parent company
retained the real estate assets and changed its name to Host Marriott. The
entire transaction was structured to pass the tax test, and stockholders in
Marriott were not taxed on any of the profits from the transaction.
 The third reason for a spinoff or split-off occurs when problems faced
by one portion of the business affect the earnings and valuation of
other parts of the business. As an example, consider the pressure
brought to bear on the tobacco firms, such as Philip Morris and RJR
Nabisco, to spin off their food businesses because of investor
perception that the lawsuits faced by the tobacco businesses weighed
down the values of their food businesses as well.
 Finally, spinoffs and split-offs can also create value when a parent
company is unable to invest or manage its subsidiary businesses
optimally because of regulatory constraints. For instance, AT&T, as a
regulated telecommunications firm, found itself constrained in decision
making in its research and computer divisions. In 1995, AT&T spun
258 INVESTMENT PHILOSOPHIES
off both divisions: the research division (Bell Labs) was renamed
Lucent Technologies, and its computer division reverted back to its
original name of NCR.
Why would a firm use a split up instead of spin off or split off? By giving
existing stockholders an option to exchange their parent company stock for
stock in the split up unit, the firm can get a higher value for the assets of the
unit. This is so because those stockholders who value the unit the most will be
most likely to exchange their stock. The approach makes sense when there is
wide disagreement between stockholders on how much the unit is worth.
Market Reactions to Spinoffs Two issues have been examined by researchers
who have looked at spinoffs. The first relates to the stock price reaction to
the announcement of spinoffs. In general, these studies find that the parent
company’s stock price increases on the announcement of a spin off. A
study by Schipper and Smith in 1983 examined 93 firms that announced
spinoffs between 1963 and 1981 and reported an average excess return of
2.84 percent in the two days surrounding the announcement. Similar
results were reported in Hite and Owens in 1983 and by Miles and
Rosenfeld in the same year. Further, there is evidence that the excess
returns increase with the magnitude of the spun-off entity. Schipper and
Smith also find evidence that the excess returns are greater for firms in
which the spinoff is motivated by tax and regulatory concerns.
The second set of studies looks at the performance of both the spun-
off units, and the parent companies, after the spinoff. These studies, which
are extensively documented in Miles and Woolridge, can be summarized as
follows:
1. Cusatis, Miles, and Woolridge report that both the spun-off units and
the parent companies report positive excess returns in the three years
after the announcement of the spinoffs. Figure 8.10 reports the total
returns and the returns adjusted for overall industry returns in the
three years after the spinoff. Both groups are much more likely to be
acquired, and the acquisition premiums explain the overall positive
excess returns.
2. There is a significant improvement in operating performance at the
spun-off units in the three years after the spinoff. Figure 8.11 reports
on the change in revenues, operating income, total assets, and capital
expenditures at the spun-off units in the three years after the spinoff,
before and after adjusting for the performance of the sector.
Note that the spun-off units grow faster than their competitors in terms of
revenues and operating income; they also reinvest more in capital expendi-
tures than other firms in the industry.
Graham’s Disciples: Value Investing 259
You Can Be Too Conservative In corporate finance, there has long been a debate
about whether a firm can become more valuable as a result of changing the
amount of debt that they carry on their books. There is one school of
thought, attributed to Miller and Modigliani, that argues that value is
independent of financial leverage, but only in a world without taxes and
default risk. Another school of thought argues that in the presence of taxes
and default risk, there is an optimal amount of debt that a firm can carry
and that value is maximized at that point. Finally, there is a school of
thought argues that firms should not use debt because it makes equity
more risky and that less debt is always better than more debt. We believe in
the optimal debt ratio school and that firms can, in fact, be too conserva-
tive in their use of debt.
Are Some Firms Underlevered? What kinds of firms have too little debt or
are underlevered? At an intuitive level, you would expect a firm with stable
and large cashflows from operations and a high tax rate to gain substantial
value from the use of debt. If such a firm chooses not to borrow money or
has very little debt on its books, you could argue that it is in fact costing its
stockholders.
260 INVESTMENT PHILOSOPHIES
Total Return
Industry-adjusted Return
Spun-off units
Parent company
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
Percentage returns in 
3 years after spin off
FIGURE 8.10 Returns at spinoffs and parent company. 
(Source: Cusatis, Miles, and Woolridge)
Your Firm is Underlevered
There is both anecdotal and empirical evidence that some firms are
underlevered and that others are overlevered. You can come to this con-
clusion by comparing a firm to otherwise similar firms in the same busi-
ness or by looking at the relationship between debt ratios and variables
such as earnings variability and tax rates across the market. In 1984,
Bradley, Jarrell, and Kim analyzed whether differences in debt ratios
can be explained by some of the variables listed above. They noted that
the debt ratio was lower for firms with more volatile operating income.
Because these firms are also likely to face much higher likelihood of
bankruptcy, this finding is consistent with the proposition that firms
with high bankruptcy costs borrow less. They also looked at firms with
high advertising and research and development expenses; lenders to
these firms are likely to be much more concerned about recouping their
debt if the firm gets into trouble, because the assets of these firms are
intangible (brand names or patents) and difficult to liquidate. These
firms, consistent with the theory, have much lower debt ratios. They
also find that the there are a significant number of firms whose debt
Graham’s Disciples: Value Investing 261
Sales
Operating
Income Total Assets
Capital
Expenditures
Total growth
Industry-adjusted 
growth 0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
Percentage Change in Income in
 3 years after spin off
FIGURE 8.11 Operating performance of spun-off units. 
(Source: Miles and Woolridge)
ratios are much lower and much higher than predicted by the cross-
sectional relationship.
So what if you were an activist investor in a firm with excess debt
capacity and a conservative management? Left to themselves, the managers
will not use the debt capacity. Investors can try to force them to borrow
more and increase the proportion of capital that comes from debt—this
process is called a recapitalization. At the limit, investors even might use
the firm’s debt capacity to borrow the money themselves and buy the entire
company in a leveraged acquisition or buyout.
Recapitalization In a recapitalization, a firm changes its financial mix of
debt and equity, without substantially altering its investments or asset
holdings. You can recapitalize in many ways. For instance, you could try to
increase your debt ratio by borrowing money and paying a dividend or
buying back stock. The first action increases debt and the second reduces
equity. Alternatively, you can swap debt for equity, where equity investors
in your firm are offered equivalent amounts (in market value terms) in
debt. If you want to reduce your debt ratio, you would reverse these
actions, raising equity and reducing debt.
The boom in debt for equity recapitalization occurred in the late
1980s. A study that looked at these recapitalizations came to two conclu-
sions. The first was that almost every one of them was triggered by the
threat of a hostile takeover. In other words, it is external pressure that
forces managers to increase financial leverage. The second was that the
average stock price reaction to recapitalizations is very positive. On aver-
age, in the sample of 45 recapitalizations studied, the stock price increased
by 21.9 percent. This finding is not restricted to just stock buybacks. A
study of 52 offers to exchange debt for equity found that stock prices
increased by 14 percent.
We might be overreaching when we conclude that this is definitive evi-
dence that these firms were under levered. After all, the stock price reaction
to a buyback or exchange offer might be explained by a much simpler
story, say dilution—there are fewer shares outstanding after these actions.
Notwithstanding this, the evidence seems to indicate that firms that issue
debt are often treated favorably by markets.
Leveraged Acquisitions Another phenomenon of the late 1980s was the
leveraged buyout. Here, a group of investors raise debt against the assets
of a publicly traded firm, preferably one with stable earnings and mar-
ketable assets, and use the debt to acquire the outstanding shares in the
firm. If they succeed in their endeavor, the firm becomes a private com-
pany, and the debt is partly or substantially paid down with the firm’s
262 INVESTMENT PHILOSOPHIES
cash flows or from asset sales over time. Once the firm has been nursed
back to health and efficiency, it is taken public again, reaping (at least if
all goes according to plan) substantial payoffs to the equity investors in
the deal.
Studies of leveraged acquisitions suggest that they do, on average,
deliver significant returns to their investors. However, some of the lever-
aged buyouts done towards the end of the 1980s failed spectacularly, high-
lighting again that leverage is a double-edged sword—elevating returns in
good times and reducing them in bad times.
You Have Lousy Managers Both conglomerate discounts and under leverage are
manifestations of a larger problem, which is that managers do not always
put stockholder interests first. While you can fashion specific solutions to
both of these problems, they might not be sufficient in a firm where the
source of the problem is poor management. For such firms, the only long
term solution to value generation is a new management team.
Changing Top Management If you are an activist investor in a firm with
incompetent management, how would you go about instituting change?
Needless to say, you will not have the cooperation of the existing manage-
ment, who you have labeled as not up to the job. If you are able to harness
enough stockholders to your cause, though, you might be able to increase
the pressure on the top management to step down. While some might view
the loss of top management in a company to be bad news, it really depends
upon the market’s perception of the management. The overall empirical
evidence suggests that changes in management are generally viewed as
good news. In Figure 8.12, for instance, we examine how stocks react
when a firm’s CEO is replaced.
The price goes up, on average, when top management is changed.
However, the impact of management changes is greatest when the
change is forced. Management is more likely to be forced out in the
aftermath of negative returns, and stock prices increase after the change
is announced.
Hostile Acquisitions If you cannot get top management to leave the firm, you
can actively seek out hostile acquirers for the firm. If others share your jaun-
diced view of the management of the firm, you may very well succeed. There
is evidence that indicates that badly managed firms are much more likely to be
targets of acquisitions than well managed firms. Figure 8.13 summarizes key
differences between target firms in friendly and hostile takeovers.
Note that target firms in hostile takeovers generally have much lower
returns on equity (relative to their peer group), have done worse for their
Graham’s Disciples: Value Investing 263
stockholders and have fewer insider holdings than target firms in friendly
takeovers. Needless to say, the payoff to the stockholder of a firm that is
the target of a hostile takeover is huge.
Empirical Evidence on Activist Investing
The overall evidence on whether activist investing works is mixed. While
there are individual activist investors who have earned high returns by get-
ting corporate managers to bend to their wishes, studies indicate that man-
agers are both stubborn and resilient. 
For instance, studies14 that have examined proxy fights find that there is
little or no stock price reaction to proxy proposals by activist investors. This
suggests that markets are not optimistic about changes occurring as a result
of these proposals. However, a study by Wahal indicates that the price reac-
tion to proxy fights is more positive when you look at only the sub-sample of
companies that were targeted for poor stock price performance.
264 INVESTMENT PHILOSOPHIES
-25.00%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
Forced 
Resignations
Normal 
Retirements
All Changes 
Type of Management Change 
Abnormal Returns 
Returns after change
Returns before change
FIGURE 8.12 Returns around management changes.
14 
See Karpoff, Malatesva & Walkling (1996).
A study by Caton, Goh, and Donaldson looked at companies on the
Focus List—a list of poorly performing companies targeted by the Council
of Institutional Investors. On average, these companies report higher earn-
ings and stock returns after they are put off the list. However, when the
sample of 138 companies were broken up into companies that traded at a
market value less than replacement cost (Tobin’s Q<1)>1), the improvement in
earnings and stock prices was only in the latter group. Summarizing the
evidence, we would suggest that shareholder activism has a chance of suc-
ceeding at firms whose stock prices have done badly and where there is
potential for improved performance. It is unlikely to yield results when it is
focused on firms with positive stock price performance or where manage-
ment is not at fault for poor performance.
Determinants of Success
Activist value investors have an advantage over passive value investors
since they can provide the catalysts for value creation. So, what is it that
stops all of us from being activist value investors? When we consider some
of the pre-requisites for being a successful value investor, we can also see
why there are so few successful ones:
 This power of activist value investing usually comes from having the
capital to buy significant stakes in poorly managed firms and using
these large stockholder positions to induce management to change
their behavior. Managers are unlikely to listen to small stockholders,
no matter how persuasive their cases might be.
Graham’s Disciples: Value Investing 265
Hostile 
Friendly 
20.00%
Target
ROE-
Industry
ROE
Target 5-
yr Stock
Returns -
Market
% of
Stock
Held by
Insiders
15.00%
10.00%
  5.00%
  0.00%
-5.00%
Hostile 
Hostile 
Friendly 
Friendly 
FIGURE 8.13 Target characteristics—hostile versus friendly takeovers.
(Source: Bhide)
 In addition to capital, though, activist value investors need to be
willing to spend substantial time fighting to make themselves heard
and in pushing for change. This investment in time and resources
implies that an activist value investor has to pick relatively few fights
and be willing to invest substantially in each one.
 Activist value investing, by its very nature, requires a thorough
understanding of target firms, since you have to know where each of
these firms is failing and how you would fix these problems. Not
surprisingly, activist value investors tend to choose a sector that they
understand well and take positions in firms within that sector. It is
clearly not a strategy that will lead to a well diversified portfolio.
 Finally, activist value investing is not for the faint hearted. Incumbent
managers are unlikely to roll over and give in to your demands, no
matter how reasonable you may think them to be. They will fight, and
sometimes fight dirty, to win. You have to be prepared to counter and
be the target for abuse. At the same time, you have to be adept at
forming coalitions with other investors in the firm since you will need
their help to get managers to do your bidding.
If you consider all these requirements for success, it should come as no sur-
prise that most conventional mutual funds steer away from activist value
investing. Although they might have the capital to be activist investors,
they do not have the stomach or the will to go up against incumbent man-
agers. The most successful activist value investors have either been individ-
uals, like Michael Price, or small focused mutual funds, like the Lens Fund.
As a small individual investor, you can try to ride their coattails, and hope
that they succeed, but it is unlikely that you could succeed at activist value
investing.
CONCLUSION
Value investing comes in many stripes. First, there are the screeners, who
we view as the direct descendants of the Ben Graham school of investing.
They look for stocks that trade at low multiples of earnings, book value or
revenues, and argue that these stocks can earn excess returns over long
periods. It is not clear whether these excess returns are truly abnormal
returns, rewards for having a long time horizon or just the appropriate
266 INVESTMENT PHILOSOPHIES
rewards for risk that we have not adequately measured. Second, there are
contrarian value investors, who take positions in companies that have done
badly in terms of stock prices and/or have acquired reputations as poorly
managed or run companies. They are playing the expectations game, argu-
ing that it is far easier for firms such as these to beat market expectations
than firms that are viewed as successful firms. Finally, there are activist
investors who take positions in undervalued and/or badly managed compa-
nies and by virtue of their holdings are able to force changes in corporate
policy or management that unlock this value.
What, if anything, ties all of these different strands of value investing
together? In all of its forms, the common theme of value investing is that
firms that are out of favor with the market, either because of their own
performance or because the sector that they are in is in trouble, can be
good investments.
Graham’s Disciples: Value Investing 267
MICHAEL PRICE: ACTIVIST INVESTING
In the 1990s, Michael Price acquired a reputation for buying stock in what
were perceived as poorly managed companies and pushing for change. In the
process, he enriched shareholders at Mutual Shares, the fund that he ran. One
example was his investment in Chase Manhattan in the mid-90s, where after
he acquired the shares, he pushed the firm to merge with Chemical. He argued
that the latter’s management would shake up the moribund culture at Chase
and make it a more profitable firm. While Chase’s management initially fought
the merger, they ultimately succumbed to his pressure and the subsequent
merger generated substantial returns for Mutual Shares.
Price served his apprenticeship with Max Heine, a German Jew who fled
Austria and became a contrarian value investor and co-manager of Mutual
Shares. Heine looked for cheap assets that were out of favor. He bought railroad
bonds for cents on the dollar in the 1970s and made his money back several
times over. As Price paraphrases it, Heine taught him to “stay away from the
crowd and buy things at a big discount.” Like Heine, Price prefers less visible
stocks that are underpriced, though unlike Heine, he has been willing to take
large positions in high profile firms like Dow Jones and Sunbeam and push for
change. Price also does not have much faith in equity research, which he believes
is designed to enrich Wall Street and not investors.
268 INVESTMENT PHILOSOPHIES
LESSONS FOR INVESTORS
To be a value investor, you should have:
 A long-time horizon: While the empirical evidence is strongly supportive of
the long-term success of value investing, the key word is long term. If you
have a time horizon that is less than two or three years, you might never see
the promised rewards to value investing.
 Be willing to bear risk: Contrary to popular opinion, value investing strate-
gies can entail a great deal of risk. Firms that look cheap on a price to earn-
ings or price to book basis can be exposed to both earnings volatility and
default risk.
In addition to these, to be a contrarian value investor, you need:
 A tolerance for bad news: As a contrarian investor who buys stocks that are
down and out, you should be ready for more bad news to come out about
these stocks. In other words, things will often get worse before they get bet-
ter.
In addition to all of the above, to be an activist investor, you have to:
 Be willing to fight: Incumbent managers in companies that you are trying to
change will seldom give in without a fight.