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We define value investing differently. We evaluate the business and try to buy it at a discount. This is our definition of value. Ben Graham, Warren Buffett's teacher, said: determine how much something is worth, pay significantly less, leave a large margin of safety. This is our definition of value investing.
This is not investing at a low price/book value or price/ sales ratio. These are things that are traditionally associated with value. That is, if you are trading at a low price/book value, price/ sales ratio, your company is trading close to the historical value of its assets, which means it is most likely out of favor.
And if you buy a basket of stocks like that, you, you know, tend to find more than your share of cheap companies. This is a correlation. The reason is cash flow. We evaluate the business like a private investment company. And so business valuation is what stocks are. These are not pieces of paper jumping back and forth to which you apply Sharpe or Sortino ratios or other fancy metrics.
These are ownership interests in a business that you are evaluating and trying to buy at a discount. Therefore, we ignore whether the market rewards us for our assessments in the short term, because that's what stocks are. I have been teaching at Columbia University for 23 years, and I make a promise to my students on the first day of class.
I promise them: if they make a good assessment, the market will agree with them. It could take a few weeks, maybe two or three years. But that's the secret: having a consistent, disciplined process for evaluating companies and being confident enough to stick to it. You know, when it doesn't work in the short term, the market is very emotional in the short term.
We try to ignore this noise. Investing in stocks is about finding out how much a business is worth and paying less. And that hasn't changed. What makes a company worth something and what makes it cheap relative to that . It's pretty simple. You know, it's kind of Ben Graham. Determine how much it costs, pay significantly less, leave a large margin of safety.
Between the two, Warren Buffett added a little nuance that made him one of the richest people in the world. He simply said, "If you can buy a good business cheaply, even better." If you read Buffett's letters, it becomes very clear what he is looking for. The first thing he looks for are businesses that generate high profits.
We call this intangible capital. And that simply means that every business needs working capital. Every business needs fixed assets. How well it converts its working capital and fixed assets into profit. So, the example I gave in the little book that I actually wrote to explain such concepts to my children.
I said, imagine you're building a store, and you have to buy land, build the store, put up displays, fill it with merchandise, and all of that costs you $400,000. And every year this store brings in $200,000 in profit. This is 50% of the return on tangible capital . Maybe I should open more stores. There aren't many places where I can reinvest my money at those rates.
Then I compared it to another store. Remember , I wrote this for my children. And I just called that store " broccoli." This is a store that only sells broccoli, and that's not a good idea. Unfortunately, you still need to buy land, build a store, equip display cases, and fill it with merchandise. It will still cost you about $400,000.
But since it's a pretty silly idea—just selling broccoli in his store— he might only make $10,000 a year. This is a 2.5% return on tangible capital . And all I'm just saying is that I would much rather own a business that could reinvest its money, all other things being equal, I would much rather own a business that could reinvest its money at high rates of return than at much lower rates.
And this is a kind of " Buffett trick" that we implement in the companies we invest in, being very demanding about how companies make and spend their money. So we tend to pick a group of companies that are not only cheap but also manage capital well, and that's really what we're looking for. We've always done it that way.
The little book was more of a way to systematize it, and that's how I started it. I said, you know, even Warren Buffett says most people are better off just indexing. And I said I agreed with him. I didn't stop my lecture there. I said, you know, but on the other hand, Warren Buffett doesn't index, and neither do I.
Why is that? And because the opportunity exists if you know how to value a business, which most people don't, to take advantage of the fact that the market is often emotional in the short term. Well, it's quite interesting , based on the research we did for the book. Most people know that typical index funds, the S&P 500 and the Russell 1000, if you invest in them, they outperform most managers , about 70% of managers.
And this is a pretty strong argument. Well, it's because of their low commissions and the fact that most managers don't really add value. So, it would be logical to say: OK, I know that only 30% of managers outperform the typical index. So how do I find these guys? And it turns out that if you look at the performance of these managers over the past 3, 5, and 10 years, there's no correlation whatsoever to how they're going to perform in the next 3, 5, or 10 years, which is what you're trying to figure out.
That's why most, well, many, at least advisors have recommended, and perhaps rightly so, that index funds for the individual investor who doesn't know how to pick stocks on their own are probably a good option for most people. So we decided to do something a little better. And as it turns out, conventional indices like the S&P 500 or the Russell 1000 actually have serious flaws.
Even though they outperform most active managers, they still have very serious flaws. And they do something that costs investors about 2% per year. And the point is that these are market capitalization-weighted indices, which means they give more weight to larger market capitalizations. So if you believe, like Ben Graham or Warren Buffett , that the market is sometimes emotional and not efficient, as many professors have argued over the years.
It is not effective. This means that if the market becomes emotional in the short term, some stocks are overvalued and some are undervalued. And in a market cap-weighted index, if a stock is overvalued, it automatically buys too much of it. And if it is undervalued, he automatically buys too little of it because it is based on market capitalization, which is essentially the price.
It sounds crazy, but in reality he systematically does the wrong thing every time a stock is undervalued. So there is a simple way to fix this. There are also equilibrium indices. Instead of investing more in companies with larger capitalizations, it gives equal weight. So if you have the S&P 500 , it will give the same weight to stock number one as it does to stock number 500.
It still makes a lot of mistakes. In other words, it is equal weight, but these errors are now random, not systematic, as in a market cap-weighted index. So, you are actually returning that 2% per year . Several people have created so-called fundamentally weighted indices. This is just another way to weight stocks without using price.
Therefore, errors in these indices are also random. And you get your 2% back from them too. Because we are value investors and have done a lot of research on value investing over a long period of time, we created an index that we call “ value-weighted,” which simply means: the cheaper the asset, the more weight we give it.
And it's actually more diversified than, say, the S& P 500 or the Russell 1000. It has the same volatility, the same beta, but over the last 20 years, you would have made 7% more every year following this strategy. And it's ridiculously simple. Just give more weight to cheaper assets.
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