Have you ever come across a reference to a value stock that turned out to be nothing like you expected? Perhaps what you saw was a spinoff from a “factor investing” exercise.

The final appendix of Tren Griffin’s book, “Charlie Munger: The Complete Investor,” deals with a little-discussed matter: what “value” means to the disciples of Benjamin Graham and what it means to professors Eugene Fama and Ken French at the University of Chicago (Fama also developed the Efficient-Market Hypothesis and shared the Nobel prize for economics in 2013). Digging into this discrepancy provides interesting glimpses into the core of value investing.

As we have seen, Benjamin Graham, Warren Buffett (Trades, Portfolio), Charlie Munger (Trades, Portfolio), Howard Marks (Trades, Portfolio), Seth Klarman (Trades, Portfolio) and others developed what we know as “value investing.” It takes an analytical approach to evaluating individual companies; as Griffin explained it, investors using the Graham approach are solving the problem of finding investments with a low probability of losing capital and a high probability of an attractive return.

Fama and French developed the idea of factor investing in a paper published in 1993. They were trying to solve the problem of persistent discrepancies of returns across large numbers of stocks. The factor approach built upon the Capital Asset Pricing Model (CAPM) by adding three additional factors:

Market risk. Small companies outperforming big companies. High book-market companies outperforming small book-market companies.

They added two more factors in 2015:

Profitability, as in high operating profitability companies outperforming low profitability ones. Investment, based on the belief that companies with high total-asset growth have underperforming returns.

Not surprisingly, the first iteration was called the three-factor model and the enhanced version was named the five-factor model.

Note, too, that the Fama-French model assumes markets are efficient and above-average returns can only come from taking greater risk. So if some investors bring in better returns than others, then there must be some hidden risk factors. Those three, and later five, risk factors are the ones listed above.

Now, for the value connection: The ratio of a company’s book equity to market equity—factor three above—has been called the “value factor” and stocks with a high book-market ratio are consequently “value stocks.” Book equity to market equity refers to shareholder equity versus market capitalization (including debt).

Graham disciples identify value, intrinsic value, by estimating a company’s future distributable cash flows and buy only when the price is appropriately lower than the intrinsic value. To make money in the long run using this formula requires that investors follow Graham’s four investment principles.

None of these principles or processes are used in factor investing. Griffin argued that using book-market—the core factor ingredient—as a gauge of a stock’s inexpensiveness is to assume there is no difference between cash in a bank account and an operating company. There is no meaning to a company’s products, brands or operating ability because the book value in the ratio is being used as a proxy for intrinsic value, and that book value explains nothing about a company’s earnings power. That’s exactly the opposite of what Graham value investors think of these elements.

Griffin does see one bridge between book value and earnings and cash flow: A company’s return on equity, in which “earnings yield = return on equity x book to market.”

He added that while Fama might concede discounted cash flows explain a company’s value, he would also assume that no one else can be better than average at figuring out how well that company will perform in the future. The implication, then, of the Fama framework is that all companies have the same rate of return on equity. And if that is true, then book-market gives you everything you need to know about a company’s value.

To help explain these conflicting views, Griffin proposed an analogy in which the two teams would pick basketball teams. The Fama-French team would simply recruit the tallest men in town, and it would do better than the average team because of the link between height and success in basketball. In the investment context, this means there will be a correlation between an undervalued company, a value investment and a company with a low book-market ratio.

The Graham team would recruit differently. It would hold tryouts and evaluate the skill of every prospect, just as Graham value investors do when looking for the best stocks. Griffin concluded the Graham team likely will do much better than the Fama-French team, even though the latter is better than average.

The analogy leads to this conclusion: Factor investing is basically a tweak or enhancement on index investing. It should do a bit better than an index fund—the average—but not by much.

On the other hand, Graham investing is about superior returns rather than modestly better-than-average returns.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

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