The New Math of Sustainable Investing

Friday, August 14, 2015

On May 17, 1984, Warren Buffett gave away the secret that has made his face the first result when you Google “the greatest investor of all time.” He opened a speech with the stories of ten investors, including himself, whose portfolios consistently outperformed the S&P 500. It’s no coincidence, Buffet insisted1, that their careers shared a common thread: tutelage under Benjamin Graham, who, as it happens, is the second person who comes up in the Google search.

Graham is regarded as the father of value investing, an approach simply defined as buying stock in companies that are worth more than they’re currently valued. In Buffett’s speech, that self-evident definition—Graham’s core teaching—was the anticlimactic reveal behind his success, which has ballooned to a net worth of $65.1 billion as of July 9.2

“I can only tell you that the secret has been out for 50 years,” Buffett said in the speech, commemorating the 50th anniversary of the publication in 1934 of Graham’s seminal book, Security Analysis. “[Y]et I have seen no trend toward value investing in the 35 years I have practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult.”

Essentially, Graham argued that you shouldn’t try to predict the future. What separated investors like him and Buffett from the rest of the pack was their refusal to speculate. He pointed in particular to the price-to-earnings ratio, one of investors’ favorite metrics, as a good barometer to help understand the value of a company. Under most circumstances, he argued after analyzing P/E ratio data between 1871-1970, anything with a ratio above 16 was simply speculation.

Nonetheless, in the decades that have passed, the mainstream reading of a P/E ratio has yet to fall in line with Graham’s reading; as of July 9, the S&P 500 as a whole has a P/E ratio of 20.053, and the Internet and software services industry has reached a jaw-dropping ratio of 556.4.4

Perhaps more than any other5 metric, the P/E ratio has emerged as a prime symbol of how investing is equal parts art and science. To some, it’s the tealeaf that determines a company’s fate more than any other. To others, it’s almost meaningless6. But whatever your school of thought, the measure has survived endless debate over its merits for the good part of a century, remaining one of the most trusted staples for how we value companies.

Source: The Atlantic (link opens in a new window)

impact investing