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Value Investing: How to Become an Intelligent Investor

Value Investing: How to Become an Intelligent Investor

Last updated on: April 23, 2012 at 8:00 am by Darren

Value Investing: How to Become an Intelligent Investor 2012-04-23T08:00:16-05:00 Darren

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What is Value Investing?

Value investing is an investment philosophy that was created by a man named Benjamin Graham. This philosophy involves buying stocks that seem to be underpriced based on fundamental analysis.

What this means is that just like most of us who look to buy cars for less than its manufacturer’s suggested retail price, value investing is all about buying stocks at a price that’s less than their true value.

Why is Value Investing Relevant Today?

I’m sure we’re all aware of – or even personally experienced – the wild ups and downs of the stock market. But by following the value approach to investing, you’ll avoid making serious mistakes as well as experiencing a significant loss of your money. And with a willingness to devote extra time to the selection of stocks that are fundamentally sound, a value investor can expect higher-than-average returns.

Who is Benjamin Graham?

Benjamin Graham is simply one of the best investors of all time. Born in London on May 9, 1894, he and his family moved to New York when Ben was a year old. With his father making a living as a dealer in china dishes and figurines, they lived a good life.

But when Ben’s father died while he was still a child, the business failed and the family fell into poverty. Ben’s mother borrowed money to trade stocks on margin, but her fortunes were wiped out during the crash of 1907.

Feeling the pain of his mother’s humiliation, Ben turned his life around by winning a scholarship to Columbia University.

After graduating in 1914 with the distinction of being second in his class, he was offered a faculty position in three different departments. But instead of academia, Graham decided to pursue a career in Wall Street.

Before long, Graham was running his own investment partnership, having mastered the science of researching stocks in great detail. So how well did Graham perform? What were his results?

Why Listen to Benjamin Graham?

benjamin graham

Benjamin Graham: Father of Value Investing

Although there are no exact records of his earliest returns, from 1936 until he retired in 1956, his Graham-Newman Corp. achieved at least 14.7% annual returns, compared to just 12.2% for the stock market as a whole. This is one of the best long-term track records in Wall Street history.

He wrote a book called the Intelligent Investor in 1949, which contains the emotional and analytical framework that are considered by many to be crucial to financial success. It’s known as the definitive book on value investing. In fact, Warren Buffett, one of the world’s wealthiest men, says it’s “by far the best book on investing ever written.”

Now let’s get into his analytical framework for valuing stocks.

Valuing Stocks

So how do you go about the process of selecting stocks to invest in? Graham outlined seven statistical requirements of a business before it could be included in an investor’s portfolio: value investing

Adequate size of the enterprise
Sufficiently strong financial condition
Earnings stability – no earnings deficit in the past ten years
Earnings growth – ten-year growth of at least one-third in per-share earnings
Dividend record – continued dividends for at least the past 20 years
Moderate Price/Earnings Ratio – price no more than 15 times average earnings of the past three years
Moderate Ratio of Price to Assets – price of stock no more than 1 1/2 times net asset value

Let’s dig into each criteria.

Adequate Size of the Enterprise

Graham wanted to exclude small companies, which were subject to greater than average price fluctuations. To meet this test, he recommended no less than $100 million in annual sales for an industrial company, and no less than $50 million in total assets for a public utility.

What does this mean for us today? Nowadays, investors should stay away from stocks with a total market value of less than $2 billion.

Sufficiently Strong Financial Condition

Here, Graham wanted industrial companies with current assets that were at least twice as much as their current liabilities. Firms that meet this test have a large enough cushion of working capital that should sustain them through difficult times.

In addition to this, long-term debt shouldn’t be greater than the net current assets (aka working capital). For public utilities, debt shouldn’t exceed twice the stock equity (at book value).

If you build a diversified basket of stocks with these characteristics, you should end up with a list of conservatively financed companies with staying power.

Earnings Stability

There should be positive earnings for the common stock in each of the past ten years. This eliminates poorly-run companies, but isn’t so restrictive that it limits your options to an unrealistically small sample.

Earnings Growth

Graham wasn’t just satisfied with earnings stability. He also wanted a minimum increase of at least one-third in per-share earnings in the past ten years, using three-year averages at the beginning and end.

Dividend Record

There should be uninterrupted payments for at least the past 20 years.

Moderate Price/Earnings Ratio

The current price shouldn’t be more than 15 times average earnings of the past three years.

This is in contrast to the current practice on Wall Street, which is to value stocks by dividing their current price by next year’s earnings, which gives you what’s known as the forward P/E ratio. But to a value investor, it doesn’t make sense to calculate a price earnings ratio by dividing a known current price by unknown future earnings.

Moderate Ratio of Price to Assets

With this last requirement, Graham insisted that the current price shouldn’t be more than 1 1/2 times the book value. It’s important to note that intangible assets such as franchises, brand names, patents, trademarks, and goodwill are excluded from book value.

However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As long as the product of the multiplier times the ratio of price to book value doesn’t exceed 22.5, then the stock was considered moderately priced. This corresponds to 15 times earnings and 1 1/2 times book value.

Margin of Safety

Central to the value investing approach is finding stocks with a margin of safety. The margin of safety concept involves first getting a general estimate about the value of a business. But you don’t cut it close. Don’t buy a stock that’s worth $53 per share for just $50 per share. Insist on a bigger margin.

Graham suggested that you approach buying stocks just like you approach buying groceries, not as you buy perfume. What does this mean? When we buy groceries, most of us look for the best deals, wanting to pay the least amount in exchange for the most value. Use this same approach for buying stocks.

In other words, know the difference between the price you pay for a stock, and it’s underlying value.

A true investment has a true margin of safety. And a true margin of safety is one that can be demonstrated by figures. In fact, a low enough price can turn a stock of mediocre quality into a good investment opportunity – as long as you’re informed and practice diversification.

Why is the margin of safety concept important? Because although we invest in the present, we invest for the future. And unfortunately, the future has an element of uncertainty.

Investing, therefore, on the basis of prediction of future events is foolish. Investing on the basis of protection – from overpaying for a stock and from overconfidence in your own judgement – is a better solution.

Opposition to Value Investing

As mentioned at the beginning of this post, value investing is done through an approach called fundamental analysis. Fundamental analysis is a way of evaluating a security’s intrinsic value by looking at economic and financial factors.

The purpose of performing this analysis is to come up with a value that you can compare with the security’s current price, with the aim of determining what to do with that security. If the value is greater than the price, the investor should buy. But if the value is less than the price, the investor should sell the security.

This fundamental approach is in contrast to technical analysis, in which people are guided by charts and other mechanical means of determining when to buy and sell. Most of these technical approaches advise you to buy a stock because the price has gone up, and to sell a stock because the price has gone down.

But here’s the irony of this approach: it’s the exact opposite of sound business practice everywhere else! Everywhere else, we’re told to buy low, and sell high.

Successful Value Investors

How has value investing performed historically? To find the answer, let’s take a look at some of Ben Graham’s very own students.

Walter Schloss

Walter Schloss never went to college, but took a course taught by Graham at the New York Institute of Finance. In the 28 years from 1956 to 1984, the partnership he founded achieved an annual compounded return of 21.3%. This is compared to Standard & Poor’s return of 8.4% over the same period.

Tom Knapp

Tom Knapp worked with Warren Buffett at Graham-Newman, and he took Ben Graham’s course as well. In the 15 years from 1968 to 1983, his investment partnership achieved an annual compounded return of 20%. This is compared to Standard & Poor’s return of 7% over the same period.

Warren Buffett

Warren Buffett needs no introduction. In the 13 years from 1957 to 1969, his investment partnership achieved an annual compounded return of 29.5%. This is compared to Dow’s return of 7.4% over the same period.

Bill Ruane

Bill Ruane also took Ben Graham’s course at Columbia. In the 15 years from 1970 to 1984, his investment fund achieved an annual compounded return of 17.2%. This is compared to S&P 500 index’s return of 10% over the same period.

Charlie Munger

Charlie Munger is a Harvard Law School graduate, and was also Warren Buffett’s longtime partner at Berkshire Hathaway. In the 13 years from 1957 to 1969, his investment partnership achieved an annual compounded return of 19.8%. This is compared to Dow’s return of 5% over the same period.

Rick Guerin

Rick Guerin was a friend of Charlie Munger who studied math at USC. In the 19 years from 1965 to 1983, his investment partnership achieved an annual compounded return of 32.9%. This is compared to S&P 500 index’s return of 7.8% over the same period.

Stan Perlmeter

Stan Perlmeter was an acquaintance of Warren Buffett who also embraced value investing. In the 19 years from 1965 to 1983, his investment partnership achieved an annual compounded return of 23%. This is compared to Dow’s return of 7% over the same period.

Although these investors followed Graham’s intellectual theory for making stock-buying decisions, they all applied Graham’s theory in their own way. Yet all of them were able to achieve returns that beat the market.

Books on Value Investing

If you want to follow in the footsteps of these successful investors, becoming a serious student of value investing is crucial. With that said, here are two books that you should add to your library:

The Intelligent Investor – As mentioned earlier, this book, first written by Graham in 1949, is considered by many to be the definitive book on value investing. As such, it should be the starting point for any true value investor.

Security Analysis – This book was also written by Benjamin Graham in 1934, with the help of cowriter David Dodd. It’s more technical in nature, and is written in more of a textbook style. Although it’s a challenging read, this book will systematically lay out the science of security analysis.

Getting Started With Value Investing

If this post has piqued your interest in value investing, great! Now you may be looking for a tool to get started with your stock research. Morningstar is one of the best free sites that will allow you to look at a company’s various financial statements and key ratios.

As a word of caution, if you’re new to value investing, it may be beneficial to practice by first researching stocks. If you find a few that meet Graham’s screening criteria, consider holding off on buying for the moment. Follow the stock’s price movement for a year. If you’re still comfortable with the price swings and the stock still passes the screening test, then go ahead and buy.

But it you’re more of a gung-ho person and want to jump into the stock market now, start with small amounts of money that you can afford to risk. As you gain more experience and expertise, you be on a better track to invest more of your money.

Good luck with your value investing!

Investing

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