6 Questions About Value Investing, Answered

We’re touching new all-time highs in the market as I write this. If you’re in the market (and I hope you are), then life is pretty good.

Still, everyone wants to know when the party will end.

Some of us just don’t know how to have a good time.

In all seriousness, it’s a fair question. And while I can’t answer that, what I can say for sure is that one of these days it will. And when it does, there will be a some things we’ll have to unlearn — some more than others.

Among them, the notion that value matters.

A successful investor is also a lifelong learner. So I thought we’d take some time today and reinforce some principles that will come in handy sooner or later.

I was rummaging through the StreetAuthority archives recently when I came across this old research report… It was in Q&A format, and I just couldn’t put it down. Even though I’ve been a student of Buffett for years (and came up from the value school), I was really learning some new things.

Then suddenly I remembered… I was part of the staff that worked on this report so many moons ago!

Hey, it happens to the best of us.

Using this as inspiration, I went though the report and made a few updates. But the main thrust of the report hasn’t changed after all these years…

 

What is “value investing,” anyway?

Value investing is simply buying stocks that trade for less than they are really worth, i.e., their intrinsic value. Value investors look for stocks that they believe the market has undervalued. Since the market overreacts to bad news, a company’s stock price can stray far from what the fundamentals would dictate. This gives value investors an opportunity to profit by buying when the price is deflated.

Keep in mind that the very definition of value investing is subjective. Some value investors only look at present assets/earnings and place no value on future growth. Other value investors include estimates of future growth and cash flows to come up with a number that a stock is “really” worth. Despite the different methodologies, it all comes back to trying to buy something for less than its true value.

Ben Graham is widely recognized as the father of value investing. Graham and Dodd’s 1934 Securities Analysis was the ground-breaking work on buying companies based on intrinsic value of the business rather than price momentum, charting, or other technical analysis.

Graham produced annualized returns of better than +17% between 1934 and 1956 — delivering a whopping 27-fold gain for his investors. And Warren Buffett, a student and former employee of Graham, has scored average annualized gains of more than +15% over the course of the last 40 years — almost double the return delivered by the S&P 500.

How do I know what a stock’s true value is?

It all starts with the same time-tested technique that Warren Buffett inherited from Benjamin Graham before him: “Discounted Cash Flow Modeling.”

To determine a fair price for a company, we first project the amount of operating cash flow that the firm is likely to produce in the years ahead. From there, we determine how much those future cash flows are worth in today’s dollars. This gives us a pretty accurate estimate of each firm’s true, risk-adjusted intrinsic value.

We then add in cash and other liquid assets and subtract its debts to come up with a fair business value. That’s the rational price it would take to buy the entire company divided by the number of shares outstanding.

We then compare that intrinsic value with the current trading price. In extreme market conditions when panic rules the day, share prices sometimes drop below the company’s per-share cash on hand. In cases like that, you’re actually getting paid to buy the business.

How does value investing stack up to other styles in terms of performance?

No other approach has proven to be more effective or reliable than value investing over the long haul.

A classic study by Ibbotson found that value stocks generated average annual returns of 11% over a 34-year period vs. just 6.5% for the S&P 500. Ten thousand dollars invested in value stocks during this period would have grown to $347,521 vs. only $85,091 for the S&P 500 — making the value stock investor more than four times richer than an investor who put his money in the S&P 500.

While momentum investors come and go, value investing has shown incredible staying power over the decades. Just run down any list of the most successful investors of all time. Virtually all of the names are value investors: Warren Buffett, Benjamin Graham, Peter Lynch, John Templeton, etc. While all these men certainly hit cold streaks, no other investment approach has proven to be more effective over the long haul than value investing.

What is the quickest way to find value stocks?

The quickest way is to check the price/book ratio. Book value is a company’s “net worth,” and it’s figured the same way that you’d determine your own net worth, by adding up assets and subtracting liabilities. For companies, this aggregate figure is referred to as “shareholder equity” and can be found on the balance sheet. At the per-share level, it’s called “book value.”

The price-to-book ratio compares the stock’s price to its per-share book value. Most companies trade at a multiple to book value. The average price/book for the S&P right now is about 3.5. Any company trading at less than 2.0 times book could be a potential value investment, and anything trading at less than 1.0 times book is considered cheap.

If you buy a stock for less than per-share book value, you’re getting all of its net assets at a discount — the company’s business (its ability to generate future profit) — you get for free.

I’m a retiree, so capital preservation is important to me. Are value stocks safe?

By their very nature as deeply discounted “on sale” securities, value stocks are theoretically safer than most other equities.

If you have a statistical bent, you can predict the volatility of your value stocks down to the decimal point. All you have to do is look up its beta or standard deviation (both measures of volatility) to see how stable it is before you buy it. You will almost always find that value stocks score better on these risk measures.

Value investing has its risks, but it’s not roulette. If you pick the wrong stock, you shouldn’t lose as much as other investors because the stock is already scraping bottom.

If you follow the concepts of value investing and seek companies that have a strong financial footing but a depressed stock price, then your downside risk should be mitigated and the risk of losing everything is tiny.

That’s why we insist on a margin of safety. This means buying at a big enough discount to allow some room for error in our estimation of value.

A value investment could make a substantial profit in a few weeks or it could languish for years before popping back. This style of investing sometimes takes patience.

One of the best assets a value investor can have is a long memory. If you can remember a time when the business conditions were similar to this one, then you can go back and determine what happened to stock prices.

For instance, when oil rises or falls, what usually happens to oilfield service providers? When recessions hit, what happens to food companies? Value investing is a rigorous intellectual pursuit: You’ve got to merge the data with the news and decide the degree to which you’re willing to bet the outcome will be the same.

Because it’s so rigorous, value investing is mentally and emotionally satisfying — and a constant source of intellectual enrichment. What’s more, everything value investors must learn can be applied to other methods of investing. Value investors, for instance, must do real research. They study. They play devil’s advocate. And they fiddle around with spreadsheets. All of this gives them an edge over investors who simply bought a stock they heard on the news but really knew nothing about.

Most value investors learn that the first time one of their picks goes down. The fellow who bought because he heard about it on the news is upset because he moved into the losing column. But the value investor finds himself very pleased that the company’s shares are on sale and buys more.

What are the keys to finding the best undervalued stocks?

There are many ways to find bargain stocks, and no single approach can be called “correct.” Two investors can take the same information and come up with significantly different values on a company.

That said, here are five key factors we look at when evaluating cheap value stocks:

– Discount pricing — ideally, the stock should be selling at a 20% to 50% discount to the company’s fair market value. We also like a stock to be selling substantially below its 52-week high.

– Free cash flow — we want companies that generate truckloads of cash flow. Their future cash flow to sales ratios are typically far above sector norms.

– Return on invested capital (ROIC) — ROIC should exceed the company’s cost of capital to ensure that shareholder value is being created and not destroyed.

– Return on equity (ROE) — A high ROE indicates that management allocates its capital efficiently and does not spend recklessly to obtain growth.

– Wide economic moats — An “economic moat” is a market factor that helps defend the business from its competitors — for instance, a pharmaceutical company with key patents on a particular class of drugs.

Bringing It All Together

Value investing is a contrarian approach that requires a strong understanding of balance sheets and other financial data. You have to be willing to crunch the numbers and make predictions that you are willing to risk money on. It isn’t for the weak of heart. That being said, value investors who pick up cheap shares in bear markets can make massive triple-digit gains.

One thing is for sure: value investing requires work. You’ve got to roll up your sleeves and put on your reading glasses. The only way to make a sensible determination on a stock’s “real” value is to read every bit of information you can get your hands on. You need to keep your eyes on economic data and corporate trends and try to put what you hear and read into context with what you see in the pricing of equities.

 

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