How to become a value investor

First a quick note of news…I’m moving this blog to a self-hosted site in the very near future. In fact, the blog has actually already been transfered, but I’m sorting out some issues with getting traffic on this site to automatically forward to the new one.

For you, this basically means that you’ll need to update your bookmarks to the new site once it’s up (I’ll post the new domain once it’s active). For people who subscribe to the site through Feedburner, the transition should happen seemlessly. For those who subscribe some other way, I’ll also post the new feed address once it’s up.


A story of mine from the May issue on value stock investing just hit the website a couple days ago. While I’m happy with the final product, it’s a classic example of why I started this blog. For space issues, editors and I cut the story down to 650 words or so. But as you can imagine, value investing is just a tad more complicated than that.

Security Analysis by Benjamin Graham and David Dodd

Security Analysis by Benjamin Graham and David Dodd

Over the next four days I’m going to give a primer on value investing. I’m also hoping to have my regular news-based posts for readers who know this stuff already.

Here’s what’s coming up:

Today: Where value investing comes from. What is a value investor?

Tomorrow: What is a P/E ratio and how is it used properly?

Wednesday: Understanding a company’s business. How to make sure a company’s earnings don’t disappear after you buy it. Building in a “margin of safety”.

Thursday: What’s different about value investing today? Other measures of “value” in a company.

I hope you find it informative.


The invention of “value investing”

You might not be sure of the definition of value investing, but you probably do know its greatest living proponent, Warren Buffett. If you spoke to Buffett, he’d actually point to his mentor, Benjamin Graham, as the greatest value investor of all time.

Graham, and co-author David Dodd, literally wrote the book on value investing—- Security Analysis. In the preface of book’s latest edition, modern value investor Seth Klarman aptly summarized their philosophy this way:

Value investing, today as in the era of Graham and Dodd, is the practice of purchasing securities or assets for less than they are worth—-the proverbial dollar for 50 cents. Investing in bargain-priced securities provides a “margin of safety”—-room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market. While some might mistakenly consider value investing a mechanical tool for identifying bargains, it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology.

Whereas speculators hope that their purchases gain rapidly in value, Klarman says, value investors strive to avoid losing money.

You see, Graham and Dodd wrote the first edition of the book in 1934, after seeing the most dramatic stock bubble in history followed by the most dramatic bust. Their book was meant as a way of sorting through the thousands of low-priced securities to discover which were good investments.

It might surprise you to know that times like today, when stocks of nearly all companies are severely beaten down, are when Graham and Dodd would find the most bargains. It’s during manias like the tech bubble and real estate bubble that fairly valued companies are hard to come by.

The trick is figuring out what “fair value” is.

What is a value investor?

Imagine that your cousin Joe started a hero sandwich restaurant a year ago. Its earnings steadily increased for the first few months as customers got word about the place, but now they’ve leveled off, and Joe thinks it will earn about $30,000 this year after paying his rent and employee salaries. Joe’s grown tired of the fast food business and wants to sell it to you for $400,000. You have the money to buy it, but aren’t sure if it’s a fair price.

This is the dilemma facing any stock investor. An owner (the stock’s seller) doesn’t want to own it anymore. The stock’s buyer needs to decide what he’s willing to pay.

You could put your money in a money market account right now and earn about 2% on your investment without any risk. So if you bought Joe’s restaurant, where a competitor could come in and snatch your business in a heartbeat, you’d want a much greater return than that.

Before buying Joe’s company, you do a bit of research. You look in the classifieds of your local business newspaper, and find a lot of other companies similar to Joe’s. One is selling his burger restaurant for $500,000 and it makes $60,000 a year. Another is selling his pizza joint for $200,000, but it only makes $20,000 a year.

All told, you find that restaurants like Joe’s give their investors about a 10% return for their invested money.

But you take it a step further. You go to the local library and look at the microfiche of your local newspaper’s classifieds to find the prices that restaurant sellers were requesting for the last several years. During good economic times, when lots of people are eating out, you find that sellers requested prices that only have 6% or 7% returns. During bad economic times, they sold at prices that would give a 15% to 20% return, mostly because they were afraid that their earnings could keep falling or disappear.

On average, when evening out those good and bad times, companies like Joe’s gave their owners a 11% return.

Now back to Joe’s selling price. He wants $400,000 for a business that generates $30,000 a year. That’s a 7.5% return. On its face, and assuming there’s nothing about Joe’s company that make his earnings more certain than the next guy’s, Joe’s asking price is too high. You think the business is worth more in the range of $330,000 based on historical figures. But since you could buy companies very similar to Joe’s for a return as high as 12% (the burger place), you’re only willing to pay $250,000 ($30,000 divided by $250,000 gives you a 12% return). He declines, and you move on to other investment ideas.

Fast forward to next year. The economy has gotten much worse. Joe’s earnings are falling. His company will probably survive, but until the economy gets better, he only thinks he’ll make $25,000 this year. Right now, it looks like no one’s ever going to buy a hero sandwich again, and in a panic, Joe offers to sell you his company for $200,000.

That’s a 12.5% return. Your research on the economic cycles of restaurants shows that investors earned an 11% return on average. So you buy the company from Joe, knowing that once the economic mess passes, you’ll own a company that’ll still make you good money.

There, in Joe’s panicked sale of his hero restaurant, is your proverbial dollar for 50 cents.

Ok, so that example was a little quick and dirty, but in a nutshell, that’s what a value investor does every day. A growth investor buys shares of companies in the hopes that the company’s earnings will grow rapidly and make his investment worth it. A value investor finds companies with a proven track record of earnings, but waits until the company’s share price has been beaten down enough to make his purchase worth it.

Start thinking about every stock purchase you make as if you were buying Joe’s restaurant. That is, think of it as if you’re buying the entire business and as if your profits rely on how much the business makes in earnings, instead of on how much the stock price goes up the next day.

Even just that change in mindset will put you on the path of thinking like a value investor. Of course, figuring out how much similar businesses sell for, how safe a business’s earnings are, and what price is “fair” takes a bit more practice.

I’ll talk about how to learn to do that tomorrow and Wednesday.

– Joe Light


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