Archive for the ‘value investing’ Tag

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

Keep a debt bomb from damaging your portfolio

Stocks have fallen 2% so far today. In the context of recent volatility, that’s not a big deal. What is a big deal is that executives at GM are apparently preparing to declare bankruptcy, a move that would affect hundreds of large and small companies that do business with the automaker. general-motors-gm-logo

GM has the typical profile of a bankruptcy candidate – a large amount of debt and not enough cash flow to make those debt payments. Investors will not be surprised if GM goes bankrupt without getting more government aid.

But what some investors might not appreciate in their own stock portfolios is that even their profitable companies might run into serious trouble as long as the credit markets stay tight. In the past, if a company had a few hundred million dollars worth of bonds maturing, instead of having to write a gigantic check at once, the company would simply issue new bonds to refinance the debt. But now, both large and small companies have found it extremely difficult to “roll over” (i.e. refinance) their bonds when they mature.

Value investor Ed Maran, a portfolio manager with Thornburg Funds, told me that he checks the debt schedule of the companies he owns to make sure they don’t have large amounts of debt maturing in the next three years. If they do, they’d better have enough cash on hand to pay that debt off. Otherwise, even a company that shows a healthy profit on their income statement can be forced into bankruptcy.

If you want to see when your own stocks’ debt matures, go to the company’s annual or quarterly report and look in the footnotes of the balance sheet. I’ll have more on the subject in this month’s issue of Money Magazine.

– Joe Light

Why buy-and-hold-forever doesn’t work

Anyone can see that the market has been on somewhat of a rollercoaster lately. Normally, investors think of markets in binary terms. They’re either a “bull” or a “bear” with consistent increases in value or drops. Vitaliy Katsenelson, an investment manager and adjunct faculty member at the University of Colorado-Denver, argues that we’re actually in a “range-bound market”. Range-bound markets are basically long periods where the market goes up and down in the shortterm, but over a longer period goes nowhere.

Take the period between 1966 and 1982.

For about 15 years, the S&P 500 didn’t really move up or down. That means buy-and-hold investors’ portfolios pretty much stood still. For anyone relying on those historical 10% average annual returns that personal finance magazines always brag about, that kind of dry run can be as scary as a bear market.

Of course, in reality, investors who bought and held didn’t have it all that bad. Dividends probably made their real portfolio returns in the 3% to 5% range. That’s still not anywhere close to the market’s historical average.

So what do you do? In “Active Value Investing: Making Money in Range-Bound Markets”, Katsenelson argues that investors must take an active role in their portfolios if they want to get more than those dividends. Instead of buying an index fund, investors need to focus on stocks with low P/E ratios (and other value metrics) and strong brands if they want to get share appreciation in addition to those dividend payments.

In my opinion, buying an index fund and holding is still probably the best method of increasing wealth for the average investor. If you have no time to analyze stocks or are dollar-cost averaging (pretty much every 401k investor out there), you’d be better served to buy a fund and be done with it rather than take your chances and possibly lose a lot of money in a value trap.

But we also shouldn’t assume that we’re going to get a 10% return just because that’s what investors got over the last 80 years. Buy-and-hold forever isn’t an investing “strategy” per se, but a prayer that the U.S. economy continues to grow at a pace that will give us enough to retire on when the time comes. Not a bad bet, but a prayer nonetheless.

– Joe Light

How to buy a company for nothing

Back when Benjamin Graham trolled the market, value investors could find great deals on stocks simply by doing the heavy lifting that lazy investors weren’t willing to do. sale-tim-parkinson Analyzing balance sheets and income statements is a lot of work. Graham loved buying companies with a particular kind of balance sheet. Take a company’s current assets (that is, cash and inventory), subtract all of their debt and liabilities, and pay no more than two-thirds of that per share.

What does that mean in lay terms? In short, he’d find out how much cash a company would have if they simply liquidated everything they could on short notice and paid off all their debts. Then, he’d pay no more than TWO-THIRDS of that price per share. He’d basically get one-third of the company’s cash and inventory and all of its non-liquid assets, like factories and equipment, for nothing.

Unfortunately, in the age of the stock screen, investors tend to snap up those deals quick.

But right now, investors seem to be so scared of equities that even a simple stock screen comes up with several such companies. John Spears, one of the principals at Tweedy Browne, a value fund manager, told me: “That was a formula that tended to work before computers. We used to go page by page through the stock guide to find these things. They’re starting to show up again though.”

As always, use this screen as the start of your research, not the end. But, hell, if I could find a solid company that could pay me more–in cash–right now than I’d have to pay for their shares, you can count me in.

– Joe Light