Value Investing is Back in Vogue

by Nancy Zambell, Contributing Editor

With the market's state of turbulence, investors are scurrying to find those hidden gems that are not only trading at bargain prices, but which also have some hope of surviving - relatively intact - from the ups and downs of market volatility. That's why an increasing number are tapping into that old standby that can be counted on through thick and thin: value investing.

Value investing is simply investing in companies whose shares are temporarily trading at lower prices than their true worth.

In 1934, Benjamin Graham, with his colleague David Dodd, co-authored Security Analysis, the primer for value investing. Many editions later, the book has become the bible of security analysts nationwide.

Graham felt that too many investors were speculators - buying or selling simply because a stock or the market went up or down, investing in "hot" stocks, and margin buying - all trends of the era in which he grew up. He lived through the debacle of the '29 crash, the bank closings and the utter loss of confidence in Wall Street. He knew for confidence to be restored, and for corporate America to obtain the funding needed for expansion, individual investors would have to be brought back into the fold.

Graham proposed that the foundation of sound investing should not change with the whims of trends or the winds of time, but should be altered only as a result of important economic and financial changes. Such events might include changes in interest rates, inflation, the trend toward mega-corporations, or significant bankruptcies - all occurrences which might alter the way a stock is to be valued  - quite a different train of thought than what was currently espoused by the "professionals". You might imagine how popular that advice was with the Wall Street crowd!

The father of value investing felt that a good investment should be a company that was worth considerably more that what its stock was selling for. He calculated this "value" of a company by estimating its future earnings as well as taking into account the worth of its assets - what would be the value of this business to someone interested in buying it. And although even during Graham's day, there were always analysts ready to build a mountain out of a molehill, cranking out scores of ratios to analyze one company, Graham felt that just a few - the most important - criteria would do the job.

Graham especially liked to invest in companies whose earnings were reasonably stable, with good growth prospects. Additionally, he required that they be conservatively financed, large companies that paid dividends, and had price-earnings ratios of less than 25. And he found legions of such companies - many that were selling for less than their net working capital (current assets - current liabilities). But for some reason, the stock market and the market pros were underestimating, or undervaluing the potential of the companies' earnings, resulting in an "undervalued" stock price.

Graham's success was legendary. During his most active years - from 1936-1956 - he consistently posted annual returns of 20% plus, while the S&P 500's performance ran around 14%.

And his legend lives on. One of his most diligent students at Columbia University was Warren Buffett, who followed Graham's teachings and became even more famous than his professor.

While Benjamin Graham introduced value investing to the investment community, Warren Buffett actually formed a company whose sole purpose is to "value invest". He is chairman of Berkshire-Hathaway (NYSE: BRK-A) - a holding company that is essentially a portfolio of the stocks of businesses he has bought over the past 50+ years. And along the way, he has expanded on Graham's version of value investing.

Like Graham, Buffett seeks those companies that are undervalued in terms of today's numbers. He certainly looks at future earnings but doesn't rely on them to make a buying decision. He expresses this concept by saying, "Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results". His secret to Wall Street riches is simple: "You try to be greedy when others are fearful and you try to be very fearful when others are greedy". Alternatively stated: Don't follow the crowd.

Buffett believes that research is the key - nothing beats old-fashioned elbow grease. He disregards "hot tips", sets his goals and targets for the company at the time he buys the stock and believes that too much diversification - what he calls the Noah School of Investing, or buying two of everything - is not prudent. In fact, Buffett tends to take rather large positions in the companies that he owns in his Berkshire-Hathaway group, and keeps his portfolio fairly lean, in terms of numbers of companies.

That focus on a smaller group of investments led to one additional criterion that Buffett added to Graham's model and ultimately made his trademark - he believes in really getting to know the companies in which he invests. That means personal visits and conducting ongoing communication with the decision-makers. But Buffett takes that step even further. He also gets to know the company's customers, suppliers, and its competitors.

Another expansion of Graham's strategy is Buffett's addition of qualitative factors to the investment equation. While Graham certainly considered whether or not management was strong, efficient, and cost-conscious and that the company's products seemed worthwhile, Buffett also looks at more intangible qualities, such as franchise or brand name value. For example, before he bought Disney stock for the first time, he factored in the value of Disney's huge movie library, which did not show up on Disney's financial statements at that time.

This led to Buffett changing Graham's concept of the worth of a business by adding such intangibles to a company's book value, which is basically defined as a company's assets minus its liabilities, or the capital that has gone into a business, plus retained profits. Together, the actual balance sheet figures plus the intangibles, add up to the "intrinsic value" of the company.

And lastly, Buffett enlarged Graham's definition of risk to include the risk of paying more than a business would prove to be worth.

Buffett has often been maligned in the media for his conservative investing practices. He has always avoided what he calls "fashion investing", or buying into go-go stocks. And he has stated more than once that investors should only buy stocks within their "circle of competence", meaning if you can't explain it to your 90-year old grandmother, you shouldn't spend your hard-earned money on it. His portfolio has always consisted of household-name companies, including Coca-Cola, American Express, Disney, the Washington Post and GEICO.

In the late '60s, he was attacked for staying out of the "hot" electronics sector and retaining his old-line retail stocks. But he had the last laugh there, just as he had during the recent technology boom. At the turn of the millennium, Buffett was crucified in the media and called a "has-been" for admitting that the business of most of the hi-tech stocks was over his head and he was sticking to his knitting. As time would tell, he was right again.

And Buffett has the juice to back up his strategy. For the last 200 plus years, the stock market has averaged 11% annual gains, while Buffett's average annual return since 1951 is around 31%. And he inspired countless other value investors, including Peter Lynch, whose spin on value investing will be covered in next week's issue.

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


Disclaimer & Important Information

Financially Fit is owned and published by Business Financial Publishing, LLC of Washington D.C.  Business Financial Publishing is neither a registered investment adviser nor a broker/dealer.  Readers are advised that this electronic publication is issued solely for information purposes and should not to be construed as an offer to sell or the solicitation of an offer to buy any security.

The views expressed herein are based upon our analysis of the issuer's public disclosures, and assumes both their accuracy and completeness.

The opinions and statements included herein are based on sources (including the companies discussed and public sources) believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness. We have not independently verified the information contained herein. This information is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. We encourage you to consult with independent financial advisors with respect to any investment in the securities mentioned herein. You should review a complete information package on all companies, which should include, but not be limited to, the Company's annual report, quarterly reports, press releases and all regulatory filings. All information contained in Financially Fit should be independently verified with the subject company. The foregoing discussion contains  statements which are based on current expectations, estimates and projections, and differences from such expectations, estimates and projections can be expected.

Financially Fit is intended only for residents of the United States. Financially Fit is not for residents of the United Kingdom and is not an approved publication by the Financial Services Authority in the UK.

The information contained in this newsletter is not intended to be a complete discussion of information regarding all of the current and/or intended business activities of the covered companies. Any opinions expressed in Financially Fit are statements of judgment as of the date of publication, are subject to change without further notice, and may not necessarily be reprinted in future publications or elsewhere.

Business Financial Publishing and its members, managers, writers and employees do not accept compensation from the companies discussed within Financially Fit, nor any of our individual newsletter publications (Growth Report, Rising Star Stocks, Supernova Stocks).

Business Financial Publishing and its members, managers, writers and employees, and their families from time to time positions in the securities of the companies discussed within Financially Fit.  These positions are subject to change at any time without notice.