Value Investing

Finding Bargain Investments

Value investing is basically like shopping for a bargain at garage sales. The idea is to look for something that may have on it some dust, some rust, or even may have been badly beaten up. But underneath the obvious defects is something you think is a treasure that will become worth a lot more than the price tag that's on it in the bargain bin.

Stocks can be exactly like that. They may have a low price tag for a lot of reasons. The market often reacts wildly to earnings news that arrives under The Street’s expectations by a penny or two; or economic times may be bad; or a company may have terrible management. However, some companies have assets that are more valuable than the market generally assumes. It may have a marketing strategy better than Market Analysts calculate. Maybe the company has been like a sinking ship, where the captain is thrown overboard and a new management crew is brought in.

The following video explains the difference between Value Investing and Growth Investing:

Growth vs Value Investing

Classic Value Investing

If the new captain and his officers are better than the market thinks they are, the price of the stock probably will be lower than it should be. Perhaps the company owns something, like a patent or an oil field, whose true worth is unrecognized by the market. Of course, not every cheap stock is valuable, just as not every item in a flea market is a bargain. Sometimes there is good reason the price is so low. Value investors try to sort out the gems from the junk.

One of the great features of value investing is supposed to be that, if the stock is already beaten up and it falls even more, the low price means it won't have that far to fall - just as if you bought a beaten-up lamp at the garage sale. If you were wrong, and that purchase turned out to be nothing more than an old, banged-up lamp, and you had to sell it at a loss, you probably wouldn't lose much because you paid so little to begin with. If you are right, and it is a prized antique, a collector will pay you a lot more than you paid at the swap meet because, again, the price was so low to start with. At least, that is the theory.

Relative Value Investing

This method is called Relative Valuation. First, you take a benchmark you think is appropriate for the stock. Maybe you would use the S&P 500. Maybe, if it is a technology stock, you would look at that specific tech sector. Using that group as a basis of comparison, you decide how the stock compares to the others in terms of dividends, yield and earnings. Is it better, worse, or just about average?

A few definitions:

  • Dividends are the amount the stock pays shareholders, usually every three months.
  • Yield is the rate of return on a stock as a percentage. If a stock is worth $10 and pays $1 in dividends, it has a 10% yield (don't hold your breath waiting for one paying that well).
  • Earnings consist of how much profit a stock has compared to the number of shares stockholders own. A stock with a $50 million profit (after taxes) and 10 million shares has earnings of $5 per share.

We need to determine the “real” value of the company. By taking a stem-to-stern look at the basic circumstances of the company, you decide what the stock's price actually should be. This kind of examination involves closely inspecting the earnings, assets (what the company owns and is owed), dividends, plans for the future, and just how good the management really is.

Famous Value Investors and Their Tools

Benjamin Graham

“Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble... to give way to hope, fear and greed.”

Benjamin Graham

The truly classic Value investor, Benjamin Graham, is considered the father of modern equity analysis and certainly knew how to ferret out bargains. But even he had to learn from his mistakes, just as you will. Graham had several yardsticks for measuring whether a stock was undervalued. He also knew that his methods weren't the only ones that would work.

He was a broad thinker. He decided that an investor had to examine both the hard numbers and the factors that were more abstract. The numbers included assets, liabilities (what the company owes), operating profit or loss (how much money the business has coming in, minus the costs and expenses related to the business), and capitalization (the number of shares multiplied by the price of the share). The abstract aspects leaned toward the management team’s education backgrounds, their previous performances and even their visionary foresight.

Graham liked larger companies. He also liked having a record of paying dividends without interruption plus earnings growth, as well as low debt to equity. Just as important, he said, were the hard-to-quantify qualities, including what the nature of the business is, what its prospects are, the company's stability, the quality of the management and where future earnings might be headed.

Warren Buffett

“Risk comes from not knowing what you’re doing.”

Warren Buffett

Buffett, also known as "The Sage of Omaha," is one of the most successful investors on record. He has taken the stock of Berkshire Hathaway, his holding company, to such heights that buying one share costs tens of thousands of dollars.

Buffett moved from Omaha to work for Graham in New York from 1954-1956. When Graham retired, Buffett then returned to Omaha, where he has lived ever since. In the early 1960’s, Buffet began purchasing shares of a textile manufacturing firm known as Berkshire Hathaway. In 1965, he took over Berkshire Hathaway and named Ken Chase the new president. In 1966, Buffet had closed the partnership and began investments elsewhere. Buffet first appeared on Forbes 400 list in 1979, and was dubbed the wealthiest person in the world in 2008.

Buffett has some investing guidelines that seem incredibly simple and, in some ways, actually are. Buffett doesn't focus on yearly results. Instead, he looks at the longer-term picture, typically four to five years. Buffett prefers Return On Equity (ROE) as a very solid measure of a company.

To get a company's ROE, first determine its net worth (assets minus liabilities) at the beginning of an accounting period, such as a quarter (a three-month period during the year after which a company makes earnings reports to shareholders and pays a dividend). Then divide that number into the company's net income for that same quarter after the company has paid the dividends on its preferred stock (the class of stock which gets paid first but at a fixed rate and has no voting rights) but before it pays dividends to the company's common stock (the class of stock which gets paid second but which does have voting rights and gets dividends which may go up or down). The result is expressed as a percentage.

Return on Equity tells stockholders how “well” their money is being spent. It tells whether the company is doing better or worse than previous quarters, and how well it is doing compared to businesses in its sector. Buffett likes to see a company increasing its ROE while having very little debt.

He doesn't like cash flow. Instead, Buffett prefers what he calls “owner earnings,” which adds together a company's annual net income, depreciation, depletion (a special tax break for companies which take oil, gas, coal or other minerals out of the ground) and amortization (which is generally the gradual writing off of a fixed asset, of which depreciation and depletion are part; in addition, it includes writing off intangible assets such as copyrights, import-export licenses, licenses and advertising costs) minus future capital expenditures and any working capital which might be needed. Trying to figure out what capital assets will be needed cannot produce precise figures, but Buffet is okay with that.

The Sage also likes low expenses and high profit margins. To get that number, find the company's gross profit, which is the company's net sales (the company's total sales minus returns, allowances and shipping costs). Next, subtract the costs of buying any raw materials and producing the end product. Then divide the result by the net sales.

Another calculation Buffett likes is the “dollar-for-dollar” rule. For every dollar the stock goes up in price, the company's retained earnings should go up a dollar. That figure is easy to come by: It is the difference between total income and total expenses. But the retained earnings are the amount the business keeps accumulating after the dividends are paid. For Buffett, if the stock's price goes up more than retained earnings, that is even better.

John Templeton

“Tell your readers to use it or lose it. If you don’t use your muscles, they get weak. If you don’t use your mind it begins to fail.”

John Templeton

Mr. Templeton is a renowned value stock picker, who sold his entire group of mutual funds to what is now the Franklin-Templeton Group. Templeton is particularly well-known for venturing into foreign stocks when others considered anything beyond American borders as unworthy.

Templeton has several measures he applies to determine if he likes a stock or not. Among them are a low P/E, high earnings growth rate combined with a low P/E and escalating pretax profit margins. He likes consistent earnings rates, though gradually rising rates are considered a bonus. Other factors he considers are the extent to which the company's competitors are effective and the major challenges to the company aside from competition.

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