The Great Investing Wisdom That Wall Street Forgot

When you hear the phrase "value investing," Warren Buffett most likely comes to mind. But hopefully, you also think of Ben Graham -- the father of value investing. And considering that some of the world's most successful investors carry Graham's flag, there's good reason for Fools like us to be obsessed with the concept.

Graham had a plan
But with thousands of stocks out there, how do we separate the value plays from the throwaways? In The Intelligent Investor, Graham lays out a basic framework for winnowing through the sea of stocks to get to the good stuff.

1. Financial stability. Graham wanted investors to be sure that they weren't investing in castles made of sand, so he put requirements on prospective investments' balance sheet strength and record of past earnings.

2. Growth. You wouldn't have caught Graham dead chasing the high-flying stocks of the day, but he did want to see that over the long haul, earnings were at least moving in the right direction.

3. Valuation. This, of course, is what Graham is probably best known for -- requiring that a stock be selling for less than it's really worth. While a simple valuation ratio can't tell you the whole story, it may signal a stock that's definitely not a deal.

4. A dividend.

Did you catch that last part?
That wasn't a typo -- whether you are a defensive or enterprising investor, Graham thought it necessary that you stick to companies that pay out a dividend.

Dividends have largely been relegated to a dark corner on Wall Street, but Graham didn't equivocate. The safest stocks would have "uninterrupted payments for at least the past 20 years," but every investment should have "some current dividend."

When you think about it, this makes perfect sense. Graham's whole approach to investing in stocks revolves around thinking and acting like a businessperson, and treating your stock holdings as ownership shares in a business, not gambling slips. And when businesspeople buy a piece of a business, they expect to know how much profit will be sent back their way.

The full Graham
Graham's basic idea of buying a piece of a business for less than it's worth has been twisted and shaped in a thousand different ways to accommodate a wide variety of stocks that wouldn't fit into Graham's original screening criteria. Some of these tweaks may make sense, particularly for those interested in companies like Microsoft (Nasdaq: MSFT  ) and Procter & Gamble (NYSE: PG  ) , which rely on intellectual property and brand value rather than costly physical assets.

Neither of these companies, however, look like classic Graham value stocks, since he often focused on the balance sheet for valuation purposes. P&G trades for close to three times its book value, while Microsoft carries a multiple almost twice that. But the value embedded in these companies isn't reflected in balance sheet assets. For P&G, much of the value comes from brands such as Gillette, Oral-B, and Pampers, while Microsoft sits on a gold mine of intellectual property in the form of its Windows operating system and Office suite of products.

These assets don't show up on the balance sheet, but they do show up on the bottom line. P&G currently has a return on equity of nearly 19%, while Microsoft's is an astonishing 42%. Those bottom-line returns mean that though the book value multiples are high, the price-to-earnings ratios are more value-like -- in this case, roughly 16 for both stocks.

However they adjust the rest, I think investors should stick with Graham and be unyielding when it comes to yield. While there may be a few companies out there that truly have great reinvestment opportunities for all of their earnings, the vast majority of financially sound companies should be kicking back part of their profits to the company's owners (that's you, by the way).

But don't worry -- including this additional screening criteria still leaves you with plenty of great potential investments. Here are just a few of the options that came up when I searched for companies that fit Graham's criteria -- in this case, companies with a debt-to-equity ratio less than 100%, earnings growth over the past five years, a price-to-earnings ratio below 15, and a dividend payment in each of the past five years.

Company

Current Dividend Yield

Price-to-Earnings Ratio

Debt-to-Equity Ratio

Annualized 5-Year Earnings Growth

AT&T (NYSE: T  )

6.5%

12.9

68.1%

19.7%

Abbott Laboratories (NYSE: ABT  )

3.4%

14.7

73.3%

10.3%

CVS Caremark (NYSE: CVS  )

0.9%

14.3

31.2%

32.1%

The Travelers Companies (NYSE: TRV  )

2.8%

7.7

24.5%

44.1%

Best Buy (NYSE: BBY  )

1.2%

14.4

28.5%

6%

Source: Capital IQ, a Standard & Poor's company.

Graham would be rolling in his grave if I were to suggest that anyone should blindly invest in the results of a screen. As the heft of Graham's original masterwork Security Analysis suggests (I'm pretty sure you could take down a full-grown antelope with a hardcover copy), the savvy investor has a significant amount of work to do to determine which stocks are actually worth buying.

Digging in
With AT&T, for instance, we would find that growth is hard to come by in the landline telephone business, while competition is superheated when it comes to wireless communication. But even if growth isn't torrid, the business is stable from year-to-year and there's plenty of cash flow to support that fat dividend.

While CVS and Abbott Labs play in different parts of the health-care industry -- pharmacy services and health-care product development -- both companies benefit from the fact that health-care spending tends to be dependable and fairly inelastic. As for Traveler's, the company hasn't exactly been a huge growth engine. However, it has set itself apart from others in the property and casualty insurance industry by staying disciplined and conservative -- and by not messing with crazy financial products (cough, cough, AIG).

Best Buy may not have quite the same level of stability as the other companies above, because it's so tied to discretionary consumer spending. But by establishing itself as a cut above the rest in electronics retailing, it has navigated one of the country's worst recessions in decades with surprising ease.

These are the kinds of stocks our Motley Fool Income Investor service looks for -- just like Graham. To check out what stocks the team is recommending right now, you can take a free 30-day trial of the newsletter. Just click here to get started.

Fool contributor Matt Koppenheffer owns shares of AT&T and Abbott Labs, but does not own shares of any of the other companies mentioned. Best Buy and Microsoft are Motley Fool Inside Value picks. Best Buy is a Motley Fool Stock Advisor recommendation. Procter & Gamble is a Motley Fool Income Investor pick. Motley Fool Options has recommended a diagonal call position on Microsoft and a bull call spread on Best Buy. The Fool owns shares of Best Buy and Procter & Gamble. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants ...


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  • Report this Comment On May 05, 2010, at 10:32 PM, jomueller1 wrote:

    Mr. Grahams ideas were simple to follow when businessmen were largely honest. GM is a prime example of deceit. They paid dividends from borrowed money which I call insane and criminal. Supposedly they did that to avoid getting downgraded (again those devilish rating agencies) and they did not want to fall out of favor with pension funds. They were knowingly killing retirement investments.

    That does not prove Ben Graham wrong but it raises the bar for the investor for the research he has to do. I do not feel up to that so I feel left stranded.

  • Report this Comment On May 06, 2010, at 5:29 AM, TMFKopp wrote:

    @jomueller1

    Thanks for reading and thanks for the comment.

    "Mr. Grahams ideas were simple to follow when businessmen were largely honest."

    Actually, if you read Security Analysis, you quickly realize how distrustful Graham is of many companies. There were fewer regulations back then and a LOT of scheisters.

    "They paid dividends from borrowed money which I call insane and criminal."

    I'll agree with you on the insane part for sure.

    "That does not prove Ben Graham wrong but it raises the bar for the investor for the research he has to do. I do not feel up to that so I feel left stranded."

    The amount of work that Graham suggests that investors do is actually quite significant, particularly for investors that consider themselves "enterprising."

    The situation with GM is a perfect example of why Graham would suggest that we do that work -- looking at just the dividend, an investor might be fooled into thinking that everything was hunky-dory. But a look at GM's financials would have revealed that the company was burning so much cash that it was amazing that it kept the lights on, let alone maintained a dividend.

    You do raise a very good point though -- investing is an endeavor that requires a good deal of work to get it right, and those that don't have the time or interest to put in that work are better served simply investing in index funds.

    Matt

  • Report this Comment On May 06, 2010, at 6:35 PM, TMFKopp wrote:

    @WallaceSean

    That's a great direction to go if (as I mentioned above) you don't have the time or interest to do research on individual stocks.

    My personal belief is that, free of the constraints that many mutual funds and Wall Streeters face, individual investors do have the ability to beat the market. But it takes work. For some people that's awful drudgery and they'd rather be watching "The Real Housewives..." For me, I have more fun reading an annual report than I do watching rich women from Jersey threaten each other (though I will admit it's amusing at times...).

    Matt

  • Report this Comment On May 07, 2010, at 9:04 AM, bluestarmom wrote:

    I have been naive because I thought by subscribing to MF I was getting the research necessary to invest in individual stocks. Apparently you just made the case to not subscribe. Call me stupid.

  • Report this Comment On May 07, 2010, at 4:22 PM, azmfool wrote:

    Hi all. Regarding GM's earnings, if you've read Mary Buffett's "Buffettology", she used GM as a prime example of why Warren also looks at Return on Capital - it flushes out potentially misleading Returns on Equity. It has always stuck with me that she pointed out that GM's (and Ford's) debt load would take 40 years (yes, 40!) to pay off if every dime of their earnigs were applied towards their debt.

    The greater point is you have to look at more than one metric, and you have to understand how those metrics apply to certain types of businesses. I doubt anyone in Benjamin Graham's time could have forseen a ubiquitous intellectual property such as MSFT having a long term competitive advantage.

  • Report this Comment On May 07, 2010, at 7:26 PM, TMFKopp wrote:

    @bluestarmom

    What I was discussing above is the difference between investors that are willing to do research and learn about companies so that they can make informed investments in individual stocks and those who are not. If you ask me, going with individual stocks is an individual investor's best option for returns that beat the market, but it takes some effort.

    In his books, Graham basically said that same thing -- that is, he said that getting better returns isn't about taking on more risk it's about putting more effort into your investing.

    There are folks out there that have absolutely no interest in reading up on the stocks they're about to invest in. Researching a stock for them is akin to getting a root canal. This group is best off putting their money into index funds. (in my opinion at least)

    If you're subscribing to a TMF newsletter, and you're reading the recommendations and participating on the discussion boards, then you're doing the work that I'm talking about. Hopefully you're going beyond that and reading annual reports, quarterly releases, and learning about companies' products.

    Maybe one way to think about the newsletters is like a personal trainer. The trainer can teach you about working out, help motivate you, show you what exercises to do, but at the end of the day, you still have to show up at the gym and put in the work to get results.

    Matt

  • Report this Comment On May 08, 2010, at 7:19 AM, hardymason wrote:

    I doubt Graham would have bought stock in a company with a large NEGATIVE tangible book value like AT&T.

    Hardy

  • Report this Comment On May 08, 2010, at 3:42 PM, TMFKopp wrote:

    @hardymason

    Graham probably wouldn't have. But as I noted in the article, there have been some "extensions" of value investing since Graham's time. Buffett, for instance, believes very much in the existence of franchise and brand value and it's hard to say that AT&T doesn't have considerable brand value.

    Matt

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