Value Investors Seek Reasonable Growth

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Ben Graham, the man commonly known as the architect of value investing, focused on finding businesses selling at less than the net liquidating value of their assets. Back during Graham's time, the proverbial "fifty-cent dollar" was more abundant, as the stock markets had fewer participants and the information flow was not as rapid as it is today.

I think most investors will agree that today's markets are much more efficient when compared to the markets that Ben Graham and even Warren Buffett (during his early years) were involved in many decades ago.

But Mr. Market is not perfect, and the markets will occasionally confuse true value with market value. During the Internet boom, for example, market valuations far exceeded intrinsic valuations for many companies. Similarly, after the bear markets of the early 1970s, plenty of stocks were selling for cheap and discounting any future earnings growth.

By definition, investing is simply the acting of seeking value by attempting to buy something for less than it is worth. You find such investments in one of two forms:

1. Excellent businesses trading at incredibly low valuations that could sell for more in a private negotiated sale. Earnings growth may be slow or dormant, but these companies spin out very predictable levels of cash and possess several low valuation metrics.
   
2. Growth at Reasonable Price companies (GARP)

Say GARP
Believe it or not, most "value investors" prefer the latter over the former. Value investing and growth investing are merely two sides of the same coin. Value is created as a company continues to grow its business, and subsequently, its profits.

The best investment is one that promises high growth and is selling at a price below the intrinsic value. In the most basic example, a likely GARP investment would be a business that trades for, say, 10 times earnings and grows its profits by 15% or more a year, along with similar returns on equity.

I can't emphasize enough how elementary this explanation is. Never, ever invest simply because such conditions exist. But if you do find them, then you can go on to determine whether the business can sustain this growth for a period of years and whether or not this growth will require high levels of capital expenditures. As the company grows, so will intrinsic value, and ultimately, so will the market value.

Buffett loves GARP
Buffett's renowned investment track record is a result of a handful of truly terrific investments that fit the mold of GARP-style businesses. The obvious ones that come to mind are Coca-Cola (NYSE: KO), American Express (NYSE: AXP), GEICO, and the Gillette Razor Company (now a subsidiary of Proctor and Gamble (NYSE: PG)).

Even today, Buffett's most recent common-stock investments still fit this mold. Railroad operator Burlington Northern (NYSE: BNI) should experience very solid steady growth as the high price of oil and increased efficiency of railcars make railroad transportation more economical relative to trucking. Buffett's recent 8.6% stake in Kraft Foods (NYSE: KFT) should also outperform the market over the years, as more and more consumers all over the world continue to gobble up its products. And on top of the growth, you collect a respectable 3.5% dividend yield.

A reasonable price
Remember that we are investing in growth at a reasonable price, not growth at any price. This distinction is of paramount importance. Buying Google (Nasdaq: GOOG) when it was at $600 a share is not GARP investing ... the growth is strong, but the price is even richer. Now if Google revisits $200 a share or so, then you have an excellent GARP candidate.

GARP businesses, when you find them, are very simple investments. You buy them and sit still.

This article was designed to teach you how to fish. In the follow-up, I will ... just this once ... give you a fish and let you decide if you want to reel it in.

For more very reasonably priced Foolishness:

• The Value of a Franchise
• Invest Big in Great Companies
• Low Risk, High Potential