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. 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 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 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. 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 Philip Morris International
Neither of these companies, however, looks like a classic Graham value stock, since he often focused on the balance sheet for valuation purposes. Accenture trades for more than 10 times its book value, while Philip Morris carries a multiple 26. But the value embedded in these companies isn't reflected in balance sheet assets. For Accenture, the value is in the company's brand, reputation, and highly skilled workforce. Philip Morris, meanwhile, leverages the formidable power of the Marlboro cigarette brand.
These assets don't show up on the balance sheet, but they do show up on the bottom line. Accenture currently has a return on equity north of 62%, while Philip Morris' is a sky-high 129%. 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, 15 and 14 for Accenture and Philip Morris, respectively.
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 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.
Current Dividend Yield
Annualized 5-Year Earnings Growth
Teva Pharmaceutical Industries
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.
There's not a whole lot that's special about one company's oil versus the next, but there is a definite difference in the stability and long-term potential of oil companies when you can talk about the kind of global scale that Chevron has. Sure, it's not the only attractive oil major right now, but with a rock-solid balance sheet, low valuation, and that nice dividend, it's near the top of the list.
Considering the value that the market has put on Intel's earnings, it's pretty obvious that investors aren't terribly sanguine about the company's future growth prospects. To be sure, the semiconductor industry is a cyclical one, but Intel is an absolute monster sitting atop that industry and gushing cash. Even without significant future growth Intel's stock could still be a winner.
Teva's stock carries quite the bargain price for a company with a bright future. While big pharma companies gird themselves for the upcoming expiration of many major patents, Teva is licking its chops as it prepares to offer generic versions of some of the best-selling drugs. And with health-care costs front and center in many people's minds, there should be plenty of demand ahead for this generic-drug manufacturer.
While Aflac and General Dynamics are in very different industries, their stories are along the same lines as the rest of the group. Solid businesses, strong balance sheets, and a history of not only dividend payouts, but dividend growth have made these good companies to own in the past, while attractive current valuations make them good stocks to own now.
Not only do all of these fit some numerical measures that Graham might have appreciated, but, more importantly, they're all attractive businesses that are well worth owning. It's exactly these kinds of businesses that the investment team at Motley Fool Million Dollar Portfolio has focused on to build the core of its $1 million real-money portfolio. It's tracked down those high-quality investments by taking the very best picks from the entire menu of Motley Fool newsletters.
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This article was originally published May 5, 2010. It has been updated.
We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
Fool contributor Matt Koppenheffer owns shares of Intel and Philip Morris International, but does not own shares of any of the other companies mentioned. Accenture, General Dynamics, and Intel are Motley Fool Inside Value recommendations. Aflac is a Motley Fool Stock Advisor pick. Philip Morris International is a Motley Fool Global Gains recommendation. Chevron is a Motley Fool Income Investor pick. Motley Fool Options has recommended buying calls on Intel. The Fool owns shares of Aflac, Intel, Philip Morris International, and Teva Pharmaceutical Industries. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.