The tagline for the classic board game Othello reads, "A minute to learn, a lifetime to master." In a nutshell, that means that the rules of the game are quite simple to grasp, but becoming an expert takes significant time and experience. In truth, the same thing can be said about successful value investing. Just like in Othello, the rules of successful value investing are simple, but mastering them takes a concerted effort.
The practice of value investing began with Benjamin Graham, who set out a few straightforward principles in his seminal book, The Intelligent Investor. Graham's writing has withstood the test of time, the boom and bust of market cycles, and the onslaught of academic theories like the Efficient Market Hypothesis. Yet through it all, generations of investors have profited from his teachings, consistently delivering long-term results dramatically higher than those provided by the S&P 500 index.
Graham's rules are so simple, in fact, that they hardly seem like rules at all, and more like a dose of good old-fashioned common sense. In summary, they are:
- Estimate a fair value for the company.
- Buy only if the company's market price is significantly below that value.
- Look for a strong dividend policy as a sign of financial strength.
- Diversify appropriately to spread your risk.
It's a time-tested strategy that still works today, and one that my friend and colleague Philip Durell has used with great success as lead advisor for Motley Fool Inside Value.
The siren song
This, of course, raises the question: If the rules that allow individual investors to beat the market are so simple, why isn't everyone following them? Well, in a word, greed. Every few years, a new whiz kid comes along, with extremely rapid growth rates and a skyrocketing stock. Visions of quick riches dance before the eyes of those who are unwilling to wait for value investing to work its magic. Currently, Internet search and email juggernaut Google is wowing speculators with visions of dollar signs, thanks to rapidly rising earnings and a stock that has more than quadrupled since its IPO last year.
Yet, as Google's shares climb to ever higher heights, the connection between the company's stock price and its underlying business value gets more and more tenuous. Recently trading at 23.8 times its trailing sales and 95.3 its trailing earnings, the market clearly expects tremendous growth and perfect execution from Google for the foreseeable future. As long-time shareholders of technology companies like Sun Microsystems
What will stop Google's ascent? There are two insurmountable forces working against it: competition and size. On the competition side, other companies can clearly see the success of Google's business model and may soon start to emulate it. The added entrants will eventually provide reasonable alternatives for the advertising dollars fueling Google's growth, putting pressure on its margins. Then, there's its size. With $5.25 billion in trailing sales, rapid growth on a percentage basis simply becomes unsustainable. At current valuations, the market is pretty much pricing in expectations of Google doubling in size for each of the next few years. For perspective, should it be able to double in size for the next four years, Google would have around $84 billion in revenues. That's more than the current combined total revenue of beverage giants Coca-Cola
Think about that for a minute. To justify Google's price today, the market is essentially predicting that in four years, it'll be larger than the combined might of three of the companies behind some of the biggest and best known brands in the world. Could it happen? Possibly. Am I willing to put my own money behind that assumption? No.
Reasonable growth does matter
Despite problems associated with expecting too much growth, business improvement over time is a critical part of any investor's analysis of a company. In fact, when looking to buy a firm, its future prospects are the sole reason to bother investing. For the vast majority of companies, including behemoths like banking giant Bank of America
What has happened in the past may be a guide, but there's certainly no guarantee. For instance, oil giants like ExxonMobil
Unfortunately, we don't have a crystal ball. Therein lies the rub: With no certainty about what will happen, predicting growth rates and using them to value a company becomes little more than an educated guess.
Though there is no certainty in predicting the future, there is a plethora of information available for investors to use in determining growth rates. The relevant data include:
- The overall expected growth in the economy.
- The strength of the moat protecting the company from competition.
- The expectations for the future of the markets in which the firm competes.
- The recent financial performance of the business.
- The integrity of an enterprise's management.
- The business and commodity cycles and their impact on the company's operations.
And that's just the tip of the iceberg. Even the most robust spreadsheet cannot reflect all the factors that affect a business and its potential growth. And even if one could contain all that information, the answer it would spit out would still be determined by the assumptions and presumptions put into the model. If the assumptions are wrong, the answer will be, too. That's where experience factors in. With experience, you can learn how to answer the all-important question of "What's reasonable?" And with that question answered, fixing a true value to a company becomes a far more achievable goal.
The true power of Inside Value comes from that experience. Lead analyst Philip Durell has some 37 years of investing under his belt. That's enough time to have "been there, done that." Through experience, he has learned how to determine reasonable valuations for companies and how to profit from those times when the market gets it wrong.
The journey of a thousand miles begins with a single step. Click here to start your risk-free 30-day trial to Inside Value and begin gaining the experience you'll need to become a market-beating value investor.
This article was originally published on October 28, 2005. It has been updated.
At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Bank of America. Coca-Cola and Anheuser-Busch are Inside Value recommendations, Bank of America is an Income Investor pick. The Fool has adisclosure policy.