Years ago, when I first started following the stock analysts here at Fool.com, one stuck out. He bought and sold stocks more often than I thought a good Fool should -- at least, based on my reading of The Motley Fool books that first attracted me to the website.
I was indignant. Back then, I thought that anyone who bought and sold more than once a decade was a day trader. (Cue opening chords of Beethoven's "Fifth Symphony.")
And as for the concept of a valuation metric -- an intrinsic or fair value -- that dictates when you buy and sell? That struck me as suspiciously like a Wall Street price target. What was The Motley Fool doing advocating market timing?
That was then
After some years of study, capped most recently by a dive into the recently reprinted 1940 edition of Benjamin Graham and David Dodd's Security Analysis, I think I get it. That first Fool writer -- Warren Gump -- and other favorites, such as Matt Richey, Zeke Ashton, and Whitney Tilson, are value investors all or in large part. I myself count value investing among the several strategies I use to manage my own portfolio. (And so do Tom Gardner and his guest analysts in our newest subscription stock newsletter, Hidden Gems.)
So, just what is value investing? In the spirit of the terrific new play, The Complete Works of William Shakespeare (Abridged), I will now tie together Benjamin Graham, value investing, big-name companies, index investing, and market timing all in one neat package -- and I'll do it in 1,200 words (editor's note: more or less).
Newbies and analysts
In Security Analysis, Graham distinguishes between the untrained investor and the securities analyst. He identifies two bedrock principles. "1. Principle for the untrained security buyer. Do not put money in a low-grade enterprise on any terms." He writes:
... untrained investors should confine themselves to the best regarded enterprises. It should be realized, however, that this preference is enjoined upon them because of the greater risk for them in other directions, and not because the most popular issues are necessarily the safest.
In other words, untrained investors -- I'll call them beginners -- won't find that sticking with the popular crowd will necessarily help, but it's sure safer than skipping class with that gang in the parking lot. (I would have said "losers," except that I spent some time there myself. Ahem.)
But what are the best-regarded enterprises, these most popular issues? That's easy. These are the companies and stocks you would recommend to a loved one ready to buy a first stock, probably after some time investing in a low-expense, broad-market index fund.
Most of these will be familiar large capitalization stocks, such as Wal-Mart
Yet, as many point out, not one of these businesses is without risks. General Electric has almost $50 billion in off-balance sheet debt it may have to consolidate, potentially to the detriment of its credit rating and more. Whitney Tilson has assailed IBM's Accounting Tricks, while Rex Moore questioned Big Blue's Accounting Clues. Can Microsoft live on Windows forever, and will any of its new ventures succeed? And so on.
... bring high valuations
Add to this business risk the risk of lofty valuation. These companies are so popular that everyone wants them, and more buyers than sellers drive stock prices higher -- in some cases, until they offer limited or no upside reward. According to Graham, this kind of company can become so highly valued that it qualifies as speculative. How's that for irony?
Still, in Graham's view, these stocks are better for beginners because they beat the alternative. If beginners wander beyond the usual suspects to the secondary or "low-grade" companies, there be dragons. Beginners lack the ability to analyze the available information -- most importantly, the financials -- to determine whether any stock, but especially a lesser-known issue, is cheap or dear. So they are more likely to pay too much and lose more. It happens every day, but most spectacularly in 1927-1929, the go-go years of the late-1960s, and 1999-2000.
Experience adds options
So, too, Graham lays it out for the analyst -- which I'll call the experienced investor -- succinctly: 2. Principle for the securities analyst: Nearly every issue might conceivably be cheap in one price range and dear in another. In his view, it's all about price. Just about any company could theoretically offer value at a low enough price and be a speculative risk if too highly priced. But how to know "cheap" from "expensive"?
While the beginner rightly feels accomplished in understanding the price-to-earnings ratio (P/E), the experienced investor digs deeper, dissecting the financial statements and getting to know everything about the individual business and its industry. The goal is to quantify business value and compare that value to the price the market has assigned.
Caveat: Graham's most famous student, Warren Buffett, and many value investors today also emphasize business quality in their search for value. As Matt Richey points out this week, a low P/E is not enough, because "cheap crap is still crap."
Bookshelves are lined with tomes on value investing, but let's focus on one tool popular with today's securities analysts: discounted cash flow analysis. The goal is to estimate a business' future cash flows (represented by earnings or free cash flow or some other measure) for some number of years, and then discount this stream of cash to present value using a given discount rate. Add in cash and equivalents per share net of debt and you get intrinsic value (IV), which Graham also calls fair value. This was a promising new development in 1940 that Graham cites approvingly in a footnote.
The value investor might say that if the stock price lags this intrinsic value by a certain amount, it represents a value, or if it's much lower, deep value (discussed further in Matt Richey's Quest for Deep Value and another guy's The Risk-Reward Tradeoff). The lower the stock price relative to IV, the greater the margin of safety -- that is, the more remote the chance that if your estimates are wrong the stock will blow up on you. The higher the stock price relative to IV, the reverse.
To Graham, intrinsic value is not exact. The idea is to come up with a range of IVs to guide the purchase and sale of stocks.
Discipline, not market timing
There are some happy consequences of value investing. Graham's Mr. Market is an emotional being, and stocks move broadly in waves up and down with his moods. At times of great enthusiasm, value investors may find that more holdings reach or exceed estimates for IV. They might then sell and watch their cash balances bulge. When enthusiasm declines, it is likely that more stocks will sell at attractive valuations and offer value investors good use for that cash.
This is why value investors need not know or care whether the "the market" is high or low; they just have to value individual businesses. Mr. Market's notorious mood swings may bring higher prices for a stock after you sell it, but value investors knows that the same swings will bring values in the future.
Growth vs. value?
So is value investing better than growth investing -- whatever that is? Research by Eugene F. Fama of the University of Chicago and Kenneth R. French of Dartmouth and cited by Mark Hulbert in The New York Times reportedly finds that the average value stock outperformed the average growth stock by an annualized 3.5 percentage points per year, over the last 77 years. Sounds good, but how on earth did they distinguish a growth stock from a value stock?
Price-to-book value, reportedly. Well, I'll pass. It's not my favorite indicator, and if it were that good a proxy and easy to apply as a strategy, I wouldn't be writing, you wouldn't be reading, and we'd all be sipping umbrella drinks on the beach.
Better to say that the more skilled you become in analyzing financials, the more value investing is a strategy to add to your investor tool kit. To get started and learn more, enjoy:
- How to Value Stocks
- Thoughts on Value Investing, Whitney Tilson (Whitney's archive)
- Value in the Cash Domain, Matt Richey (Matt's archive)
- Time for Deep Value Again, Matt Richey
- Value Stocks in Your Portfolio, uh, me (my archive)
And don't miss the terrific exchanges on our discussion board for Berkshire Hathaway
Have a most Foolish week, and thanks for reading.
Writer and senior analyst Tom Jacobs (TMF Tom9) writes commentary on Fool.com each Tuesday and short Takes throughout the week on issues that catch his attention. He welcomes your comments at TomJ@Fool.com . For individual financial advice, enjoy your freeTMF Money Advisortrial today! Tom owns shares of Microsoft and others you can find inhisprofile. The Motley Fool isinvestors writing for investors.