Value Investing

Value investing has been around since the beginning of investing history. Legendary investing author Benjamin Graham is the widely considered to be the father of modern security analysis and value investing. Graham and David Dodd, another Columbia academic, introduced the concept of intrinsic value and the wisdom of buying stocks at a discount to that value. Graham’s ability to find profitable investing ideas led him to start the Graham-Newman Partnership in 1926. The Graham-Newman partnership prospered, boasting an average annual return of 17% until its termination in 1956. It was at this firm that Warren Buffett worked early in his career, learning from the master. Graham also blazed trails for the profession of investing and helped start what would later become the CFA Institute.

Value Investing Defined

Value investing is the strategy of choosing stocks that are undervalued and investing in those for future profits. Markets overreact to both positive and negative news, resulting in stock price movements that do not correspond with the company’s long-term fundamentals. The result is an opportunity for value investors to profit by buying when the share price is low. That is why value investors are often referred to as bargain hunters or even treasure hunters. Typically, value investors select stocks that trade at discounts to book value, have high dividend yields, have low price-to-earnings multiples or have low price-to-book ratios.

Value Investing is generally considered to be:

1. Conservative, relative to other investment disciplines (growth investing, momentum)
2. Defensive – as a safeguard against adverse future developments encountered in the stock market

Now that we have a basic understanding of what value investing is, let’s take a look at some characteristics of the value stocks.

Graham’s Stocks Selection Criteria

It was in the first edition of Security Analysis that Ben Graham put his mind to converting his views on markets to specific screens that could be used to find undervalued stocks. Graham suggested that the first five are essentially valuation criteria, and the following five are criteria that ensure the financial health of the business.

1. An earnings-to-price yield at least twice the AAA bond rate
2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
3. Dividend yield of at least 2/3 the AAA bond yield
4. Stock price below 2/3 of tangible book value per share
5. Stock price below 2/3 of Net Current Asset Value (NCAV)
6. Total debt less than book value
7. Current ratio great than 2
8. Total debt less than 2 times Net Current Asset Value (NCAV)
9. Earnings growth of prior 10 years at least at a 7% annual compound rate
10. Stability of growth of earnings in that no more than two declines of 5 per cent or more in year-end earnings in the prior 10 years are permissible

Tenets of the Warren Buffett Way

Warren Buffett is considered to be one of the greatest investors of all time. Early on in his investing career, Warren Buffett took Ben Graham’s work as the bedrock upon which he would build his investing philosophy. In Chapter four of The Warren Buffett Way, Robert Hagstrom identifies Buffett’s set of basic principles, or tenets, that guide his decisions.