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Andrew Allentuck

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Bargain hunters

Andrew Allentuck

All equity investing rests on a single premise that the market has gotten the wrong idea of a stock and that through some form of analyis, a true value can be found with which other investors will eventually agree.

The most common denominator of theories focuses on the ratio of price to earnings, p/e. Value investors tend to focus on the (p) part of the measure, seeking stocks that are priced below their present or near term intrinsic value. Growth investors tend to focus on the (e) and seek stocks that are increasing their earnings above those the market has estimated for them. Growth investors look to the future, attempting to find companies that will be winners tomorrow. Value managers just want to find companies that are underpriced by today's numbers. Some are hard core value investors who insist on buying companies ignored or beaten up by the market. Others use "value lite" techniques to find stocks not adequately appreciated for their assets and business.

Regardless of which sect of value in investing one embraces, the value discipline is bargain shopping. If stocks were fruit, value investors would want what's on sale. By contrast, growth investors figure that if apples have doubled in price, they must be especially good.

The two schools of investing are a world apart, yet value investing, the older of the two disciplines, has probably made more people rich than trying to forecast earnings for years ahead, which is what growth investors have to do. "Over the long term, value portfolios beat growth, even though there are periods when growth may surge ahead," says Jackee Pratt, a vale investor who is vice-president and portfolio manager at Mavrix Funds Management Inc. in Toronto. "But over the long run, the vulnerability of growth investing to momentum players who overpay for stocks lets more conservative value strategies win," she explains. "It's a tortoise and hare contest and the tortoise eventually comes out the winner."

Warren Buffett, America's second richest man, the majority stockholder in Berkshire Hathaway, and perhaps the most respected investor in the world, told Fortune magazine in 1988, "great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised." Translation: seek out strong businesses that are looking a little ugly.

Buffett learned to appraise value stocks at the foot of the master, Ben Graham, co-author with David Dodd of the 1934 classic, Security Analysis. Professor of Finance at Columbia University, Buffett's alma mater, he is widely credited with creating the entire discipline of securities analysis. His book taught how to find bargains in the stock market, which, at the bottom of the Great Depression, was littered with them.

In 1956, Buffett set out on his own to manage his and others' money, using Graham's methods. Buffett achieved a 29 per cent return on his money over the next 13 years, according to New York University Professor of Finance Aswath Damodaran in his analysis of stock picking styles, Investment Philosophies. Buffett bought Coca-Cola stock when the company was suffering a wave of exploding bottles and other embarrassments, shirt makers and a candy store and other, unrelated businesses that met his standards. He suffered losses on airline stocks, but Berkshire Hathaway has become mainly a huge insurance business that spins off immense amounts of cash for reinvestment.

Ben Graham's principles, which remain embedded in more recent distillations of value investment theory, come down to what amount to 10 financial commandments for buying stocks. To meet Graham's value standard, companies must have:

  1. An earnings to price ratio double the yield on AAA corporate bonds;
  2. Stock with a p/e less than 40 per cent of the average market p/e;
  3. Yield (dividend/price) at least 67 per cent of the AAA corporate yield;
  4. Price less than 67 per cent of book value;
  5. Price less than 67 percent of net current asset value (liquid assets minus current liabilities);
  6. Debt to Equity ratio less than one;
  7. Current assets twice current liabilities;
  8. Debts less than two times net current assets;
  9. Growth of earnings per share 7 per cent or more for the last decade;
  10. No more than two years of decreasing earnings over the last decade.

This is investing according to balance sheets and historical income statements. The problem in attempting to employ Graham and Dodd investment methods today is that the world has changed and the old ratios no longer apply. Just before he died in 1976, Graham admitted that the rules had to be relaxed. Analysts have done just that.

Thomas P. Au, author of A Modern Approach to Graham & Dodd Investing, compressed the master's rules into 10 recommendations. In Au's revised system, companies must have:

  1. Strong balance sheets with debt no more than 30 per cent of total capital (debt plus equity);
  2. Ten years of reported results with no loss in the last five years;
  3. Five continuous years of dividend history without breaks up to the present;
  4. Strong net assets of known value for protection in case of earnings declines;
  5. Market capitalization of $500-million (U.S.);
  6. Reported income of $25-million (U.S.) or more in the most recent year;
  7. Survived a major recession and emerged in good shape;
  8. Mature and experienced management;
  9. A stock market trading history of at least two or three years;
  10. A listing on a major national exchange, frequent trading and good liquidity.

There is much scholarship to show that value investing is more profitable than growth investing over extended periods. In a comprehensive look at investment methods, What Works on Wall Street, author and statistical guru James P. O'Shaugnessy explained that while growth strategies beat value strategies on raw performance alone, once risk is factored in, value beats growth.

Warren Buffett summed up the Graham discipline, still the foundation of most approaches to value investing, with an insistence on sticking to the rules. "It's like spending eight years in divinity school and having someone tell you the 10 commandments are all that matter."

Books on value investing and its practitioners:

  • Thomas P. Au, A Modern Approach to Graham & Dodd Investing (New York: John Wiley & Sons, 2004).
  • Aswath Damodaran, Investment Philosophies (New York: John Wiley & Sons, 2003).
  • Benjamin Graham, The Intelligent Investor (rev. ed. with commentary by Jason Zweig; New York: McGraw-Hill, 2003).
  • Benjamin Graham and David Dodd, Security Analysis (New York: McGraw-Hill, 1934).
  • Janet Lowe, Warren Buffett Speaks (New York: John Wiley & Sons, 1997).
  • James P. O'Shaughnessy, What Works on Wall Street (rev ed.; New York: McGraw-Hill, 1998).
  • Martin J. Whitman, Value Investing: A Balanced Approach (New York: John Wiley & Sons, 1999).
  • Andrew Allentuck writes about investments for The Globe and Mail, and reviews books on finance for globefund.com and globeinvestor.com. He is also the author of several books.

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