Value Investing Principles

How to Shop for Real Stock Market Bargains

By Steve Christ
Thursday, September 11th, 2008

Baltimore, believe it or not is the home to the famous streak.

And I'm not talking about Cal Ripken's famous run or Johnny Unitas' mark of 47 straight games with a touchdown pass.

Instead, I'm talking about the investment streak of a life time for Legg Mason's Bill Miller. His Legg Mason Value Prime (MUTF: LMVTX) mutual fund beat the S&P 500 for 15 straight years, making him a legend in the world of value stock investing.

But as impressive as Miller's run was, it ended just like all streaks do. Miller eventually came up short in 2006 with a 5.6% return while the S&P delivered 15.8%. And unfortunately for Miller and his investors, it has been downhill for his legend ever since.

In fact, Miller latest bungle was loading up on shares of Freddie and Fannie as late as this summer costing his shareholders big time. In 12 short months both of them have fallen by over 98%.

Miller's fund—not surprisingly—has fallen right along with them, as some other bad bets on "values" never materialized either. In fact, Miller's famous fund is down some 48% in the last 15 months.

That's not exactly easy to do in a diversified fund—especially one built on value.

But despite Miller's recent trials with this time-tested style, value investing lives on. The key however, as Miller has found out is sticking to the value plan. And doubling down like some desperate gambler isn't exactly part of it.

What are the Core Value Investing Principles?

And at is core, the plan is as simple as the man who devised it—Benjamin Graham. It is to buy companies at a deep discount to their intrinsic value.

That involves a fundamental analysis of a company's balance sheet. So typically, value investors select stocks with lower-than-average price-to-book or price-to-earnings ratios and/or high dividend yields.

The key here, of course, is the business model, and in that respect a true value investor is never interested in companies that lose money.

And while that may seem pretty obvious to some, the biggest mistake retail investors make is chasing companies that have never booked a profit. I see it all the time.

It's risky and it's wrong.

Not surprisingly, one of Graham's greatest students was none other than Warren Buffett himself.

His value legend is untarnished so far as he has racked up one terrific buy after another. And while there have been a few flubs, there is a lot to learn about investing by looking at the way "the Oracle" determines value.

Investing in Value Stocks with Warren Buffett

So how does he do it, buying companies and investing on the cheap?

Well in short, Buffet keeps it as simple as possible and he's incredibly patient, moving only when the markets are so far in his favor that he can hardly lose. And while numerous books have been written about him, a few of Buffett's many tenets for successful value investing stand out.

These are a few of them - investment questions that when answered properly have helped Buffet cement his reputation as the best value investor in the business.

They are:

• Has the company's performance been consistently good? A value investor's tool in this regard is return on equity or ROE. Return on equity is a company's net income divided by shareholders equity (book value). Value investors use ROE as a measure of how a company has consistently performed over time vs. its peers. A good ROE in this regard would be a 5 yr. average between 15-17 percent.

 

• Does the company carry too much debt compared to its peers? The measure of debt a value investor uses in this regard is the debt/equity ratio. Value investors like Buffett, in general, frown upon companies with high levels of debt. Instead they prefer that earnings growth is generated by shareholder equity as opposed to borrowed funds. In this case, the higher the ratio, the more debt that a company carries. And while this figure varies from industry to industry, a good way to measure it would be by looking for a ratio that is less than 80% of the industry average.

• Are profit margins high compared to its peers? Are they increasing? Value investors look for companies with above average profit margins. It's calculated by dividing the net income by the net sales. Companies with a strong history in this regard, say over an extended period of 5-10 years typically outperform. An above average performer will typically carry profit margins that are 20% above the industry average. Moreover, those same profit margins will tend to rise as the company becomes more efficient over time.

• How long has the company been public? In general, Buffett typically only considers companies that have been around for at least 10 years. That gives them the historical track record to make a proper evaluation of the company's future prospects.

• Are the company's products vulnerable to commodity pricing? Buffett is a strong believer in the "economic moat" and value investors need to be too. Therefore, if the company doesn't offer anything that is unique or substantially different from its competitors it true value is suspect.

• And finally, is the company cheap on a valuation level? This is the part of the Buffett magic that is hard for value investors to quantify because it deals with a company's intrinsic value. That's the value that goes beyond its liquidation value and includes all the many intangibles that are hard to put a figure on, such as the worth of a brand name. That's the gray area that separates the men form the boys. In general, Warren Buffet buys companies he believes are available at a 25% discount to their intrinsic value.

These, of course, are just a few of the many ways that a value investor like Warren Buffet has built up his massive portfolio over the years. That's because to a large extent, successful value investors never buys stocks, they buy long term values at an intrinsic discount to their earning potential.

That is the key to successful value investing. It's not always all about price.