We meet again, readers. I apologize for the delay of posts on UI; it’s been a hectic couple of months. So I figured I’d fire up the engines again. Today I’d like to speak to you about the most intelligent way to invest in the market: value investing. Since Ben Graham and David Dodd incepted it in 1928, value investing has proven to be the most rewarding investing methodology. Between 1988 and 2004, the largest 1000 stocks that also tend to contain many symptoms of a value investment earned a 22.9% return on invested capital versus the S&P 500’s return of 11.7%. And that is just the return for the largest 1000! Imagine if you put in an hour or two into briefing over a group of those 1000—the returns would probably be higher.
You might ask why more people aren’t recognized as value investors or aren’t investing in these discounted companies if they consistently receive such high return. That is a valid question and I have a valid answer: retail investors either don’t have the time or don’t want to spend the time to find these undervalued stocks. More often than not, everyday investors buy and sell based on analyst estimates or their own emotions. It is easier to just follow the herd or follow what a professional says instead of taking time to understand a business. However, if you have the ambition to become a consistent and successful investor (after all, you are on this website), value investing is your best bet. It gives you the tools to make your own investment decisions with confidence and provides you with the opportunity to outperform the market for years and even decades. Does this sounds too good to be true? Read Joel Greenblatt’s short book, The Little Book that Beat the Market, and you’ll see where I’m coming from.
Even my main man Warren Buffett has been evaluating securities based on value principles since he first began Berkshire Hathaway. And we all know how his investments have performed—KO, PSX, GM, COP, MCO, GS, WMT, PG, among many other multinational corporations that have all yielded handsome returns over the past several decades. (Check Safeer’s first post on UI for examples). He doesn’t even invest in dozens of stocks like the diversification that many experts advise you to apply. It’s not an impossible task. His approach is similar to other value investing forefathers, and so can YOURS.
So just what is value investing? Value Investing is the process of buying investments at prices below their intrinsic value or discount prices. To come to a proper valuation, you must look at and understand the financial health and cash flow sustainability for a company.
As is commonly said on The Street…”Cash Flow is King.” By the way, if you want to be more advanced, you can create a Discounted Cash Flow (DCF) Model to draw out the future value of present cash flows that a company generates, which is the essential measurement of a business. This requires time, extremely accurate data entry, and multiple situation forecasting to project future cash flow yield. For those with less time or less interest, metrics like the Price/Earnings Ratio (P/E), Enterprise Value/Earnings before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA), Price/Cash Flow, Price/Sales, and others all hint at how the company is performing. I won’t go into the definition of each of these metrics, but understand that these are all multiples of financial performance statistics that equate to the current market value. If the price multiples are low, it may be undervalued. It is typical for a value investor to pore through 10-K’s (company’s annual filings of financial statements with the SEC) and quarterly investor presentations (available online under company’s investor relations tab) to get a sense of where the company is headed in the short run and long run.
I recently joined the USC Value Investing Group and quickly learned that a good value investment thesis requires 3 major components that can be explained very well:
- Industry environment: is the industry undervalued or why it will be more profitable in future, untapped future potential for industry
- Company-specific: reasons for undervaluation, such as great management, overestimated pitfalls by market analysts, untapped future potential for company
- Valuation: the metrics mentioned above but formally includes several tweaks of a DCF model
Further detail of the methodology can be found in Ben Graham’s books, The Intelligent Investor and Security Analysis, which are considered the bibles of value investing. All it takes is some confidence, effort, and patience to pick an undervalued company and hold it until it is overvalued. In The Intelligent Investor, Graham describes the “Margin of Safety,” which is a necessary precaution of purchasing investments at an even lower price than what you have found to be an undervalued price to allow for random market noise. Allow me to clarify…
Let’s say you’re looking to buy a car model to eventually sell in a yard sale several years later, and vow not to open the packaging until then. You go to a model shop and find one that you like being sold for $40. However, you have gone around to various model stores in the area, researched car models online, and found the average price of that model to be around $25. You may have even talked to model makers to ensure the labor costs for that piece result in a $25 selling price. (Now you see why being an investment analyst is not the most exhilarating job out there—unless spending hours interrogating car model makers is your cup of tea!) You could employ a margin of safety and find or wait for a seller to offer the model at $23.
Remember Joel Greenblatt? He urges the fact that stocks are essentially just ownership in businesses. If you can keep this in mind whenever you’re researching for value investments, you’ll be golden. A fully in-depth coverage of the method could take hours to explain, so I urge you to do some independent reading and research to find your style of value investing and hopefully adopt its principles. Check out these Columbia Grad School students’ pitch on Hertz to see what an amazing and in-depth pitch looks like. These guys are BEASTS!
Hopefully after reading this, you can comfortably say that “Nothing was the same.”