4 Value Investing Tips - dummies

By David Stevenson

The first great value investor Ben Graham believed that you make money by focusing. The path to true riches lies in a relentless focus on good value and a margin of safety. When you choose to invest hard-earned money in a share (a real-world business, not just a piece of paper) ensure that the company and its shares are cheap.

Getting great businesses at bargain prices

Cheap indicates a great many things to value investors. On a surface level it can mean that the vital statistics (the fundamentals) of the company’s share price are cheap in relation to the wider market, or that the PE ratio is low, or that the ratio of sales to share price is unreasonably high.

But the word suggests more than simple ratios: it also means that a safety margin is built into the shares. Look at the company’s balance sheet and consider which assets back the shares – is the share cheap in relation to these assets?

Other value investors like to look at future prospects as well and consider whether future profits growth and cash generation are going to add to the intrinsic value of the business. They ask whether the stock is cheap relative to its future growth prospects.

Loving that dividend

Value investors are rigorous folk and they make the effort to acquaint themselves with all sorts of measures of shareholder wealth. In particular they love dividends – a juicy dividend can make a big difference to total shareholder returns over the long term.

As an investor, not only do you benefit from any increase in the capital value of the shares (following a re-evaluation by the market of the intrinsic value of the business), but you also get all those lovely dividend cheques. Add it all up and you can make above-average returns.

Buying a solid business with intrinsic value

The bottom line for value investors is that the market all too frequently undervalues decent companies with good prospects. Ben Graham disciple Mario Gabelli sums up the core of this philosophy:

We’re buying a business and a business has certain attributes . . . as surrogate owners there are certain characteristics with regard to the franchise, the cash generating capabilities of the franchise and the quality of the management . . . . You also have a notion of price. Where are you buying that stock within the context of what I call ‘private market value’ – what others might call intrinsic value? And within that framework, Mr Market gives you opportunities to buy above that price and below that price, that intrinsic value.

Focusing on this intrinsic value means looking at what you believe the assets and liabilities of the business are worth. Think like an informed industrialist and ask what such a person would pay to buy this business.

Consider the total business value: cash, receivables (that is, all day to day debts owed to the company), inventory and goodwill, earnings power, plus some modicum of future value potential. If the total is something you can view as cheap, you stand a better chance of making a profit.

Finding fallen angels

Ben Graham famously advises investors to ‘fish where the fish are’. In other words, if you spot lots of seemingly cheap companies in a particular sector, start investing because some of those stocks are probably cheap.

Graham’s core insight is that, despite wild speculative variations, shares do have a fundamental economic value that’s relatively stable and can be easily measured by the term intrinsic value. Over the long run, performance of companies and share prices generally reverts to a mean: the lowly priced cheap stock no one seems to like eventually rises in price as the market comes to love its intrinsic value in relation to the share price.

Only buy shares when their market price is significantly below that of the calculated intrinsic value.