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Value Investing Basics

10 December 2012 No Comment

There is merit in investing only in ETFs (index funds) for individuals with exposure to the stock market.  The fees are low and you are guaranteed an index’s return; something many individual investors and mutual funds miss.  Some decide to invest in individual stocks because they want to try to beat the index, or they prefer more control.  For those investors, there are several choices for evaluating stocks.  Technical analysis (buying and selling stocks based on a company’s price and volume fluctuations) is one option, but this post will not delve into that arena.  The other major branch of investing is fundamental analysis, which analyzes a company’s financial statements, management, competitive advantages, and sector.  The two main branches of fundamental analysis are value and growth investing. This post will explore these two branches.

Some of the 20th century’s greatest investors have something in common: Ben Graham, Warren Buffett, John Templeton, John Neff, David Dreman, and Marty Whitman are all value investors.  Value investing means different things to different people, but Warren Buffett distilled the definition well in his 1992 Berkshire annual report: “What is investing if not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can be sold at a still higher price — should be labeled speculation (which is neither illegal, immoral nor — in our view — financially fattening.)”  A value investor buys a company because she believes it is intrinsically worth more than what the market is asking.  A growth investor, by contrast, may think that a stock is currently fairly valued, or overly valued, by the market, buts she expects the company’s future growth to drive the market price upward.  A value investor looks at a company’s growth too, but she is unwilling to overpay for it.

The easiest way to gauge a company’s value is to look at its price to earnings ratio (P/E).  You can compare it to the sector, or competitors, and get a sense for value.  A P/E is exactly as it sounds: the market capitalization of a company divided by the earnings of that company.  I prefer looking at free cash flow (FCF) and the price to FCF ratio (P/FCF).  FCF is the figure you get by subtracting capital expenditures — such as the sum a company might lay out to acquire new machinery — from the cash it has taken in from business operations.  Wall Street tends to focus only on earnings.  Just as with P/E, P/FCF can be similarly compared to competitors and sectors.  I find FCF is a more helpful number because earnings can be clouded by accounting gimmicks.  It is much harder to manipulate the bottom line in FCF.

The key ability for growth and value investors is to estimate the true value of a business, including its future FCF.  Unfortunately, there is no precise science to estimating the likely cash flow profitability of a business.  That is why most value investors prefer to have a substantial margin of safety when buying a stock.  For instance, if an investor deems a company’s value to be $10 a share, he may not want to purchase for more than $5 a share, giving him a 50% margin of safety.  A growth investor spends little time on margin of safety, because he expects future growth to dwarf the current price, regardless of the present value of the company.

A value investor would be wise not to give up on FCF growth, but he should try to pay a sensible price for it.  When a value investor creates a value analysis for a company, he should generally use a conservative growth forecast.  If a company has had average FCF growth of 25% over the past five years, he might run scenarios with future five year growth at perhaps 12% and 5% to see if there is a significant margin of safety should growth slow.  Unexpected events happen to even the most stable companies; invest with multiple future scenarios in mind, not just the best case.

If you’re interested in picking stocks, there are lots of avenues to follow.  I recommend following the value investing path laid down by Graham and Buffett.  Look for strong companies, but only at prices that offer you a significant margin of safety.  Growth is helpful, but remember not to overpay for it.

Aram Durphy is portfolio manager and principal of Liberty Hill Investing, an independent investment advisory in San Francisco, CA.  He specializes in value analysis of stocks and bonds

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