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How to Start Investing (Part 2)

| April 27, 2015 | Value Investing, Value Investing 101 | 10 Comments

Enterprising InvestorThe Enterprising Investor

Welcome to Part 2 of this “How to Start Investing” series.

In the first article, I explained all about:

  • Brokerage accounts
  • Index funds
  • Dollar-cost averaging
  • How to earn a long-term return of over 9% per year

If you haven’t already read Part 1, take a moment to check it out now.

In this article I will describe the main value investing strategies available to Enterprising Investors. 

It All Starts with Price

Price versus value.

This is the one concept that unites all value investors, and is where any investment decision should begin and end (see the section “Price is What You Pay, Value is What You Get” in this Vintage Value article).

While other stock market participants may buy a stock without regard to its price (hoping perhaps that they’ll be able to sell the stock at an even higher price to someone else in the future), a value investor will always seek to understand what is supporting a company’s current valuation, and whether that valuation is in fact justified.

In other words, the first question any good value investor should ask him or herself is “What am I giving up for this stock and what am I getting in return?”

This may seem like a very logical and straightforward question – and it is in theory. But it’s a real challenge to put into practice, mostly because of how difficult it is to value a business.

To overcome this difficulty, value investors will often look for stocks that have a “margin of safety.”

Seeking a Margin of Safety

The concept of “Margin of Safety” – first used by Ben Graham and David Dodd in their 1934 book Security Analysis – is the difference between a stock’s intrinsic value and its market price.

The more a stock’s market price is less than its intrinsic value, the greater its margin of safety.

Warren Buffett best explains margin of safety in his famous essay, The Superinvestors of Graham-and-Doddsville:

You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in.

According to Graham, the presence of a margin of safety was the defining characteristic that separated an investment stock purchase from a speculative one.

The Benjamin Graham Method: Cigar Butts

Ben Graham ran his investment firm, Graham-Newman Corporation, from 1926 to 1956. During those 30 years, he employed a handful of strategies, including arbitrage, liquidations, and related hedges.

However, the strategy we are going to focus on here is his purchase of net-current-asset stock issues.

This is the strategy of purchasing stocks that are trading for less than their “net working capital value,” or the per-share value of current assets minus total liabilities.

These are the really dirt cheap companies, because theoretically they could be liquidated nearly immediately and return more value to the shareholders’ than the company’ s current market valuation.

Graham also called these “bargain” or “net-net” stocks, but the term of his that I most like is “cigar butts”. As Alice Schroeder writes in The Snowball (emphasis mine):

These companies were what Graham called “cigar butts”: cheap and unloved stocks that had been cast aside like the sticky, mashed stub of a stogie one might find on the sidewalk. Graham specialized in spotting these unappetizing remnants that everyone else overlooked. He coaxed them alight and sucked out one last free puff.

Graham knew that a certain number of cigar butts would turn out foul, and thought it futile to spend time examining any individual cigar butt’s quality. The law of averages said most of them were good for a puff. He was always thinking in terms of how much companies would be worth if liquidated. Buying at a discount to that value was his “margin of safety” – his backstop against the percentage that presumably would go bankrupt.

And Buffett has said this about cigar butts:

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long- term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

Graham suggests the following criteria for net-net or cigar butt stock investments:

  1. Financial condition: (a) Current assets at least 1.5x current liabilities, and (b) debt not more than 110% of net current assets.
  2. Earnings stability: No deficit in the last 5 years.
  3. Dividend record: Some current dividend.
  4. Earnings growth: Last year’s earnings more than those of 5 years ago.
  5. Price: Less than 120% net tangible assets.

While any stock meeting the above criteria would undoubtedly be a great investment, the requirements Graham used decades ago are incredibly constrictive in today’s market, which shrinks the universe of possible candidates to virtually zero.

So, I suggest concentrating your search on stocks of companies that are: (a) trading for less than their current assets minus total liabilities, and (b) with positive free cash flow over the past 5 years.

Additionally, it is wise to protect yourself by diversifying your holdings here (to the extant the universe of potential investments allows you to).

The Warren Buffett Way: Wonderful Companies at Fair Prices

At one point, Warren Buffett described his investment style as 85% Graham, and 15% Fisher (that is, Philip A. Fisher, author of Common Stocks and Uncommon Profits).

This was true for many years: even after Buffett left Graham-Newman Corp. he used primarily Graham’s strategies. But after he met Charlie Munger in 1959, who introduced him to Fisher’s concepts, his investment style changed drastically.

While margin of safety and price are still central concepts of his investment style (although Berkshire’s sheer size poses some challenges on those fronts), Buffett is much closer to 85% Fisher and 15% Graham today.

Fisher’s 15 main investment points can be summarized as the following:

  1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
  2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potential when the growth potential of currently attractive product lines have largely been exploited?
  3. How effective are the company’s research and development efforts in relation to its size?
  4. Does the company have an above-average sales organization?
  5. Does the company have a worthwhile profit margin?
  6. What is the company doing to maintain or improve profit margins?
  7. Does the company have outstanding labor and personnel relations?
  8. Does the company have outstanding executive relations?
  9. Does the company have depth to its management?
  10. How good are the company’s cost analysis and accounting controls?
  11. Are there other aspects of the business somewhat peculiar to the industry involved that will give the investor important clues as to how the company will be in relation to its competition?
  12. Does the company have a short-range or long-range outlook in regard to profits?
  13. In the foreseeable future, will the growth of the company require sufficient financing so that the large number of shares then outstanding will largely cancel existing shareholders’ benefit from this anticipated growth?
  14. Does the management talk freely to investors about its affairs when things are going well and “clam up” when troubles or disappointments occur?
  15. Does the company have a management of unquestioned integrity?

Buffett’s conversion from Graham’s “cigar butt” investment style to Fisher’s “excellent company” style was really driven by two underlying beliefs:

  • First, Buffett rejected the idea of diversification. He believed that he could make the most money by concentrating his investments in only his very best ideas, instead of holding a portfolio that included mediocre companies.
  • Secondly, Buffett realized that cigar butt companies were actually really bad companies, and the stock prices for such companies could jump in 1-2 years (in which time you’d be able to realize a decent profit) or you could hold the stock for 10 years and the price would never increase. And if you did hold the stock for 10 years, the company’s earnings would never have compounded. “Time is the friend of the wonderful business, the enemy of the
    mediocre.”

In short, Buffett prefers to “buy a wonderful company at a fair price than a fair company at a wonderful price.” Owning a wonderful company over a very long period time also takes advantage of the magic of compounding.

Enterprising value investors can copy Buffett’s strategies by looking for wonderful companies that are undervalued – at the very least reasonably priced.

Investors can identify wonderful companies by keeping within their circle of competence, by looking for companies with wide “economic moats” (Buffett’s term for what Michael Porter calls a sustainable competitive advantage), and by selecting companies with large profit margins, high return on equity and return on invested capital, and that generate great amounts of free cash flow.

Summary

It is up to you, as the Enterprising Investor, to choose which end of the spectrum to operate in. Both strategies can even be employed at the same time (although the criteria should obviously never be mixed and investment decisions should remain separate).

But no matter which end of the pool you choose to dive from, remember to always keep the price-value relationship at the top of your mind and a margin of safety within your grasp.

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