The Enterprising Investor
Welcome to Part 2 of this “How to Start Investing” series.
In Part 1, I explained all about:
- Brokerage accounts
- Index funds
- Dollar-cost averaging
- How to earn a long-term return of over 9% per year
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:
“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.”
Cigar Butt Criteria
Graham suggests the following criteria for net-net or cigar butt stock investments:
- Financial condition: (a) Current assets at least 1.5x current liabilities, and (b) debt not more than 110% of net current assets.
- Earnings stability: No deficit in the last 5 years.
- Dividend record: Some current dividend.
- Earnings growth: Last year’s earnings more than those of 5 years ago.
- 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:
1. Trading for less than their current assets minus total liabilities
2. Generating 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:
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.
So, which strategy is better: Graham’s or Buffett’s? Good question.
While Graham’s Cigar Butt strategy is a bit antiquated in today’s high priced markets, it still can produce fantastic results when properly employed. It is quite a bit riskier than Buffett’s strategy since the investor must determine exactly when to buy, hold, and sell. It also requires a lot of research and analysis to determine why the business is trading below market value, and when the market can properly re-value the stock.
Warren Buffett’s quality, buy and hold strategy is quite a bit less research intensive. The investor simply determines the rate of return based on the current trading price. While this can be easier, it requires an in depth knowledge of the business’s fundamentals. Quality investors also must be willing to stomach market volatility and possibly watch the stock lose value. At the same time, a long time horizon is an investor’s greatest asset when achieving stellar returns.
It is so intriguing that both methods are vastly different, yet are based on the same fundamental values. Both styles are valid, and I argue that both methods can be employed to boost even greater returns in an investor’s portfolio.