Buy stocks like you buy groceries, not like you buy perfume. - Ben Graham

The first kind of fundamental analysis is "value investing", the man usually credited with turning around the general view of shares from a speculative gamble to an investment was Ben Graham. Without going specifically into the sort of numbers to look at right now, Graham was a man who liked to pay 50 cents for one dollar.

As market valuations are so susceptible to fluctuations caused by investor hysteria, Graham often found that many stock prices were so depressed that if you were to calculate the value of the land a company owns, estimate how much a liquidator could get for selling off all the company's other assets, subtract out liabilities and then discount it again, you would still find companies who's share price was less than this (fairly commonly in bear markets). He would buy a bunch of stock and sit on it a few years. While he bought a few dud companies now and then his profits were gigantic for their day. The trick is to find companies like this and then choose them based on the talent of the management and the likelihood of producing a successful turn- around. The key principle was that he bought stocks with a large margin of error, by buying stuff that was stupidly cheap already he wasn't going to buy anything that was about to take a huge dive on some bad rumour. (Didn't stop him suffering catastrophic losses in 1929 though!)

Now you might not find stocks with discounts as great as this too often these days, in Graham's day the stock market did not quite enjoy the fairly respectable reputation it does today, back then accounting was murky, profits were kept under wraps so as to try to dupe both investors and the taxman and an uninformed market found it very difficult to estimate the intrinsic value of a company. Graham's greatest talent was finding this information (often through studying company submissions to various regulatory bodies). The world's greatest living investor Warren Buffett was a student of Graham, and if you examine Buffett's investment style you notice that however good a company is, he always insists on paying less than it is worth. With the billions Buffett now controls one can see that fully understanding a stock value is essential.

The reason why value investment works is because of a systematic misjudgement of risk by the market. According to a number of academic studies, security analysis is much more difficult than most people think and so in general whatever you think of a company's prospects is quite irrelevant. If enough people have a strong, but misguided, opinion about a stock then the price will reflect this bias. Generally, stocks trading at low prices reflect excessive pessimism. In other words, stocks trade at low prices because of the incorrect market perception of higher risk. The opposite occurs with "overvalued" stocks, where opinions are so rosy that a virtually impossible task lies ahead for company management in delivering an incredible performance in line with market expectations.

Since value investing is so well known, to be honest you won't find any leading stocks these days trading at a large discount to book value. If the stock market crashes and goes into a bear market you will get some good candidates, but it isn't a good idea to sit about for too long waiting, you will miss a lot of dividends if you are going to spend the next 15 years being bearish. Since the market has such a pronounced upward bias over time, it is better to be patient while in the market than patiently waiting for an unspecified amount of time holding nothing.

You will find plenty of value candidates among the lesser stocks however. Even in our "informed" and "efficient" markets, only the top stocks are subjected to the most intense scrutiny. There are lots of little businesses out there going cheaply, and this is the case even in the most expensive markets. On the other hand Graham himself wasn't fond of investing in these, in order to get a decent return on your money you want something that won't necessarily take 10 years to correct itself. Graham invested in the blue chips of his day when they traded at below the price of their liquid assets. His policy was to invest in big stocks because he knew that gross undervaluations would not persist for long in such stocks. Anonymous metal bashers in marginal industries can trade cheaply for many years since few brokers will even bother looking at them. As O'Shaughnessy showed in What Works on Wall Street, most forms of value investment produce the highest returns when applied to the biggest and best stocks.

There is no point putting your money in cash for 15 years waiting for a crash, and Graham himself knew that when in 1976, shortly before his death he was quoted in an interview in the Financial Analysts Journal as saying:

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when Graham and Dodd was first published; but the situation has changed... [today] I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost .... I'm on the side of the "efficient market" school of thought...

 

Even Peter Lynch is an advocate of index funds, rather than actively managed funds (though he didn't say this publicly until after he retired from Fidelity Magellan!)

You might note that there are "value index" funds available. Using a low turnover passive strategy they only buy stocks trading on low price earnings ratios etc. These combine some of the benefits of value investment with the benefits of indexing, and their historical performance is very good.

Warren Buffett is still very much an active value investor, the margin of safety concept is central to his thinking and he won't buy unless the price is right for him. He seldom searches for stocks that are below book value any more. Buffett credits Graham for most of his strategy, so of course value is the core of his ideas, but Buffett is a fusion of Graham and other investors like Phil Fisher, who think more in terms of business strengths and competitive advantages. To Buffett a good business is surely worth more than the price its bits and pieces would fetch on the chopping board, so Buffett modified and extended value investment to include economic goodwill as well. A more thorough summary of what this means is given in my article on Warren Buffett.

Even so, the basic principles of value investing remain to this day:

• Never invest unless you have enough information to be able to estimate the intrinsic value.

• Only invest when there is a margin of safety, the price is already discounted, bad news won't have such a dire effect on the share price.

• Only invest if you have the patience to wait a while until the market wakes up and realises how much this company is really worth.

• Sell when a company is priced substantially higher than intrinsic value, even if the price can still rise there are other opportunities out there for a wily value investor.

Warren Buffet bought heavily in his blue chip portfolio just after the 1987 crash, taking full benefit of the restored value in the strongest shares on the market. Since then his gains have been vast.

In The Warren Buffett Portfolio by Robert Hagstrom, there is a study (pg. 75) on the correlation between earnings of a company and the price of the stock. In the short term, the correlation is quite low. For stocks held for three years the degree of correlation ranged from .131 to .360, not very high. Stocks held for five years showed a .374 to .599 correlation between earnings and price. Over ten years the correlation ranged between .593 and .695. Over 18 years, the length of the study, the correlation between price and earnings was .699 - a highly significant relationship. When a company's earnings increase, its value increases. In the short term this may, or may not, affect the price of the stock. Over the long term though the correlation is absolute, whatever the flavour of the month is, the price will eventually reflect the intrinsic value, provided you have the time to wait for the gain.

Tweedy, Brown Company, one of the world's best value managers, using techniques little different to Ben Graham himself has published a very interesting booklet on value investment. Click on the link below to download a copy.

http://www.tweedy.com/library_docs/papers/what_has_worked_all.pdf