Value Investing Takes Advantage of Market Fluctuations
By
J. Royden Ward, Analyst and Editor of
Cabot Benjamin Graham Value LetterFrom Cabot Wealth Advisory
Sign up for free Cabot Wealth Advisory e-newsletterMany years ago, I was taught to believe that value investing, using fundamental analysis, is the best long-term approach when making investment decisions. I was taught to follow the teachings of Benjamin Graham, the father of value investing and Warren Buffett, his most famous protégé. I buy stocks at bargain prices and wait patiently until they become overpriced.
Buy an industry leader at a low price and sell
at a higher price. Buy low and sell high--it's that simple!The basic principal is simple: the stock market and the individual stocks that make up the stock market have always bounced back and forth from overvalued to undervalued to overvalued, over and over again. As a value investor, I am simply taking advantage of the fluctuations of the stock market.
In the years since, I learned some growth and momentum techniques as well. I never argue whether one approach is better than another. But I do believe in using more than one methodology when choosing stocks in order to diversify my portfolio and reduce my risk. Thus my portfolio contains a mixture of growth stocks and value stocks.
In previous Cabot Wealth Advisories, Timothy Lutts, Michael Cintolo and Paul Goodwin have described how to find the best growth stock opportunities. Today I will describe my methodology for discovering sound value stock opportunities.
I use a couple of value approaches to find stocks that are selling at bargain prices, and I use Benjamin Graham's criteria to guide me.
My first approach is to find stocks that are cheap, and I use Benjamin
Graham's criteria to guide me. Benjamin Graham is known as the father
of value investing and Warren Buffett is his most famous protégé. Why
try to re-invent the wheel when a proven, excellent system is there for
the taking?
In his book, "The Intelligent Investor," Mr. Graham details seven criteria that differentiate between a bargain stock and a stock that is priced too high. Included in his criteria are:
Low price to book value ratio
Low price to earnings ratio
Strong balance sheet
Some earnings growth
No earnings deficits during the past five years
Currently paying a dividend
Future outlook for the company must be positive (This eliminates banks and homebuilders for now.)
I know what you are thinking—this is old-fashioned stuff and won't work in today's fast-paced stock market. But that's not true; Warren Buffett has become the richest man in the world using the old-fashioned knowledge he gained from Benjamin Graham.
After I buy a value stock, I use my checklist as described above and wait...and wait...and if necessary I wait some more for the stock to reach my Minimum Sell Price. The time frame is usually about two years.
I use a couple of value approaches to find stocks that are selling at bargain prices: the Classic Benjamin Graham Value model and the Wise Owl Model (so named because I wanted everybody to think that the approach is wise, clever, eh?) The methodology is based upon a meeting between Benjamin Graham and my former college professor, Dr. Wilson Payne.
In the meeting, Benjamin Graham and Dr. Payne developed a method for estimating the intrinsic value of a company. From that came methodologies for calculating the Maximum Buy Price and a Minimum Sell Price. Dr. Payne then taught me and many other students how to estimate buy and sell prices. The estimated prices are not perfect, but when intelligent analysis is added, results are outstanding.
My goal in the Wise Owl Model is to find sound, high-quality companies with positive outlooks. Buying industry leaders with annual 20% to 30% price appreciation potential makes sense to me, especially if losses are few and far between.
The system is not infallible (none is), but as Benjamin Graham once said, "Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices."
In a diversified portfolio including growth stocks, value stocks can reduce volatility while delivering high consistent returns. In fact, Benjamin Graham's value system has delivered 20% a year to its followers for more than 80 years in all sorts of markets.
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