Independent Investment Advice Since 1970

The Intelligent Investor: Two Approaches to Value Investing

By J. Royden Ward
Value Investment Specialist, Analyst and Editor of Cabot Benjamin Graham Value Letter

November 13, 2008 - The Intelligent Investor

Ward's Words of Wisdom

Simple System: Buy Low, Sell High

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Many 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 buy stocks at bargain prices and wait patiently until they become overpriced.

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 to diversify my portfolio; broad diversification reduces risk significantly. Thus my portfolio contains a mixture of growth stocks and value stocks.

In previous Cabot Wealth Advisories, some of the other Cabot editors have described how to find the best growth stock opportunities. Today I will describe my methodology for discovering sound value stock opportunities.

I have two favorite approaches to find stocks that are selling at bargain prices.

The first 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 to identify a bargain stock. Included in his criteria are: low price-to-book value ratio, low price-to-earnings ratio, strong balance sheet, some earnings growth and no earnings deficits during the last five years. In addition, the company must be currently paying a dividend and the future outlook for the company must be positive.

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.

If a stock meets all the criteria, and is trading well below its fair value, 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.

Warren Buffett has said, "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years."

What about us ordinary investors who can't wait 10 years? I have an easy solution--I buy when a stock is undervalued and sell when it becomes overvalued. Historically, it takes about two years for this to happen, on average.

The basic principle 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.

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My second value approach is called 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 these methodologies.  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."

Ward's Words of Wisdom: Buy an industry leader at a low price and sell at a higher price.  Buy low and sell high--it's that simple!

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I download a large amount of data into my computer each month and then turn my computer loose to determine preferred buy and sell targets for my stocks.  My database includes 10-year histories of sales, cash flow, earnings, dividends, book value and price per share for about 1,000 companies.

The initial objective is to organize the numeric history of each company, so that future stock prices can be predicted.  Calculations can be a little tricky, because anomalies such as deficits, exceptionally good or bad years, or a multitude of other variables could throw the predictions out of whack.  But I've programmed my computer to deal with anomalies, and the resulting stock price forecasts are quite accurate.

Each month, I publish my price predictions for 250 companies in the Cabot Benjamin Graham Value Letter.  I recommend that investors buy at or below my Maximum Buy Price and sell when the stock reaches my Minimum Sell Price.  It's that simple.

Everybody wants to buy when a stock is undervalued and sell when the stock price is fully valued.  But the trick is having a proven, time-tested system that helps you spot bargains, and rip-offs.  It's taken years to hone, but that's what my system is able to do!

I hope you found this explanation of value investing helpful. I'll be back with you soon.

Sincerely,

J. Royden Ward
For Cabot Wealth Advisory

Editor's Note: J Royden Ward, editor of Cabot Benjamin Graham Value Letter, says now is the time to buy, especially because many great stocks are so cheap. He even called this an once-in-a-lifetime buying opportunity. The Letter can help you get your portfolio back on track and recoup the losses you've suffered during the market's crash. The system, laid out by the father of value investing and followed by billionaire investor Warren Buffett, has brought investors returns of 20% annually since its inception 80 years ago. Don't wait any longer to get your investments on the right path. You've got everything to gain. Click the link below to get started today.

http://www.cabot.net/info/bgv/bgvir03.aspx?source=wc01

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