In practice: Finding companies and analysing them

Part 4 of a series of 4 articles on beginning value investing, originally published in the gleaming new-look Interactive Investor mothership’s Trading and Investing Strategies pages. If you’re new to value investing, or a seasoned bargain hunter, I’d like to know whether you think I’ve done a good job explaining the basics.

Peter Lynch famously urged investors to "buy what you know", but he complained in the second edition of his bestselling book One Up on Wall Street, that people had misinterpreted him.

Readers had taken him literally and he subsequently wrote:

Liking a store, a product, or a restaurant is a good reason to get interested in a company and put it on your research list, but it’s not enough of a reason to own the stock! Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition… and so forth.

Lynch even interrupted family holidays to visit nearby companies, never missing an opportunity to ‘kick the tyres’.

Warren Buffett says he always stays within his ‘circle of competence’, jargon that has joined ‘margin of safety’ in the value investors’ lexicon. But Buffett flicked through catalogues of companies getting to know them, and constantly reads the business press and company reports. Both men are intensely curious, and as they have invested, they have expanded their circles of competence.

Learning about different companies is one of the rewards of investing, and it’s essential if you are to diversify. To find them, you could start at ‘A’, and work right through the stock market investigating the companies. But there’s a more efficient way: using a computer to screen out companies that don’t meet basic value criteria. In other words, focus on those that, statistically speaking, look cheap and sound.

Let’s start with two fundamental statistics in investing, net profit and book value. You can find these figures in any set of company accounts.

Net profit is the money earned by the company for its owners in, say, a year. It’s recorded on the bottom line of the company’s income statement. Book value is the value of the company’s assets, what it owns, minus its liabilities, what it owes, at the end of the year according to its balance sheet. It’s also called shareholders’ equity, because it’s that part of the company funded by shareholders, as distinct from other forms of funding which are broadly speaking kinds of debt.

If we calculate net profit as a percentage of shareholders’ equity, we get return on equity, which is a measure of how profitable the company is.

If we calculate shareholders’ equity as a percentage of all the company’s assets (ie those funded by debt as well as equity) we are measuring leverage, or gearing. That is, we’re discovering how indebted the company is.

A high level of profitability suggests the company’s managers are doing something right and the company may be a growth engine. Although it may pay a dividend to its shareholders, it will also retain some of the profit to invest, and because the company is so profitable, those investments should earn shareholders a good return in future.

A high level of equity (as opposed to debt) suggests the company has the financial resources to fund itself into the future, even if profits should fall unexpectedly.

By instructing your computer to find companies with high levels of profitability and low levels of debt it’s likely you’ll find lots of good companies. But that’s only half the recipe for success. Good companies are not good investments, if you pay too much for them.

To guard against paying too much you can compare the book value to the market value. The higher the book value in relation to the market value, the cheaper the shares look.

So a simple, but effective strategy for a new value investor is to concentrate your search on companies that are:

• Profitable: the higher the return on equity, the better

• Mostly funded by equity: the lower the level of debt to equity or assets, the better

• Cheap: the lower the market price relative to book value the better.

Generally speaking, shares with combinations of characteristics like this perform better than the stockmarket over long periods of time, but individual companies will often disappoint because these measures are neither precise nor invariable

A company’s accounts are the result of a large number of often questionable judgments made by accountants, some companies’ assets are intangible, meaning literally you can’t touch them, and impossible to value with precision, and just because a company is profitable in one year, does not mean it will be profitable the next.

Some investors are content to get the basics right and play the averages using mechanical investing strategies. Others improve on and interpret the financial statistics.

When you get to that stage, you’re definitely no longer a beginner, but as Warren Buffett and Peter Lynch know, and Benjamin Graham knew, the learning never stops.

Taking the next step:

• Screen stocks at Interactive Investor

• Try a more advanced screener at Sharelockholmes.com

• Participate in my blog

Accounting texts for value investors:

• How to figure out Company Accounts by Michael Brett

• Guide to Analysing Companies by Bob Vause

• Interpreting Reports and Accounts by Geoffrey Holmes, Alan Sugden and Paul Gee

Advanced reading for value investors:

• Security Analysis by Benjamin Graham and David Dodd

• Behavioural Investing by James Montier

• Value Investing by James Montier

• Financial Statement Analysis and Security Valuation by Stephen Penman

In practice: First steps

Part 3 of a series of 4 articles on beginning value investing, originally published in the gleaming new-look Interactive Investor mothership’s Trading and Investing Strategies pages. If you’re new to value investing, or a seasoned bargain hunter, I’d like to know whether you think I’ve done a good job explaining the basics.

No matter how many guides you’ve read, every company is different. Investing, which may seem comprehensible in theory, suddenly looks complicated and uncertain when you put it into practice.

The only way to get experience is to invest, but plunge right in and your first years as an investor will probably be the riskiest. If you’re lucky you’ll pick winners and survive long enough to develop the skills you need. If you’re unlucky you’ll pick lemons, lose money and give up.

To add to the dilemma, the standard defence against stupidity and bad luck is diversification, owning shares in lots of different companies. The more shares you own, the less severe the impact if one or two do badly. But to buy lots of shares you must commit lots of money at the riskiest time of your career, and you must know about many different companies when you’re profoundly ignorant!

It’s a Catch-22 situation, but there are ways around it:

Phantom portfolios

To set up a phantom portfolio, you pick stocks but never buy them. Instead, you track the shares in an online portfolio like Interactive Investor’s, or an Excel spreadsheet, or even a piece of paper, and see how you do.

It sounds like a painless way to learn from your mistakes and you don’t need any money to do it, but there are two big disadvantages. It takes years, five at least, to establish an investment record you can credit to skill, as opposed to luck, and people behave differently when their children’s’ inheritances rest on the decisions they make.

Run a phantom portfolio by all means if you’re very patient, and prepared to take it very seriously.

Investment clubs

Clubbing together with other investors means you can pool your money and your talent. Setting up an investment club is fairly easy; an organisation called Proshare sells a guide. You’ll be risking only a fraction of the money required to build a diversified portfolio of your own, and the sum of your intellects may be greater than the parts.

The only problem is you’re investing with other people who make decisions about your money by show of hands in monthly meetings, so you must get on with them.

Start an investment club if you can gather enough people you trust who are committed to researching shares, learning about investment and administering the club.

Fund plus ‘fun money’

You can commit a small amount of ‘fun money’ to a small portfolio of say four or five shares, and remain diversified by investing the rest of the savings you have earmarked for shares in a sensible fund. Choosing a sensible fund can be as difficult as choosing a sensible company but the advantage is you only have to do it once, rather than twenty times to fill your portfolio.

I apply the same principle to choosing funds as companies; I want a good fund at a cheap price. The price, in this case, consists of the fees you pay the fund manager and the broker. The easiest solution is a global or FTSE All-Share index tracker which guarantees diversification and average performance at low cost.

Many experienced stock pickers continue to use funds to diversify their portfolios. Nearly 75% of my pension is in individual companies, but the rest is in Fundsmith. Its manager, Terry Smith, follows value investing principles like mine, but applies them to the world’s biggest companies, while I focus on small UK companies. The charges are low, so it meets my criteria of a good fund at a cheap price.

Invest in a fund plus ‘fun money’ if you can afford to put aside enough for a diversified portfolio. Realistically, that’s about £20,000 or £1,000 for every company, with the balance in a fund.

Mechanical investing

Finally, there is a way to invest in a portfolio of shares relatively quickly without throwing darts at the companies and markets page of the Financial Times. You let the computer do the leg work by programming it to find good companies at cheap prices using financial data from company accounts.

The ‘programming’ is far easier than it sounds as there are sites and software that do it for you. The difficulty is finding a system you can trust. That’s because all systems do badly at times and if you give up then, your investments will have done badly too. Your only defence is to understand the system well enough to stick with it for better and worse.

Joel Greenblatt‘s Magic Formula is a good example because it targets good companies at cheap prices. Greenblatt is a respected value investor, and his bestseller The Little Book That Still Beats The Market explains the system well. His site only covers the US market, but various companies offer Magic Formula picks for the UK.

Only follow a system if you understand it, are prepared to follow it through thick and thin, and invest enough money to fund a diversified portfolio.

Taking your first steps:

• Start a portfolio on Interactive Investor

• Start an investment club with Proshare

• Read The Little Book That Still Beats the Market by Joel Greenblatt

• A review of Magic Formula data services

In theory: How much to pay

Part 2 of a series of 4 articles on beginning value investing, originally published in the gleaming new-look Interactive Investor mothership’s Trading and Investing Strategies pages. If you’re new to value investing, or a seasoned bargain hunter, I’d like to know whether you think I’ve done a good job explaining the basics.

When an investor strikes a deal with the owner of a business to buy a share of his company, like in Dragons Den, it’s easy to see the principle of margin of safety in action. The investor haggles for a better deal, his margin of safety, and the entrepreneur compromises, or walks away.

Investing in the stockmarket is very similar. One way or another you decide whether the share price is cheap enough, whether it gives you a margin of safety, and if it is, you place an order with your broker. If it isn’t, you walk away.

Shares aren’t always cheap. Sometimes they’re expensive, and sometimes the market price seems about right. Benjamin Graham likened the stockmarket to a hyperactive business partner, Mr Market, who would offer you his share in the business, or make an offer for yours, every day:

Sometimes his idea of value appears plausible… Often, on the other hand Mr Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

Over many years, markets accurately reflect the value of companies, but in the short term Mr Market is fickle. This gives investors an opportunity to buy shares when prices are low, and sell when they are high.

It sounds easy, but in practice people find it very hard to do. When a share price is rising it gives them confidence and they tend to buy. When it’s falling they tend to lose confidence and sell. Sometimes following the crowd like this is justified, but generally you’re buying high and selling low, which is not a way to make money.

Thinking like a value investor means thinking independently. Low prices are good, unless the business you’re buying a share of is cruddy. That’s a technical term, meaning it’s got serious problems that diminish or eradicate its ability to profit in the future. The mistake many investors make is in thinking the market price tells them something about a company. It doesn’t, it tells you what Mr Market thinks of the company. Value investors decide whether they agree with Mr Market or not.

There are two ways to decide. The first is to examine the company’s finances, its record of profitability, and its prospects, and calculate the company’s value. Graham called this ‘intrinsic value’ analysis to differentiate it from the more erratic market value. By comparing the two, it’s easy for an investor to see whether a company’s shares are cheap or expensive.

Unfortunately, intrinsic value analysis is very difficult to do. In the early 1970s and late in his career, Graham rejected it. He doubted both the use of increasingly complex mathematics to calculate the present value of dubious profit forecasts, and whether any individual analyst could expect to produce consistently superior valuations. It just wasn’t worth the effort now that everybody was doing it.

He reckoned investors could earn 15% a year in a typical year by following very basic rules identifying good companies at cheap prices. Those rules (simplified even more here) were to buy shares that cost less than about ten times earnings in companies where shareholders owned more than 50% of the company’s assets, and to buy lots of them.

These two factors, the price/earnings ratio and the ratio of equity/assets, are rough and ready proxies for value and quality. They help us gauge the cheapness of the shares, and the quality of the company, without having to calculate intrinsic value. But they are fallible, which is why Graham proposed owning portfolios of 20 or 30 companies.

Sometimes the shares look cheap, but the business really is cruddy. Woolworths, which went bust in 2008, was an example. And HMV (HMV), which is in trouble right now, could be another.

On average, over long periods of time, research shows value portfolios beat the stockmarket average handsomely. Put all your money in a few companies selected this way, though, and you could lose everything if you pick the wrong ones.

More advanced books on value investing:

• The Intelligent Investor by Benjamin Graham (updated by Jason Zweig)

• The Rediscovered Benjamin Graham by Janet Lowe

• The Financial Times Guide to Value Investing by Glen Arnold

In theory: Value investing from the masters

Part 1 of a series of 4 articles on beginning value investing, originally published in the gleaming new-look Interactive Investor mothership’s Trading and Investing Strategies pages. If you’re new to value investing, or a seasoned bargain hunter, I’d like to know whether you think I’ve done a good job explaining the basics.

You’ve probably heard of some of the great value investors. Most famous of all is Warren Buffett, who tends to swap places every so often with his friend, software billionaire Bill Gates, as the world’s richest man.

Buffett is no longer an investor like you, or I. His company, Berkshire Hathaway (BRK.A), is one of America’s largest and as well as being a major shareholder in giants like Coca-Cola (KO) and American Express (AXP), it owns numerous companies outright; insurance companies, a railroad and a sweet manufacturer, for example.

Even though he’s as much a businessman as an investor, or perhaps because he’s a businessman, Buffett still adheres to many of the value investing principles he learned as an apprentice in the 1950s.

As for pure investors, it’s a mildly embarrassing fact for the fund management industry that few of its members beat the market consistently over a long period of time. Coincidentally two that did, worked for the same company, both of them value investors. Peter Lynch who ran Fidelity Magellan is perhaps America’s most famous former fund manager, and Anthony Bolton who ran Fidelity Special Situations is perhaps Britain’s most famous.

There are many other examples of successful value investors, but the important point about them is they share a common philosophy. That is, when you invest you become part-owner of a business, and the success of that investment depends on two things; the price you pay and how well the business does in future.

You can see the value principle at work in the TV programme Dragon’s Den. A successful pitch always plays out the same way. The dragons ask the entrepreneur about their business: how it makes money, how it’s funded at the moment, and how it’s performing – the value of sales and profits in recent years and maybe some forecasts.

If a dragon understands the business, and they’re satisfied it will earn enough profit to give them a good return on his investment, they’ll make the entrepreneur an offer. Almost always they’ll demand a bigger share of the company than the entrepreneur wants to part with because the company may not do as well as the entrepreneur thinks and if it doesn’t, the dragon’s share of the profits, their return, will be lower.

By demanding a bigger share of the company for the same amount of money, the dragon’s are trying to pay less than they think the companies are truly worth. You might think that’s tight-fisted, but actually it’s a form of insurance. Since a company’s value depends upon how much money it earns in the future, which nobody can know for sure, an investor must pay less than their estimate of a fair price, to be confident they’ll get their return.

The difference between a fair price, and the price an investor pays, is, in value investing terms, known as the ‘margin of safety’ although, since safety is elusive in investing, I prefer to think of it as a margin of error in valuation. The bigger the margin of safety (or error), the more profitable an investment is likely to be.

This principle was first articulated by perhaps the most significant value investor of all, Benjamin Graham. He was a hedge fund manager who made a fortune in the Roaring Twenties, lost it in the Wall Street Crash, and regained it during the depression years. Graham was a professor of finance and he literally wrote the textbook on investment analysis. The first edition of Security Analysis was published in 1934, and it’s still in print today.

Warren Buffett trained at Graham’s firm, and though he, Lynch, Bolton and countless other investors have embellished Graham’s methods, the one thing that unites them all is a refusal to pay more than they think a business is worth, hence their reputations as value investors.

Value investing primers:

• The Little Book of Value Investing by Christopher Browne

• One Up on Wall Street by Peter Lynch

Greenblatt on the small investors’ advantage

From a (recording of a) live chat with Joel Greenblatt. We’ve heard the most important advantage value investors have before, but its worth repeating to stop us trying to play the same game institutional investors do (only even less well):

Small investors don’t have customers. They can afford to have a long term horizon.

Professional managers, their time horizons have gotten shorter and shorter. It’s mostly because their clients have very short time horizons, so If you’ve underperformed for the last year, two, or three, you don’t get new money and you lose a lot of the money that you already have. So understandably, just because of the way the system works and managers are looking to gather assets, they’re very focused on short term results, trying to find companies that will do well in the very short-term…

By following value investing [strategies]…, usually the companies that we’re buying the most of, their near term results don’t necessarily look so rosy… they may be good. The stock may be cheap. But next year may be a little bit uncertain. Or next year may not be quite as good as last year…

And it just turns out that because the business has become more institutionalised, that time horizons have really shrunk over the last twenty/thirty years, most people can’t take advantage of the long term perspective a value investor needs.

The whole chat is worth watching, if you’re a fan of the Magic Formula, or you’re interested in fundamental indexing, or his new initiative: value weighted indexing. The new book, to go with the new initiative, is The Big Secret for the Small Investor.

He ends the book with a quote from Ben Graham I have used before:

The main point is to have the right general principles and the character to stick to them. The thing that I have been emphasising in my own work for the last few years has been the group approach. To try to buy groups of stocks that meet some simple criterion for being undervalued regardless of the industry and with very little attention to the individual company. Imagine. There seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after sixty years of experience it seems to stand up under any of the tests that I would make up.