Dear Investment Academy Reader,

Browse through the economics/investing section of your local bookstore and you’ll likely come across several books that talk about the “value investing” concept.

To many investors, though, it remains something of a mystery. What exactly does it mean? How do you find “value”? And how do you use the idea properly?

Today, I’ve asked the Global Investment Director of the renowned South African Investor, Alexander Green, to sheds some light on the subject. He’s also agreed to show you some of the characteristics to look for in value stocks, the potential problems with a traditional value approach and the best way to incorporate “value analysis” into your investing.

Here’s to your financial freedom,

Karin Iten
For the Investment Academy

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Why value and trading don’t mix

Last week, I spoke at a special conference on value investing at the beautiful Driskill Hotel in Austin,  Texas.

Virtually every stock market investor talks about “recognising value”. I’ve found that interest in value investing ebbs and flows depending on the market. No one wants to overpay for a stock, or keep holding one if the price gets nutty.

And that leads to ask a basic question: How do you find value in the stock market?

It depends whom you ask...

The fathers of value investing

The fathers of value investing, of course, were Ben Graham and DavidIten Dodd, two teachers at Columbia Business School who wrote the investment classic, Security Analysis.

They argued that value investing is about buying companies that are selling below their intrinsic value.

How do you determine that? According to Graham & Dodd, that means buying companies that...

*** Trade at significant discounts to book value.
*** Have high dividend yields.
*** Have low price-to-earnings (PE) ratios.

Buying this way is not only supposed to lead to higher returns. It’s also designed to provide a significant “margin of safety”. The idea is that if you buy a security right, your downside is limited.

A number of academic studies have shown that if you follow the principles of Graham and Dodd, you should do very well over the long-term.

But there are potential problems with this approach...

Don’t let a cheap stock suck you in

First of all, stocks are rarely as cheap as they were back in the 1930s when Security Analysis was written. Or even as cheap as they were back in 1982 when the typical stock sold for less than book value and eight times earnings and yielded more than 6%.

And if you sat out the last 28 years out because stocks were too expensive, you missed an awful lot of opportunities.

When you do find a stock that does meets Graham and Dodd's stringent requirements, you also need to be patient. Why? Because companies that are very cheap are out of favour for a reason. Sales are often flat or down. Earnings are weak. Profit margins are low.

You can’t succeed just by buying a company that’s cheap. (It can always become cheaper.) You have to buy a company that will someday – and perhaps not too far off – be dear to others. Otherwise, when will you take profits?

So maybe Graham and Dodd's message needs modifying. (Warren Buffett, Graham's most famous student, has certainly found ways to modify it.)

The problem with defining “value”

I've found that the definition of value and the tools to achieve a margin of safety are flexible. And The South African Investor has found successful ways to bend them.

To my mind, any stock that goes from R10 to R50 was a “value” at R10. I don’t care what the PE or price-to-book was at the time. With the luxury of hindsight, it was clearly a bargain. Why quibble?

But die-hard value investors will argue that if the stock was “overvalued” at R10, it’s only more grossly so at R50 - and therefore, you’re at great risk holding it.

I disagree. If you use trailing stop losses, your upside is unlimited and your profits fully protected. As long as a stock keeps trending up, you should be content to hold on – no matter what the valuation. When the stock eventually turns, as all do eventually, your stop loss will keep the profits from slipping through your fingers.

As for value analysis, quite frankly, I don’t spend a lot of time poring over PEs and book values. I’m only interested in identifying companies that are likely to show dramatic, better-than-expected growth in the quarters ahead. These stocks tend to be more expensive than average, just as companies that will show little or no growth tend to be cheaper than average.

This method works, too...

Do you have the key traits to profit from this approach?

Growth stocks tend to sprint. Profits often come sooner rather than later. As someone who spent 16 years as a money manager, I know that most investors don’t have the patience to be good value investors. (John Templeton, for instance, held companies in his flagship Templeton Growth Fund an average of 7.5 years.)

Yet clients will start to grouse if a stock doesn’t move for six months. They call it “dead money” and start itching to move it elsewhere.

I understand this instinct. But deep value investing and rapid trading don’t mix.

If you’re a patient, truly long-term oriented investor, value investing can work wonders. If you’re not, you’ll be better off searching for companies that are set to smash estimates.

Good investing,

Alexander Green
For Investment Academy