Benjamin Graham' value investing strategy is widely believed to be the most successful of all time.
And while many of you may not know much about Ben Graham, I'm sure all of you have heard of Warren Buffett and are keenly aware of his success as an investor.
What you may not realise is Warren Buffett was a student of Benjamin Graham and he bases his success as a stock picker on what he learnt from Benjamin Graham.
And that is the ability to seek out companies the market has undervalued.
These investors believe the market overreacts to good and bad news, resulting in stock price movements that do not match the company's long-term fundamentals.
The result is an opportunity for value investors to profit by buying when the price is deflated.
So which factors determine how much you should be willing to pay for a stock?
What makes one company worth 10 times earnings and another worth 20 times?
How can you be reasonably sure that you are not overpaying for an apparently rosy future that turns out to be your worst nightmare?
According to Benjamin Graham’s
best-selling book, The Intelligent Investor, he feels that four factors are decisive…
“The easiest money I’ve ever made”
Benjamin Graham uncovered this investment secret in the 1930’s.
Warren Buffett uses it… and his partner, Charlie Munger uses it…
And Sir John Templeton made $100 million in six months with this strategy...
He called it the “easiest money” he ever made.
He was 88 years old when he said that.
Now regular investors can use this investment strategy to pull in large sums of money.
#1: A company’s long-term prospects are vital to identify its real potential
The intelligent investor
should begin by downloading at least five years’ worth of annual reports from the company’s website.
Then explore the company’s financial statements, gathering evidence to help you answer two overriding questions:
What makes this company grow? And where do (and where will) its profits come from?
Good signs to look at for are…
1. A strong “moat” or competitive advantage.
2. Diversification allowing it to generate revenues from multiple sources.
3. Smooth and steady revenue and earnings growth over the past 5-10 years.
4. Investments to develop new businesses and products, or upgrade existing operations.
#2: A company’s financial strength and capital structure
The most basic possible definition of a good business is this: It generates more cash than it consumes.
Good managers keep finding ways of putting that cash to productive use. In the long run, companies that meet this definition are virtually certain to grow in value, no matter what the stock market does.
Start by reading the statement of cash flows in the company’s annual report. See whether cash from operations has grown steadily throughout the past 10 years. Then you can go further.
Warren Buffett popularised the concept of owner earnings (in other words, free cash flow). If “owner earnings” per share have grown at a steady average of at least 6% or 7% over the past 10 years, the company is a stable generator of cash, and its prospects for growth are good.
Next, look at the company’s capital structure.
Turn to the balance sheet to see how much debt (including preferred stock) the company has; in general, long-term debt should be under 50% of total capital. Another ratio you can use is the debt to equity ratio, which shows you how much debt a company is using to finance its assets.
#3: A company’s quality and conduct of management are just as key as profits and growth
A company’s executives should say what they will do, then do what they said.
Read the past annual reports to see what forecasts the managers made and if they fulfilled them or fell short.
Directors should admit their failures and take responsibility for them, rather than blaming their poor performance on scapegoats like “the economy,” “uncertainty,” or “weak demand.”
#4: A company must have a consistent record of paying shareholders dividends
The burden is on the company to show that you are better off if it does not pay a dividend. If the firm has consistently outperformed its competition in good markets and bad, the managers are clearly putting the cash to optimal use.
If a business is faltering or the stock is underperforming compared to its rivals, then the managers and directors are misusing the cash by refusing to pay a dividend.
You see, dividends are owed to investors. It’s a form of reward and they belong in the shareholder’s hands. What’s more, consistent dividend-paying stocks will be much more attractive investments – especially for value investors.
So start using these secrets of one of the world’s greatest investors to uncover the best value stocks today!
See you next week.
Managing Editor, Real Wealth