The 7 Secrets of a Shrewd Value Investor

More than sixty years back, a 19-year-old boy seemed to have given up all hope of making money in the stock markets. All the investing techniques that he practiced from reading the books came a cropper. Then accidentally, in one of the libraries he used to frequent, he stumbled upon a book. After merely glancing through the first few pages, he realized that his 'Eureka' moment had arrived.

What followed over the next 50 years and more is the stuff of legends. Closely sticking to few of the very important principles laid out in the book and of course, picking up a few more as years passed by, he has created one of the biggest conglomerates in the world and is currently ranked amongst the world's richest men.

The book, he strongly feels, is by far the best book on investing ever written and remains as vital today as it was when he first stumbled upon it. The man in question is none other than the Oracle of Omaha, Warren Buffett, one of the savviest investors the world has ever seen. The book is The Intelligent Investor, written by the Benjamin Graham, under whom Buffett later studied.

Graham first published The Intelligent Investor in 1949. The book marks an approach to stock selection that is still applicable in the current environment. It remains the single best book ever to describe, for individual investors, the emotional framework and analytical tools essential to financial success.

Therefore, as part of our investor education initiative, we made it our mission to adapt the main lessons of The Intelligent Investor into a beginner's guide to value investing. Think of it as your investment manual.

If you're just starting to invest or you haven't yet read the book, our guide will help understand Graham's most important principles. (Even if you're an experienced investor and are familiar with the book, it's always 'intelligent' to review The Intelligent Investor.)

So let's take a walk in the value investing world and see how great returns-and safe returns-are in store for anyone who decides to follow the principles laid out in what Warren Buffett has called 'by far the greatest book on investing ever written'.

This is where it all starts. For successful investing, it simply does not get any more basic and any more important than this.

And so the very first chapter of our value investing guide revolves around knowing your place in the investing world-that is, knowing whether you are speculating or investing.

Graham placed vital importance on this concept. In fact, he begins The Intelligent Investor with this subject. In his own words:

'An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.'

So it is only when a thorough analysis of the facts strongly indicates that your investment will be protected from a loss under most conditions that you are investing.

However, in the easy language of business channels, newspapers, and brokers, anyone who buys and sells stocks is an investor, regardless of what he buys, why he buys it, or at what price. But not for Graham.

Warren Buffett, the greatest executor of Graham's philosophies, was once asked this curious question in an interview: 'Isn't speculating and investing all the same?' 'Most definitely not!' came the reply.

Buffett went on to expound that, with an investing attitude, you look to the asset itself to produce the return. So if you buy a farm and expect it to return Rs 1 lac per acre in profits from selling corn, wheat, etc, and you buy it for Rs 10 lac, you are looking at the returns from the farm itself to justify the price you pay for it. That is an investment attitude.

On the other hand, if you buy a stock and hope it goes up next week, that's pure speculation.

So be clear crystal clear about what you are doing before putting money in the markets. Remember, investing and speculating are different ball games. Indeed, speculating when you think you are investing is a quick way to lose your hard-earned money!

Stay with us on this guide. Once you are certain that you are taking an investing approach, you also need to know what type of investor you are. We will take you through this aspect in the coming segment of this guide.

The first principle of value investing asks you to be mindful of what investing truly means. Undoubtedly, you would have found investing more profitable than speculation. With the second principle, we move a step further and define the different types of investors. Graham classified investors into two categories based on a few criteria. Chief among them were the time and effort devoted by the investor, the returns expected, and the risk he undertakes.

Graham emphasised a distinction between the enterprising investor and the defensive investor. Only after you've identify which investor category you belong can you know which investment strategy you should follow.

The enterprising investor is also referred to as the active or aggressive investor, a path very few investors embark on, according to Graham. Investors who fall into this category have both the time and proper guidance or experience in the investing world. They have high expectations from their investments. But they are prepared to put in the effort required to analyse, research, and select investments.

To achieve a above average rate of return, Graham has laid a fine path for the enterprising investor. The aggressive investor has to follow policies that are inherently sound and promising and have not reached out the ears of amateur traders. The aggressive investor should look for undervalued stocks and cull out cigar butt stocks to yield strong returns.

The other type of investor is the defensive investor, the self-styled passive investor. Simply explained, the defensive investor is unwilling, or unable, to put in the time and effort required to be an enterprising investor. They also want to limit their risk when they invest. The investor here seeks a portfolio that entails minimal effort, research, and monitoring. Nonetheless they expect a satisfactory return while preserving the safety of their principal.

According to Graham, the defensive investor should follow a diversified path. Risk is adequately spread. An allocation to stocks and bonds is advised. In addition, the defensive investor should confine himself to the shares of large and conservative companies. He should invest in companies that have a record of profitable operations and have strong financials. With this approach, he can ensure pleasing returns and the safety of principal.

The shrewd value investor realizes that his chief problem-and his worst enemy-is neither market crashes nor market manipulation. It is often himself. Especially if he hasn't clearly determined which type of investor he is before investing. Because without this understanding, he cannot know the returns to expect, how much effort is required, the level of risk to take, or the strategies that to follow.

'The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage.'

Graham wrote that in the context of market fluctuations, which is the topic of our third principle.

The eighth chapter of The Intelligent Investor offers the best explanation of how an investor should view the market. It also introduces Mr Market.

All investors face the wide fluctuations of stock prices. As no one can control the movements of markets, it's smart learn how to turn this disadvantage into an advantage. You can do this in two ways: by way of timing and by way of pricing.

The way of timing is to hold or buy a stock when it is expected to move upward. Inversely, you sell or refrain from buying when the course is expected to be downward.

Pricing, on the other hand, is buying stocks when they are available at undervalued prices and to sell them when they cross their fair value.

To explain this, Graham asks us to imagine that we have an obliging partner named Mr Market. Everyday Mr Market tells you what the shares of a business you own are worth. On that basis, he offers to buy you out or sell you an additional interest. Sometimes the prices he quotes are agreeable to you. However, most of the time, Mr Market lets his enthusiasm or despair influence the prices he is willing to buy or sell shares. When exuberant, he fixes the price above the fundamental value of the business. When fearful, he sets the price of the business below the fundamental value of the business.

An intelligent investor, as against all, follows a very different path to get the most from Mr Market. He has done his groundwork well and knows the fundamental value of his interest. When Mr Market wants to sell at prices far below intrinsic value, the intelligent investor will buy from him. When Mr Market is excited and wants to purchase at a price above its fundamental value, the intelligent investor may choose to sell to him. At other times, he forgets about the market movements and pays attention to his dividend returns and the operating results of his company.

This example gives us the vision to look at opportunities based on value and price rather than emotion. You can expect the prices of your portfolio to change, but that should never allow you to change your investment decisions. This is because the market quotations are there for your convenience. They are either to be taken advantage of or to be ignored. But never, ever, to be taken seriously!

Stay tuned... In the next chapter, we will introduce you to a principle that takes us to the very heart of value investing.

Okay, so the broad rules of investment and portfolio construction are all fine. But eventually stock investing is all about what we do at the individual stock level. Thus, knowing how to appraise and value stocks is what will give us the definitive edge over other investors.

Did Graham have anything to say on this topic? Of course he did. As a matter of fact, this is what he chose to focus on the most in the latter half of his investment classic.

So, what are the chief factors entering into the valuation of a common stock? It was quite evident that Graham wasn't a fan of the discounted cash flow method of valuation (DCF). For him, valuation of a common stock is all about ascertaining the average future earnings over a period of years and multiplying that by what he calls the capitalisation factor. Please note that capitalisation factor is what we know as the price to earnings multiple.

Quite naturally, he then dives into how to go about finding out the most dependable value of each of these parameters.

Trust us-finding the approximate future earnings of a company is not at all easy. Many variables are involved. To be consistently on top of most of these on is beyond the capabilities of almost all investors.

Therefore, how do we work around this issue? Graham is of the view that as long as an investor sticks to only those companies where earnings can be predicted to a great degree of accuracy, he is likely to get dependable results. Besides these, the investor can consider another category of stock.

And that is the one where prices are so beaten down that one gets a huge margin of safety, even if one valued the stock using earnings based on past performance. In this case, even if the actual earnings are off by a good margin, the investor has good chance of making money because of the absolutely beaten down price.

Now, what about the capitalisation factor (or the price to earnings ratio)? Well, Graham opined that this factor mostly depends on the following parameters:

• The company's general long term prospects
• Its financial strength and capital structure
• Its dividend record and
• Its current dividend rate

Once you've assessed the stock on these parameters, you should have a fair idea of the capitalisation factor, or the fair P/E multiple, that you can pay for the stock.

This should be enough information for you to begin valuing a stock. Of course, there will be nuances that you will have to take into account as you move from company to company. But as far as the broad framework is concerned, the above is as good as any we believe. Now on to our next important principle of value investing...

What must you consider if you want to single out companies that deliver healthy returns? Management ethics, past records, competition, market size, and financial statements are a few. Most prominent in the financial landscape is the company's earnings per share (EPS). EPS figures occupy a lot of mind space for most investors. But Graham had reservations.

In theory, EPS figures can be an excellent indicator of a company's earnings. However, in practice, EPS figures can be deceptive. Graham discusses this extensively in the chapters titled Things to Consider about Per Share Earnings. Here Graham reminds us about the accounting tricks companies play. It's all about appearances at the reporting level. He then explains how investors can avoid this trap and get to the heart of matters.

At the outset, the best way to think about EPS is as the company's net earnings divided by its average number of shares outstanding. However, EPS figures differ according to how the company accounts for its 'net earnings' and 'shares outstanding'. A company hungry for recognition might manipulate these numbers. It may even hold back some revelations. It is important to consider all the factors that may impair the true comparability of numbers, which include:

• The use of special charges, which are never reflected in per share earnings
• The reduction in the normal income tax deduction by reason of past losses
• The method of treating depreciation costs
• The dilution factor implicit in the existence of substantial amounts of convertible securities or warrants

One must dig deep into the financial data to see through false claims.

Further, Graham emphasised that investors should analyse multiple years rather than a single year. A single year can never point out where the company is headed. One can average out the yearly earnings over the past, say, 7-10 years to arrive at an average earnings figure. This can help get a more complete picture.

Moreover, it is also important to account for the growth factor in a company's record. One should compare the average growth rate for past years with the growth in recent years. To be foolproof, the growth rate itself should be calculated by comparing the average of the last three years with corresponding figures ten years earlier.

One must always bear in mind these factors while dealing with EPS numbers. Only then can an investor be in a position to judge the past and future of a company.

By definition, shareholders are a company's owners. But do they act like owners? As far as the rank and file of shareholders is concerned, the answer is a clear 'NO'. And nowhere is this more evident than minority shareholders' apathy to dividend policies that companies follow.

Being an owner, every shareholder has a right to demand satisfactory operating results from those at the helm. And the intelligent investor will not ignore the capital allocation and dividend policies.

Emphasis must be laid on the manner in which a company is utilizing and reinvesting its profits. One approach here for shareholders is to demand a normal payout of earnings. This, Graham suggested, could be about two-thirds of the profits. If the payout is less than that, then the investor must be on alert about whether the company is reinvesting the profits profitably. Reinvestments should yield an equal or greater increase in share value.

A weak management with weak policies will take all or most of the earnings to pay debts and support the working capital position. They leave no room for a payout. It could also be a situation where the company with mediocre results opts for a policy of expanding its business. But this would require a complete clarification and a convincing defence before the shareholders accept it.

The delusion of bonus issues or stock splits should be avoided. Yes, the shareholder gets additional shares in such cases, but they add nothing to the value of his holding. It is a mere break up of shares into more units with less value than before.

Dividend payments should not be assumed to be good in all cases. The intelligent investor keenly scrutinizes the dividend policies of the company and holds company board members accountable for them. If the policy they follow isn't rational or appropriate, he tries to get it corrected by highlighting the issue to management. If that is still of no use, he must avoid companies that follow arbitrary or irrational dividend policies.

With that discussion on dividend policies, let's move on to the seventh and final golden principle of value investing...

Imagine you're on vacation and you're travelling on an airplane from India to New York. Now, if you were in charge of filling fuel in the aircraft before takeoff, how much would you fill? Will you fill exactly the amount of fuel that the plane needs to New York? Or to be safe, would you throw in at the very least 40% to 50% more than the plane needs to reach New York?

The answer would be the latter without a doubt. You would correctly reckon that a hundred unexpected things could come up along the way to extend the flight beyond the scheduled distance or time. And you wouldn't want to take the smallest of chances with your life now, would you?

Warren Buffett has been flying planes for more than 60 years now. Only, his plane carries the name of 'Berkshire Hathaway'. And his most important passenger goes by the name of 'capital'. For each and every journey that the plane has made, he has ensured the safety of his capital as if his life depended on it. And the way he has done that is by chanting over and over again the three magic words while filling the plane's fuel tanks-'Margin of Safety'.

Buffett learned to think about each and every investment decision in this way from Graham's last chapter in The Intelligent Investor. Treat the safety of your capital as the most important goal of investing-like your life depends on it. And the way to do that is by factoring in a margin of safety when making every single decision.

Buffett admits that he owes a large part of his current US$72 billion of net worth to this attitude. Says Buffett in a preface to The Intelligent Investor, 'If you follow the behavioural and business principles that Graham advocates-and if you pay special attention to the invaluable advice in Chapters 8 and 20-you will not get a poor result from your investments.'

And the invaluable advice in Chapter 20 that he talks about is nothing but this very concept. Very simply put, the concept has two parts that work together to give it its power:

The above two halves of the concept of margin of safety, when put together, become a very powerful positive force for your investment results.

The world is full of investors and analysts who lay claim to perfect visions of the future-to being able to predict the future of a business to the smallest percentage point. Such confidence in their own abilities to estimate the future makes them invest on the reliance of it coming true. If it doesn't, they incur losses.

Do not be part of this folly. Be humble about your abilities to estimate the future of a business. And therefore, always invest with Graham's margin of safety principle in mind. As simple as the concept is, you will come to realize its power to deliver profitable results over your investing lifetime. Buffett surely did.

And with that, we come to the end of our guide to value investing.

You may have thought that these principles are simple or basic...perhaps even obvious. But they are precisely what the principles of profitable investing are all about.

When all around you is going crazy, these principles will help you cut through the market noise and keep your focus on what truly matters in the world of investing. They will act as your anchor in the often rough seas of the stock market, giving you direction and stability when you are most in need of it.

Indeed, thousands all over the world have charted extremely successful investing track records by closely following Graham in both letter and spirit.

We hope this guide has given you a good head start to do the same.

That you have read this guide is also ample evidence of the fact that you are inclined towards risk averse, long-term investing. It also shows that your financial goals include building a portfolio of safe stocks that could become big wealth creators in the years to come.

StockSelect, our bluechip stock recommendation service, helps you achieve just that. In fact, it goes beyond and dispels the myth that one cannot make big returns from investing in 'safe' bluechip stocks!

StockSelect's performance spans a long period consisting of both bull and bear markets. Here is the full story of how StockSelect achieved its success and how you could start benefiting from it right away....

Regards,
Rahul Shah (Research Analyst)
Co-Head - Research, Equitymaster

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