Stock trek: enterprising investors take a voyage to value investing

Entrepreneur, July, 1998 by Lorayne Fiorillo

VULCANIZE YOUR PORTFOLIO

Any Vulcan will assure you, logic is all; emotion, nothing. If you expect your portfolio to live long and prosper, selecting a strategy and sticking to it is vital to your success. Whether you're in it for a quick score or the long haul, there are two generally accepted styles of equity investing: growth and value.

Growth investors seek companies whose earnings are compounding at a rate greater than other companies in their own industry and greater than that of whatever index to which they are compared. Such stocks need to keep their momentum going to keep their prices rising; therefore, they must sustain above-average earnings growth. Investors who favor this investing style often pay a high price for the stocks, especially when compared to the company's earnings or book value. They anticipate future earnings will grow enough to justify not only current prices but considerable future price increases. Some people call this investing style "the greater fool method": You buy at a high price, hoping to later sell at an even higher price to a greater fool. Growth companies are often found in flamboyant sectors, such as technology, consumer services, healthcare and consumer staples, and anyone who invested in these sectors during the past several bull market years was anything but a fool.

Value investors, on the other hand, measure what a company's stock is worth now, then try to buy it at a price lower than this value. Value companies are characterized by a stock price lower than that of the companies' earnings and book value. These stocks pay relatively higher dividends than do growth stocks and are more often found in mature industries, including utility, energy, consumer cyclicals (such as retail and home building) and financial companies. While both stock-selection styles have their devotees, for many, value investing has a logic even Spock couldn't dispute.

To find value stocks, chartered financial analysts Marvin I. Kline and Richard E. Buchwald of Berwind Investment Management LP in Philadelphia suggest narrowing your universe to stocks that fall into a few of these eight categories:

1. Each has a price-to-earnings (P/E) ratio that is at a significant discount to the market's.

2. Each has a low price-to-cashflow ratio. (Some value enthusiasts value this more than P/E ratio.)

3. Each sells at a low price compared to its value.

4. The stock's dividend yield is greater than that of the market.

5. Each can be purchased for less than 50 percent to 60 percent of its estimated private market value.

6. Each can be purchased at two-thirds of its current net liquidation value (current assets less total debt).

7. Each has a high level of insider buying.

8. The company has implemented a stock repurchase plan.

While only a few stocks meet all these criteria, a reasonable number can meet three or more.

BEAM ME UP, SCOTTY

Value investing may be logical, but does it get results? While past performance is no guarantee of future returns, Kline and Buchwald cite a 1976 study by Benjamin Graham, the father of value investing, in which he concludes that applying value investment principles resulted in an average annual rate of return of approximately 19 percent over the 50-year period from 1925 to 1975 - well above that of the general market. Tom Jackson, a Prudential Investments portfolio manager, agrees: "If you follow the value style over the long term, you could outperform [the rest of the market]."

In a study done by Jackson, one dollar invested in 1970 in the S&P 500 (with all dividends reinvested) would have been worth $30.20 at the end of last year, representing a compound annual rate of return of 12.95 percent. The same dollar invested in low price-to-book-value stocks would have been worth $73.27, representing a compound annual rate of return of 16.57 percent. Had that same dollar been invested in a low P/E ratio value stock, it would have grown to $92.66, for a compound annual rate of return of 17.56 percent. (Taxes and fees are not considered in this example.) Jackson notes that these returns aren't garnered every quarter or even every year but that three- to five-year periods may see such returns. Value investing seems to put the probability of long-term success in the investor's corner.

But like all things in life, value is relative. "A value investor," says Janet Lowe, author of Value Investing Made Easy (McGraw-Hill), "should study the work of Benjamin Graham." Lowe condenses Graham's ideas for racking up relatively safe, high profits into six rules:

1. Don't pay too much attention to the overall market. It's easier to find good buys when share prices are generally low, but you can still spot a few bargains even when the market is high.

2. Buy a stock as if you were buying the whole company.

3. Look for signs of specific value (below-average P/E ratios, above-average yields, and earnings that have doubled since 1985 with no more than two annual declines of more than 5 percent).

4. Focus on quality.

5. Diversify with both stocks and bonds.