Part 1 of this series, I talked in generalities about laying the groundwork for becoming a successful investor. I discussed some good literature to get you started down the right path and suggested familiarizing yourself with economic cycles. Finally, you should choose whether you identify yourself as a speculator, a trader, or an investor and then to get your feet wet by putting a minimal amount of funds into a discount brokerage to get a "feel" for the market.
I have spent years researching different methods of equity investing and learned some expensive, but valuable lessons along the way. My ego has led me to believe I could trade stocks and beat the market; convincing me that somehow I had the gift to outdo the money managers who live and breath this stuff all day, every day. I have since moved on from the guessing game and built an investment strategy around the techniques of Graham, Buffett, and my favorite, Walter Schloss.
If you have any doubts about the effectiveness of a long-term value-investing approach, I highly encourage you to read "The Superinvestors of Graham-and-Doddsville", a speech by Buffett to a class at Columbia. Buffett does a fantastic job articulating the school of thought that these "Superinvestors" adhere to while dispelling the argument that randomness is solely responsible for an investor's success.
To get started, one needs to familiarize him(her)self with the tangible book value of a company. A company's book value can be found by subtracting all of the company's liabilities from all of its assets. To find a company's tangible book value, which is much more conservative, simply subtract the intangible assets from the previously calculated book value. Intangible assets would include goodwill, patents, etc. - assets that are not "material". All of this information is available on a company's balance sheet.
Once book value is established, divide it by the shares outstanding to determine the book value per share. Morningstar is a great resource that spits out this information within minimal effort on your part. Check out Morningstar's "Key Ratios" page on any stock and scroll down to "Book Value Per Share". It conveniently lists the last ten years of this calculation for each company. For example, take a look a the "Key Ratios" page for Disney here.
Generally speaking, if the company's share price is selling for less than the book value per share, you may have a winner. Some digging is required to see what makes up that book value. For example, if you are researching a commodity stock, much of that book value may be inventory. If the price of that commodity has been depressed for some time and the prospects don't look to be improving any time soon, the company may need to lower (write down) the carrying value of its inventory, which would drop the book value of the company (an asset's carrying value is being decreased, so your assets-liabilities=book equation value will decrease).
If Buffett Does it . . .Schloss typically carried a portfolio of over 100 securities at a purchase price that he calculated was less than the overall value of the company. Buffett made the observations (read more at Base Hit Investing):
“Walter continues to outperform managers who work in temples filled with paintings, staff and computers. And he accomplishes this feat by rummaging among the cigar butts on the floor of capitalism. It’s quite a 38-year track record; a tribute to Ben as a teacher, Walter as a student, and to the advantage of a free puff.”
Buffett admits that he was persuaded away from "cigar butt" investing by Charlie Munger, but merely because of how they intended to grow Berkshire. Although Buffett found success in that style earlier in his career, he claims, "Cigar-butt investing was scalable only to a point. With large sums, it would never work well." For the intents and purposes of those reading here, I see no reason to veer from the book-value, cigar-butt approach. For additional information on the book value approach and how it has performed historically, check out this write up. The author discusses oft-cited research by Eugene Fama and Kenneth French, namely:
" . . . portfolios constructed of low price-to-book stocks beating portfolios of high price-to-book stocks by an average of 3.1% per year between 1927 and 2014"
I like to add another twist to this approach. As mentioned earlier, if the book value is greater than the current share price, the stock warrants additional research. The ratio of the share price divided by the book value is known as the price-to-book ratio or p/b. A p/b of less than 1 means the company's share price is selling for less than the calculated book value.
Morningstar also tabulates the last decade of p/b's for a company. Check out the Disney "Valuation" page and scroll down to the bar graph. With this information readily available, you can observe where a company's p/b ratio sits compared to it's historical p/b. I divide the current p/b by the average of the last ten years p/b for a given company. The average of the p/b's of the last 10 years gives a good indication of how the market typically values the company compared to its book value under normal operating conditions. Using 10 years average, you minimize the vagaries that Mr. Market often brings.
Let's throw some numbers to it:Say the average of a company's last ten years of p/b's is 2. Say now, at the bottom of an economic cycle, industry cycle, or the specific company's own business cycle, the p/b for the given company drops to 0.69, with a share price $10 and a book value of $14.50. Once normal operating conditions resume, reversion to the mean would dictate that one of two things SHOULD occur: 1) The company's book value would be cut by more than half, i.e. share price of $10, book value of $5 => p/b = 2, or 2) The share price would appreciate, i.e. share price of $29, book value of $14.50 => p/b = 2. Typically, the book value of a company is much less volatile than the share price, so option 2 would likely prevail! - so long as the company's underlying fundamentals remain strong.
You need to revisit and rerun your calculation regularly (say, quarterly) to capture any new information as the business environment evolves and cycles continue to turn. Once the stock price approaches a level where the p/b reaches the average historical p/b, it's time to think about selling. This could take months or this could take years, but it's a steady approach to good returns. Most importantly, you don't need insider information or be the first one to hear pending news. Why don't more professional money managers utilize this technique more often? They are bound to quarterly performance and can not afford to stray off of the "status-quo" path. A manager who matches the market's returns keeps his job; one who has to wait on a low p/b stock to reach its potential will lose his if that stock doesn't appreciate promptly - even though waiting may result in higher overall returns. It's boring, it's tedious, and it's not flashy - but it works if you have the patience, stamina, and courage to stay the line!