"We define a bargain issue as one which, on the basis of facts established by analysis, appears to be worth considerably more than it is selling for," wrote Benjamin Graham in "The Intelligent Investor," one of the first and most famous works on value investing.
Today, Graham is considered to be the father of value investing. However, his strategy for finding undervalued securities is often misunderstood. Many people believe that Graham was only interested in buying stocks that were trading at a deep discount to net asset value. This is determined by subtracting a company's long-term liabilities from its net current assets. If the company's value is below the final figure, not only is it worth less than the value of current or liquid net assets, but investors are buying the long-term assets for free.
Graham did use this method often to find discount securities, but on the whole, he was interested in buying any security that was trading at a deep discount to his estimate of intrinsic value. Here's how he explained the approach in Chapter 7 of the Intelligent Investor:
"To be as concrete as possible, let us suggest that an issue is not a true "bargain" unless the indicated value is at least 50% more than the price."
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There are two tests by which a bargain common stock is detected. The first is by the method of appraisal. This relies largely on estimating future earnings and then multiplying by a factor appropriate to the particular issue. If the resultant value is sufficiently above the market price -- and the investor has confidence in the technique employed -- he can tag the stock as a bargain.The second test is the value of the business to a private owner. This value also is often determined to chiefly by expected future earnings-- in which case the result may be identical with the first. But in the second test more attention is likely to be paid the realizable value of the assets, with particular emphasis on the net current assets or working capital."
Here, Graham explains the two methods he liked to use to establish whether or not a stock was undervalued.
The reason why Graham preferred the second method over the first is, as he explained in the book, that it is easier to establish private market value than future earnings. For example, any investor with a minimal level of accounting experience can determine a company's net working capital level based on its most recent financial statements. However, trying to predict a company's earnings growth five or 10 years in the future requires a detailed understanding of the business, its sector and future economic growth.
As Graham was always focused on building a well-diversified portfolio of discount securities, it is unlikely that he wanted to try to identify the companies with the best growth prospects over the next decade.
Warren Buffett (Trades, Portfolio), on the other hand, does use this approach. Buffett has been buying undervalued securities based on the earnings growth approach for decades. The difference between Buffett and his mentor Graham is the fact that the former is quite happy to spend days reading up on particular businesses. He will study businesses that fall inside his circle of confidence for days or weeks. He is also happy to wait years to buy companies at attractive prices if he likes the look of them. Part of this may also be due to how times have changed, as there are no longer as many deep bargain opportunities as their were in Graham's day.
Disclosure: The author owns no share mentioned.
Read more here:
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- Warren Buffett: Mistakes of Omission Are More Costly Than Bad Investments
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