Benjamin Graham developed the core principles for investing in financial securities. He never used the term "value investing." Indeed, he did not give any name to it. Nevertheless, the common elements across various definitions from both practitioners and academics suggest that value investing implies an investing style that emphasizes using financial ratios such as the price-to-earnings or market-to-book ratios. The term is also commonly used when one does not invest in fast-growing companies or sticks to conservatively financed companies.
A value investor is someone who focuses first and foremost on preserving capital. Earning high returns is desirable but secondary.
Here are the two most significant principles emerging from the value investing literature are:
Principle 1: Price Should Not Be High Relative to a Company’s Average Earnings over a Number of Years
The first principle essentially relates to the most discussed ratio in the financial world, the price-to-earnings ratio. Generally speaking, it is deemed a good idea to avoid investing in stocks when the market P/E ratio is high, for instance, higher than 20. A wise thing to do is to examine a company’s P/E ratio over a number of years, by looking, perhaps, at the price in relation to the past five to 10 years’ earnings. If only recent earnings are used, a company may have a low P/E ratio because earnings are temporarily high, or it may have a high P/E ratio because earnings are temporarily low.
Other ratios that investors may use include the market-to-book or the S&P 500 earnings as fraction of GDP. The results of both are very similar. From an individual stock standpoint, regardless of the financial ratio used, it is necessary to depend on the nature of the company's business and the availability of suitable data.
Principle 2: Each Company Selected Should Be Large, Prominent and Conservatively Financed
Graham recommends investing in large and prominent companies because it is not easy to evaluate small and less-known companies. Their financial statements are less reliable, and they may be more easily affected by unforeseen circumstances.
Where can you look for them? Buffett suggests Value Line, which usually does not follow small companies. It also provides track records.
Graham's believes if a company is conservatively financed, it is worth analyzing short- and long-term debt levels in relation to total assets, or the debt-to-equity ratio. Why is conservatism important? Because it is difficult to predict when funds will be suddenly needed for profitable investments or for claims. A conservatively financed company can raise funds in short order, and a liquidity crisis in the economy would not affect the company.
These two principles are not specific rules. Actually, not all large companies can be subject to sound financial analysis because of the complexity of their businesses. It may not be easy to define which company is prominent and which is not. A fair amount of judgment must be used in those cases.
To narrow the field of inquiry, here are some of the most common concepts that Buffett and other investors have relied on.
A Sharp Decline in the Stock Market
A sharp decline in the stock market generally presents a good investment opportunity.
Depending on the level of tolerance of risk, it is reasonable to argue that one should increase investment in the stock market whenever there is a 20 percent correction from reasonable price levels. The price decline is not important in itself; it is the price in relation to earnings.
The valuations of the market must be evaluated as a whole in relation to its fundamentals. If the decline continues, it may be good to increase the investment. Thus, in some cases, one will only have to wait a long while for the stock market to come back. Patience, once again, is a prerequisite for earning superior returns.
The Industry That Leads the Decline
Usually, a 10 percent to 20 percent decline is led by one or a few industries. In those instances, the industry that leads the decline may lead the recovery and offer early investing opportunities.
It is widely known that if there is a market decline led by one or two industrial sectors, it is savvy to look for good companies in those sectors. Despite this situation that may lead to good opportunities, as an investor, one has to feel comfortable with the fundamentals of the company.
Watch Out for Temptations
This investment theory does not ask investors to buy without limits if the stock price has declined and the stock looks cheap vis-à -vis its past price. Indeed, not everything that seems “on sale” is profitable. Sometimes, they may take investors to collect junk.
It is important not to get tempted.
Graham is right in this regard: “Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable conditions.”
Often, companies' stock prices decline when the companies get into trouble. They appear to be a good pick. However, they end up not being successful.
Low price is not a good indicator for investing.
A value investor is someone who focuses first and foremost on preserving capital. Earning high returns is desirable but secondary.
Here are the two most significant principles emerging from the value investing literature are:
Principle 1: Price Should Not Be High Relative to a Company’s Average Earnings over a Number of Years
The first principle essentially relates to the most discussed ratio in the financial world, the price-to-earnings ratio. Generally speaking, it is deemed a good idea to avoid investing in stocks when the market P/E ratio is high, for instance, higher than 20. A wise thing to do is to examine a company’s P/E ratio over a number of years, by looking, perhaps, at the price in relation to the past five to 10 years’ earnings. If only recent earnings are used, a company may have a low P/E ratio because earnings are temporarily high, or it may have a high P/E ratio because earnings are temporarily low.
Other ratios that investors may use include the market-to-book or the S&P 500 earnings as fraction of GDP. The results of both are very similar. From an individual stock standpoint, regardless of the financial ratio used, it is necessary to depend on the nature of the company's business and the availability of suitable data.
Principle 2: Each Company Selected Should Be Large, Prominent and Conservatively Financed
Graham recommends investing in large and prominent companies because it is not easy to evaluate small and less-known companies. Their financial statements are less reliable, and they may be more easily affected by unforeseen circumstances.
Where can you look for them? Buffett suggests Value Line, which usually does not follow small companies. It also provides track records.
Graham's believes if a company is conservatively financed, it is worth analyzing short- and long-term debt levels in relation to total assets, or the debt-to-equity ratio. Why is conservatism important? Because it is difficult to predict when funds will be suddenly needed for profitable investments or for claims. A conservatively financed company can raise funds in short order, and a liquidity crisis in the economy would not affect the company.
These two principles are not specific rules. Actually, not all large companies can be subject to sound financial analysis because of the complexity of their businesses. It may not be easy to define which company is prominent and which is not. A fair amount of judgment must be used in those cases.
To narrow the field of inquiry, here are some of the most common concepts that Buffett and other investors have relied on.
A Sharp Decline in the Stock Market
A sharp decline in the stock market generally presents a good investment opportunity.
Depending on the level of tolerance of risk, it is reasonable to argue that one should increase investment in the stock market whenever there is a 20 percent correction from reasonable price levels. The price decline is not important in itself; it is the price in relation to earnings.
The valuations of the market must be evaluated as a whole in relation to its fundamentals. If the decline continues, it may be good to increase the investment. Thus, in some cases, one will only have to wait a long while for the stock market to come back. Patience, once again, is a prerequisite for earning superior returns.
The Industry That Leads the Decline
Usually, a 10 percent to 20 percent decline is led by one or a few industries. In those instances, the industry that leads the decline may lead the recovery and offer early investing opportunities.
It is widely known that if there is a market decline led by one or two industrial sectors, it is savvy to look for good companies in those sectors. Despite this situation that may lead to good opportunities, as an investor, one has to feel comfortable with the fundamentals of the company.
Watch Out for Temptations
This investment theory does not ask investors to buy without limits if the stock price has declined and the stock looks cheap vis-à -vis its past price. Indeed, not everything that seems “on sale” is profitable. Sometimes, they may take investors to collect junk.
It is important not to get tempted.
Graham is right in this regard: “Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable conditions.”
Often, companies' stock prices decline when the companies get into trouble. They appear to be a good pick. However, they end up not being successful.
Low price is not a good indicator for investing.
