The most well-known value investor today is Warren Buffet. His returns over his lifetime of investing are like no other out there. Only a few people come close to him. Warren, and in particular his partner Charlie Munger, are my heroes. I look up to them as the epitome of wealth. Having a shit-ton of it but never letting it bother or get to you. The way I look at it, their wealth is more of a proof of concept. That their ideas really do work. They seem more like scientists to me. Happier in having something actually work. The thing about Warren is that he is a student of a guy named Benjamin Graham, who is a pioneer of something called value investing. His book, The Intelligent Investor, is close to a bible for value investors. A few months ago, I decided to dig into it, to find out what all the fuss about this book was about. And after reading it, I decided to adjust my investment strategy, gearing it more towards value investing., In this article, I’ll be going through some of the ideas I use to select stocks. You can use these individually, or together to narrow down on stocks.
Price to Book Ratio
The Price to Book ratio, in simple terms, is the amount you are paying for a company, in relation to the amount of assets it has. If you pay 10 dollars to a company owning 5 dollars’ worth of assets (buildings, cars, etc.), then you are paying two dollars per dollar of assets - a Price to Book ratio of 2. Ideally, you want to deduct any intangible assets from the total value of assets the company has, such as goodwill. That’s because determining the value of these is extremely difficult - more an art than science. In value investing, you ideally want to buy a company whose assets match the amount you are paying to own the company. This means, in an ideal situation (I repeat, ideal situation), that if the company were ever to go down, you’d at least get back, in assets value, what you paid for when buying the company. You don’t lose (again, in an ideal situation).
By buying companies that have a low price to book ratio, you are creating a backstop to the amount of loss that you can experience when the company goes down. This touches on one of the most important things, especially if you are a conservative investor: you’d rather minimize risk than maximize outcomes. The downside to this is that companies that fit this bill are usually industrial companies that require a lot of capital investments just to run. Most of these companies also tend to have relatively small operating margins, something I pay close attention to. This is the complete opposite of something like a tech company, which are usually low on assets, but very high on margins. But hey, if you can find something that overcomes these two, you’ve probably found a goldmine.
Price to Earnings Ratio
The Price to Earnings ratio is basically a ratio of the price you pay compared to the amount of earnings the company generates from its business in a specific year. If a company has a PE of 25, that means that you are paying, at that particular moment in time, $25 for every dollar the company generated in the most recent full financial year. The most basic way to think about this is that it will take the company 25 years - at the current earning power - to pay you back what you invested in the company. Ideally, you want a lower PE ratio compared to a higher PE ratio. Spotify, for example, has a PE ratio of over 200 as at the time of writing this article. This implies it will take 200 years - 200 YEARS! - for the company to earn you what you paid for it. Most of us will be lucky to get to 70, leaving a balance of 130 years - and that’s assuming you started investing at birth.
Most of the companies with low PE ratios are already established companies with more predictable growth. This is good for those looking for relative security, which is most value investors. These sorts of companies are usually less volatile in terms of price movements. They have already established operations, are market leaders in most respects, and have a competitive advantage that makes them hard to bring down - all good attributes. Companies fitting this bill are usually more industrial companies, and a few tech companies that are well into maturity (i.e., close to market saturation and/or peak growth). The downside is that it invalidates a lot of exciting new companies out there, with extreme potentials for growth, and huge potential capital gains. But you have to pick your poison. Its either relative security paired with low growth, or relative risk paired with high growth.
Current Ratio
The Current Ratio, in basic terms, is the amount of current assets a company holds compared to the current liabilities it has. This basically shows how well a company can meet its ongoing operational needs (cashflow). A current ratio of more than one means that if all the current obligations were to come due today, it can easily liquidate its current assets to offset them (or use its current assets as collateral for determining a payment agreement). If a company has a million in payables due, but has 600,000 in cash and 500,000 in stock, it can pay up the cash, and use the stock as collateral for the remaining amount. This measure is useful in that it protects the company from forced liquidation and other legal issues arising from non-payment of obligations. It also provides assurance that the company won’t have to sell any of its more valuable assets just to meet some obscure short-term obligation. An extension of this is the quick ratio, which instead of using its current assets (which might include hard to move items such as inventory), uses more liquid assets such as cash and cash equivalents.
Sales Growth
Another important factor I look at is the sales growth of the company, mostly over 5 years (During this covid era, this is becoming a lot harder. You can basically eliminate 2020 and add a previous year for more reliable numbers). Sales growth, for me at least, represents the ability of the company to sell its product to more people, and the usefulness of the product to the people being sold to. You usually buy only the things you use/like. So, if a company’s sales are growing, it’s an indicator that the product is useful to people, and more people want to use it. This is also important in the sector of investing - and capitalism as a whole - where more is better! More sales, more profit (ideally), more money for me! The level of growth is based on you and your appetite. Newer companies in newer industries usually have higher growth trajectories. If you were to use the above criteria to narrow down on stocks, the number of companies with high growth (’high’ being a measure you determine) reduces drastically. Remember, value investing tends to gravitate towards already established companies, most of which are nearing saturation.
In Conclusion
There’s a couple more items I use to narrow down the scope of companies to look at. However, this article is getting pretty long, so I’ll place a cut-off here, and discuss the rest of the factors in a subsequent article. These criteria are also pretty stringent and are best for an investor who is more conservative in his/her approach. If you want slightly higher returns, you can relax some of these - or drop them entirely. This will enable you to look at a wider variety of companies and might open up the door to a higher level of return -albeit with some increased risk. But as of now, this is what I’m using as a foundation for my investments. It is helping me in building investment principles and allows me to take it slow. I will adjust my strategy over time, but it will still be on this foundation. You have to decide where you lie on the spectrum of risk/reward. Remember, the earlier you start, the higher risk you can take. Until next time!If you had a choice, would you pay more for something or less?
The most well known value investor today is Warren Buffet. His returns over his lifetime of investing is like no other out there. Only a few people come close to him. Warren, and in particular his partner Charlie Munger, are my heroes. I look up to them as the epitome of wealth. Having a shit-ton of it but never letting it bother or get to you. The way I look at it, their wealth is more of a proof of concept. That their ideas really do work. They seem more like scientists to me. More happy in having something actually work. The thing about Warren is that he is a student of a guy named Benjamin Graham, who is a pioneer of something called value investing. His book, The Intelligent Investor, is close to a bible for value investors. A few months ago I decided to dig into it, to find out what all the fuss about this book was about. And after reading it, I decided to adjust my investment strategy, gearing it more towards value investing., In this article, I’ll be going through some of the ideas I use to select stocks. You can use these individually, or together to narrow down on stocks.
Price to Book Ratio
The Price to Book ratio, in simple terms, is the amount you are paying for a company, in relation to the amount of assets it has. If you pay 10 dollars to a company owning 5 dollars worth of assets (buildings, cars, e.t.c), then you are paying two dollars per dollar of assets - a Price to Book ratio of 2. Ideally, you want to deduct any intangible assets from the total value of assets the company has, such as goodwill. That’s because determining the value of these is extremely difficult - more an art than science. In value investing, you ideally want to buy a company whose assets match the amount you are paying to own the company. This means, in an ideal situation (I repeat, ideal situation), that if the company were ever to go down, you’d at least get back, in assets value, what you paid for when buying the company. You don’t lose (again, in an ideal situation).
By buying companies that have a low price to book ratio, you are creating a backstop to the amount of loss that you can experience when the company goes down. This touches on one of the most important things, especially if you are a conservative investor: you’d rather minimize risk than maximize outcomes. The downside to this is that companies that fit this bill are usually industrial companies that require a lot of capital investments just to run. Most of these companies also tend to have relatively small operating margins, something I pay close attention to. This is the complete opposite of something like a tech company, which are usually low on assets, but very high on margins. But hey, if you can find something that overcomes these two, you’ve probably found a goldmine.
Price to Earnings Ratio
The Price to Earnings ratio is basically a ratio of the price you pay compared to the amount of earnings the company generates from its business in a specific year. If a company has a PE of 25, that means that you are paying, at that particular moment in time, $25 for every dollar the company generated in the most recent full financial year. The most basic way to think about this is that it will take the company 25 years - at the current earning power - to pay you back what you invested in the company. Ideally, you want a lower PE ratio compared to a higher PE ratio. Spotify, for example, has a PE ratio of over 200 as at the time of writing this article. This implies it will take 200 years - 200 YEARS! - for the company to earn you what you paid for it. Most of us will be lucky to get to 70, leaving a balance of 130 years - and that’s assuming you started investing at birth.
Most of the companies with low PE ratios are already established companies with more predictable growth. This is good for those looking for relative security, which is most value investors. These sort of companies are usually less volatile in terms of price movements. They have already established operations, are market leaders in most respects, and have a competitive advantage that makes them hard to bring down - all good attributes. Companies fitting this bill are usually more industrial companies , and a few tech companies that are well into maturity (i.e. close to market saturation and/or peak growth). The downside is that it invalidates a lot of exciting new companies out there, with extreme potentials for growth, and huge potential capital gains. But you have to pick your poison. Its either relative security paired with low growth, or relative risk paired with high growth.
Current Ratio
The Current Ratio, in basic terms, is the amount of current assets a company holds compared to the current liabilities it has. This basically shows how well a company can meet its ongoing operational needs (cashflow). A current ratio of more than one means that if all the current obligations were to come due today, it can easily liquidate its current assets to offset them (or use its current assets as collateral for determining a payment agreement). If a company has a million in payables due, but has 600,000 in cash and 500,000 in stock, it can pay up the cash, and use the stock as collateral for the remaining amount. This measure is useful in that it protects the company from forced liquidation and other legal issues arising from non-payment of obligations. It also provides assurance that the company won’t have to sell any of its more valuable assets just to meet some obscure short term obligation. An extension of this is the quick ratio, which instead of using its current assets (which might include hard to move items such as inventory), uses more liquid assets such as cash and cash equivalents.
Sales Growth
Another important factor I look at is the sales growth of the company, mostly over 5 years (During this covid era, this is becoming a lot harder. You can basically eliminate 2020 and add a previous year for more reliable numbers). Sales growth, for me at least, represents the ability of the company to sell its product to more people, and the usefulness of the product to the people being sold to. You usually buy only the things you use/like. So if a company’s sales are growing, its an indicator that the product is useful to people, and more people want to use it. This is also important in the sector of investing - and capitalism as a whole - where more is better! More sales, more profit (ideally), more money for me! The level of growth is based on you and your appetite. Newer companies in newer industries usually have higher growth trajectories. If you were to use the above criteria to narrow down on stocks, the number of companies with high growth (’high’ being a measure you determine) reduces drastically. Remember, value investing tends to gravitate towards already established companies, most of which are nearing saturation.
In Conclusion
There’s a couple more items I use to narrow down the scope of companies to look at. However, this article is getting pretty long, so I’ll place a cut-off here, and discuss the rest of the factors in a subsequent article. These criteria are also pretty stringent, and are best for an investor who is more conservative in his/her approach. If you want slightly higher returns, you can relax some of these - or drop them entirely. This will enable you to look at a wider variety of companies, and might open up the door to a higher level of return -albeit with some increased risk. But as of now, this is what I’m using as a foundation for my investments. Its helping me in building investment principles, and allows me to take it slow. I will adjust my strategy over time, but it will still be on this foundation. You have to decide where you lie on the spectrum of risk/reward. Remember, the earlier you start, the higher risk you can take. Until next time!