Value investing

In short

A friend of mine once told me he judged a used truck by what it would cost to keep running, not by how shiny it looked. Value investing works much the same way. You try to work out what a business is worth, and then you compare that to the price on the screen. If the price is well below your estimate, you have a cushion. If it is above, you wait. You can start today by picking one company you already understand and reading its annual report, which every public company files with the Securities and Exchange Commission and posts free on its EDGAR database. Write down, in plain words, how the company makes money. Then write down what you think it is worth and why. Check your guess against the price, and be honest about how much you do not know.

The whole of it

What it is

I once watched a neighbor of mine haggle over a plow horse at a county fair. He did not care how handsome the animal looked. He cared about how many acres it could turn in a season. That is the heart of value investing. A stock is a small piece of a real business, and that piece has a worth that is separate from its daily price.

You have probably heard that prices bounce around from day to day. Some days people are cheerful and pay too much. Other days they are gloomy and sell too cheap. A value investor tries to stand a little apart from that mood. The idea was laid out in books by Benjamin Graham and David Dodd, including Security Analysis and The Intelligent Investor. Graham used a picture that has stuck with people. He imagined a partner called Mr. Market who shows up every day offering to buy or sell at a new price. You are free to ignore him.

Notice what this asks of you. It does not ask you to predict the future. It asks you to do some homework and to be patient. That takes humility, and I think it also takes a bit of courage, because waiting while others seem to be getting rich is not easy.

How it works

If you are holding a few shares of a company, or thinking about it, the first job is to guess what the business is worth. There are many ways to do that, and none is magic. One way is to look at what the company earns each year and ask what those earnings are worth to you. Another way is to add up what the company owns and subtract what it owes. That second number is called book value, which is simply the company's assets minus its debts, as listed on its balance sheet.

Then you compare your estimate to the market price. The gap between them is what Graham called the margin of safety. Say you think a share is worth 40 dollars and it sells for 30. You have a 10 dollar cushion. If your guess turns out to be a little off, the cushion helps absorb the mistake. It is a bit like driving a loaded wagon over a bridge that is rated for more weight than you carry.

Two common yardsticks help you compare prices. The price to earnings ratio divides the share price by the profit per share. The price to book ratio divides the share price by book value per share. Low numbers can point to a bargain. They can also point to a business in real trouble. So the ratio is where your questions begin, not where they end.

The numbers, and where to find yours

Every figure you need for the homework sits in public filings. A company's annual report, called a Form 10 K, is posted on the SEC's EDGAR system. It holds the income statement, the balance sheet, and the cash flow statement. Read the notes at the back, too. That is where companies tell you about debts, lawsuits, and other things that matter.

Some numbers change by year and are set by law, and I will not guess at them here. If you hold stock in a taxable account, the tax rate on long term gains depends on your income and on how long you held the shares. The holding period that separates short term from long term is the current figure, which the official source publishes each year, and the rates that apply are on IRS.gov, in Publication 550, Investment Income and Expenses. If you invest through a retirement account, the yearly contribution limit is the current figure, which the official source publishes each year, and the IRS posts the current figure each year.

You will also find your own numbers in your brokerage statements. Look for the cost of each purchase, any trading fees, and the expense ratio of any fund you hold. Those costs are real, and they come out of your pocket whether or not the business does well.

A worked example

Let me tell you about a woman named Dolores. She runs a small bakery, so she knows a thing or two about flour and margins. She got curious about a bread company that sells its products in grocery stores, and she decided to check it the way she would check a supplier.

She opened the company's latest Form 10 K. She found that the company earned 5,000,000 dollars in net income for the year, and that it had 2,000,000 shares outstanding. She divided the two. 5,000,000 divided by 2,000,000 equals 2.50 dollars of earnings per share.

The stock sold for 20 dollars a share. She divided the price by the earnings. 20 divided by 2.50 equals 8. So she was paying 8 dollars for each dollar of yearly profit.

Now she needed her own view of worth. She read that the business had been steady for many years, with orders coming in from the same grocers. She decided a fair price for a steady business like this might be 12 times earnings. That was her judgment, and she wrote down that it was only a judgment. She multiplied. 12 times 2.50 equals 30 dollars a share.

Her estimate was 30 dollars and the price was 20. Her margin of safety was 30 minus 20, which equals 10 dollars a share. As a share of her estimate, that is 10 divided by 30, or about 33 percent.

Here is the part I admire. Dolores did not stop there. She checked the balance sheet and found the company owed a large sum that came due in two years. She worried the low price might be a warning. She decided she needed to learn more before doing anything. Good call.

Where it goes wrong

I have made my share of mistakes in life, and I expect you will make a few too. The most common trap in this style of investing is the cheap stock that stays cheap for a good reason. A low price to earnings ratio can mean the business is fading. People call this a value trap. The numbers look like a bargain, but the company keeps losing ground. So a low ratio should raise your curiosity, and never quiet it.

Another trap is fooling yourself about what a company is worth. It is easy to fall in love with a story and then set your estimate to match. Try to write down your reasons before you look at the price. That way the price cannot bend your thinking. Ask a friend you trust to poke holes in your logic. You will not enjoy it in the moment, and you will be glad of it later.

Patience is a cost, too. A cheap stock may sit there for years before the market notices. Meanwhile your money is tied up. Taxes and trading fees eat into gains, as do fund expenses. And one company is a narrow bet. Putting all your savings in a single idea, however well studied, leaves you exposed if you are wrong. Spreading your money out is a way to allow for the chance that your judgment is off. None of this is a promise of gain, since every investment can lose money.

Questions to answer before you leave this page

Can you say in two plain sentences how the company you are studying makes its money? Have you read its latest Form 10 K, including the notes at the back where the debts and lawsuits are hiding? What do you think one share is worth, and what reasons did you write down before you looked at the price? How far below your estimate is the price, and does that cushion feel big enough to cover a wrong guess? What would have to be true for your estimate to be badly off? Are you holding this company in a taxable account or a retirement account, and have you checked the IRS rules that apply to each? What are your trading fees and fund costs, and have you counted them? Could you sit calmly for years if the price did not move? And how much of your savings would be tied up in this one idea if it did not work out?