SmartMoney.com - Sturm's Screens
Meet (and Beat) Mr. Market
By Paul Sturm
biz.yahoo.com
The time is right for an update of Ben Graham's legendary value-investing approach.
MANY MODERN economists find Ben Graham's ideas on value investing — developed in the aftermath of the Depression — quaint and irrelevant. But his ideas still resonate at Columbia University, especially in Bruce Greenwald's classroom. With only a brief interruption, value investing has been part of the curriculum at Columbia ever since 1927, when Graham started teaching a night course there. Today Greenwald's value-investing class is so popular that business-school students who want to take it have to spend their entire allocation of ``class-entry dollars'' to get in. Sometimes their investment pays off even better than they expected — Warren Buffett, a former Graham student, is an occasional guest.
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Out in the real world, Graham is still attracting real dollars. In 1934 he turned his class notes into ``Securities Analysis,'' a dense, 725-page book. In 1949 he wrote a shorter, more accessible version called ``The Intelligent Investor.'' First editions of ``Securities Analysis,'' co-authored with David Dodd, have sold for more than $10,000, and late last year a signed copy fetched $20,000, close to a record for a work of 20th-century nonfiction. ``The Intelligent Investor,'' which has never been issued in paperback, is on track to sell a record 30,000 copies this year — nearly enough to put it on business bestseller lists.
Greenwald is a conventional economist (Ph.D. from MIT) who caught the value bug. He has updated and expanded Graham's ideas, and his summer seminars ($2,900 for two days) have become popular with everyone from well-known money managers to Columbia MBAs who couldn't get into Greenwald's class. But now there is a cheaper way to learn from Greenwald: He and three colleagues have just published ``Value Investing: From Graham to Buffett and Beyond.''
Greenwald probably won't outsell Graham, but I think he ought to. What follows is a peek at some of Greenwald's cleverest insights and a stock screen Graham recommended just before he died. It turns up surprising bargains at a time when value is back on shopping lists.
Graham and Greenwald agree on bedrock: Mr. Market, Graham's personification of forces that determine stock prices, is a strange fellow — subject to mood swings of the wildest sort. Still, every stock has an intrinsic value that a disciplined investor can measure. The secret to superior returns is buying when the price is well below that value, a gap Graham called the margin of safety.
* Prices as of 5/4/01.
** Based on reported earnings for the most recent 12 months, excluding extraordinary items.
*** Shareholders' equity divided by total assets.
Data: NetScreen Pro from Multex.com
That, in a nutshell, is value investing. But there's a real-world problem with Graham. He developed his value approach after he was wiped out in the 1929 stock crash (though he was already teaching by that time, the carnage of the crash caused him to hone his theories) and did most of his stock picking before the great postwar bull market. Not surprisingly, he was very conservative. Much of the time he was investing, valuations were far lower than they are today.
Studying Graham is a good way to learn about value, even though his methods can't always be applied literally. For example, Graham loved companies whose net working capital per share is 50% greater than the stock price. In other words, companies whose current assets (cash, receivables and inventory) minus total debt is greater than 1.5 times market value. Unfortunately, screen for this and you'll get a lot of garbage — tiny dot-coms losing cash so fast that the balance sheet is out of date or bigger manufacturers (Armstrong (NYSE:ACK - news), Owens Corning (NYSE:OWC - news)) with huge off-balance-sheet liabilities.
Greenwald offers a more up-to-date framework for value analysis. Applying his techniques takes work, even for the pros. But just understanding the process can help any investor think more clearly.
According to Greenwald, value comes in three tiers. The first and easiest to calculate is asset value, where Graham focused his efforts. But Greenwald goes beyond the balance sheet and measures ``reproduction cost,'' or how much a potential competitor would have to spend to get into the business. In his view, most companies are worth the reproduction cost of their assets — no less, no more. The challenge is to get a fix on this number and buy when share prices dip below it.
Next comes another Greenwald number. Estimate a company's sustainable earnings, subtract its cost of capital (again Greenwald explains how) and you get what Greenwald calls ``earnings-power value.'' What if the earnings-power value exceeds reproduction cost? Greenwald calls the difference ``franchise value,'' and in a few rare cases even a value investor will pay more than reproduction cost, if franchise value is sustainable. Examples: Microsoft's (NASDAQ:MSFT - news) lock on PC operating systems, the monopoly power of a local newspaper, the habit that has millions hooked on Coke (NYSE:KO - news).
Finally, there's growth, the third tier of value. Greenwald isn't against it, he just thinks it's rarely worth paying for. Compared with asset and earnings numbers, he points out, growth predictions are notoriously unreliable. He also argues that the only valuable growth is that within a franchise, where profits exceed required investment. A rare example might be Intel (NASDAQ:INTC - news), which held its lead in microprocessors even as the market expanded.
Instead, Greenwald worries about the downside of growth, citing industries such as airlines and consumer electronics, where profits have rarely kept pace with burgeoning demand. He's dubious about paying for brands (think Mercedes and how success lured competitors). As Greenwald writes about manufactured products, even routers: ``Ultimately, they're all toasters.''
Ben Graham — who wanted to buy at a discount and wasn't willing to pay for potential in any form — expressed things differently. But surely, he would agree with Greenwald's updated approach. Still, Graham knew that the tough slogging required to calculate a company's real value was too much work for most individuals. So late in his life, he tried to find shortcuts. In a 1976 interview, just before he died, Graham recommended a simple screen that I've updated.
Graham wanted companies whose earnings yield was at least twice the long-term bond rate. Today that works out to P/Es of 8 or below — a small universe. (The earnings yield is the reciprocal of the price/earnings ratio. So a P/E of 8 equals an earnings yield of 12.5% — 1 divided by 8 is 0.125.) Graham also disliked debt, so he looked for firms whose ratio of equity to total assets was 0.5 or better. Buy a diversified portfolio of stocks that pass these tests, he advised. Sell when the price goes up 50% or after two years, and you can expect 15% annual returns.
Sounds easy — but as Graham pointed out, few people have the discipline to follow such advice. I ran Graham's screen using NetScreen Pro from Multex.com and found 30 companies with a market value above $500 million, my minimum size requirement for this column. To get down to a manageable number for the accompanying table, I made a final cut by looking for firms scoring well on other value criteria, such as price/book and price/cash flow ratios. I eliminated firms that didn't have an average return on equity of at least 8%.
My biggest surprise was finding five fallen tech stars, including three close competitors: AVX (NYSE:AVX - news), Kemet (NYSE:KEM - news) and Vishay Intertechnology (NYSE:VSH - news). They make electronic components sold mostly to telecom companies — a business that's depressed now but certainly not going away. ADC Telecommunications (NASDAQ:ADCT - news), which sells broadband-networking and cable-management gear, is in a similar position. But with minimal debt, it is far less risky than leveraged competitors such as Lucent Technologies (NYSE:LU - news). Then there's Iomega (NYSE:IOM - news). Despite a recent sales slump, the data-storage company has a passel of new products. And insiders have been buying heavily.
The last three companies are more conventional. Apache (NYSE:APA - news) and Newfield Exploration (NYSE:NFX - news) are energy plays, savvy independents with a track record of good acquisitions. They look cheap because of worries that oil prices will fall. Even if that happens, these companies have a history of steadily expanding production. Finally, Prime Hospitality (NYSE:PDQ - news) runs 230 AmeriSuites and Wellesley Inns. These are modest hotels, popular with business people on a budget — the sort of place value investors stay while saving to buy Graham first editions. |
