A Graham-to-Buffett Guide to Value Investing: John Dorfman
I regularly dish out advice from a value investor's perspective. You may wonder what value investing really is, and how strong the evidence is for a value approach. Here's what value investing is all about. Value investors buy stocks that are cheap relative to some measure of intrinsic worth, which can be gauged in dozens of ways. In practice, most value investors measure it by a company's earnings, revenue, assets, book value, cash flow or dividends. If a stock is cheap relative to one of these measures -- or preferably several of them -- it's a value stock. By and large, value stocks are unpopular stocks. That's why they are cheap. A growth stock, by contrast, is one that has shown rapid growth in one or more of the same measures -- or that people are convinced will show such growth. Growth and value are the two main, and opposing, schools of investing. Ordinarily, value stocks aren't growth stocks. Stocks become cheap because growth has faltered, or is expected to falter. Defining Cheap What's cheap? Over the past several decades, the average stock has sold for about 15 times earnings, 1.7 times book value (corporate net worth) and 0.9 times revenue. Today, the average stock sells for about 23 times earnings, 3.4 times book value and 1.4 times revenue. Those are pricey multiples by historical standards. If a stock is below the current valuation averages, does it deserve to be called cheap? That's a judgment call. For my part, I generally prefer to invest in stocks that sell for less than 15 times earnings, less than two times revenue and less than two times book value. Some shrewd investors have been using value techniques for more than 100 years. Only in the past four to five decades, however, has the effectiveness of the technique been well documented. Dozens of studies in the past 45 years have demonstrated -- conclusively, in my opinion -- that value stocks outperform growth stocks, and outperform the overall market. This isn't true every year, but it is true in most years, and in most five-year or 10-year periods. Graham and Dodd Benjamin Graham was a New York hedge-fund manager and professor at Columbia University. Graham, who died in 1976, taught there with David Dodd, his co-author on the seminal 1934 book ``Securities Analysis.'' The phrase ``Graham and Dodd'' is used to this day to refer to a fundamental value approach to picking stocks. In 1949, Graham wrote ``The Intelligent Investor,'' considered by many people the best book on investing ever written. Discussing bargain stocks in that book, Graham wrote, ``It is true that current earnings and the immediate prospects may both be poor, but a levelheaded analysis of average future conditions would indicate values far above ruling prices.'' He added, ``The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.'' Time-Block Study In one edition of ``The Intelligent Investor,'' Graham presented a study based on annual data from Drexel & Co. It showed investment returns on the 10 stocks in the Dow Jones Industrial Average with the lowest price-earnings ratios and the 10 stocks with the highest. The study covered 33 years, from 1937 through 1969. Graham divided the 33 years into four time blocks of five years each, one block of six years (1937-1942) and one block of seven years (1963-1969). In each block, ``low-multiplier'' stocks -- that is, those with low P-E ratios -- outperformed the ``high-multiplier'' stocks. In most cases the margin was 10 percentage points or more. The narrowest margin, for 1963-1969, was 3.4 percentage points per year. Nicholson Study Less well known than Graham yet important in the history of value investing was a Philadelphia securities analyst named Francis Nicholson. His study in the July/August 1960 issue of the Financial Analysts' Journal was one of the first to show the advantages of investing in stocks with low price-earnings ratios. After Graham and Nicholson, dozens of academicians and investment managers have performed similar studies, using increasingly broad samples and ever-more-refined techniques. The validity of the value approach has been borne out repeatedly. In the 1950s through the 1990s, three of the best known practitioners of value investing were Sir John Templeton, manager of several Templeton mutual funds, John Neff, longtime manager of the Windsor Fund, and my mentor David Dreman, currently manager of the Scudder Dreman High Return Equity Fund. Perhaps the best-known practitioner of value investing has been Warren Buffett, widely considered the most brilliant investor of the present day. Buffett studied under Graham at Columbia, and hounded Graham until he gave him a job with his hedge fund. Buffett's Essay In 1984 Buffett wrote an essay called ``The Superinvestors of Graham-and-Doddsville.'' Published in Hermes, the magazine of the Columbia Business School, Buffett's essay today remains one of the most popular expositions of value investing. In his conclusion to that essay, Buffett wrote that during the 35 years that he had practiced value investing, it had not gained popularity among most investors. The academic world, Buffett wrote, ``has actually backed away from the teaching of value investing over the last 30 years.'' He concluded that ``there will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.''
