Value Investing Lives On

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Several years ago a friend mine Nancy Zambell wrote a timeless article for SmallCapInvestor.com . The timeless article is an excellent account about the common sense approach to picking stocks known as value investing.

With the market's state of turbulence, investors are scurrying to find those hidden gems that are not only trading at bargain prices, but which also have some hope of surviving - relatively intact - from the ups and downs of market volatility. That's why an increasing number are tapping into that old standby that can be counted on through thick and thin: value investing.

Value investing is simply investing in companies whose shares are temporarily trading at lower prices than their true worth.

In 1934, Benjamin Graham, with his colleague David Dodd, co-authored Security Analysis, the primer for value investing. Many editions later, the book has become the bible of security analysts nationwide. Graham felt that too many investors were speculators - buying or selling simply because a stock or the market went up or down, investing in "hot" stocks, and margin buying - all trends of the era in which he grew up. He lived through the debacle of the '29 crash, the bank closings and the utter loss of confidence in Wall Street. He knew for confidence to be restored, and for corporate America to obtain the funding needed for expansion, individual investors would have to be brought back into the fold.

Graham proposed that the foundation of sound investing should not change with the whims of trends or the winds of time, but should be altered only as a result of important economic and financial changes. Such events might include changes in interest rates, inflation, the trend toward mega-corporations, or significant bankruptcies - all occurrences which might alter the way a stock is to be valued - quite a different train of thought than what was currently espoused by the "professionals". You might imagine how popular that advice was with the Wall Street crowd!

The father of value investing felt that a good investment should be a company that was worth considerably more that what its stock was selling for. He calculated this "value" of a company by estimating its future earnings as well as taking into account the worth of its assets - what would be the value of this business to someone interested in buying it. And although even during Graham's day, there were always analysts ready to build a mountain out of a molehill, cranking out scores of ratios to analyze one company, Graham felt that just a few - the most important - criteria would do the job.

Graham especially liked to invest in companies whose earnings were reasonably stable, with good growth prospects. Additionally, he required that they be conservatively financed, large companies that paid dividends, and had price-earnings ratios of less than 25. And he found legions of such companies - many that were selling for less than their net working capital (current assets - current liabilities) . But for some reason, the stock market and the market pros were underestimating, or undervaluing the potential of the companies' earnings, resulting in an "undervalued" stock price.

Graham's success was legendary. During his most active years - from 1936-1956 - he consistently posted annual returns of 20% plus, while the S&P 500's performance ran around 14%. And his legend lives on.

And while small cap investors are typically not following Graham's classic value investing definition, we're following in his footsteps. Because today, if you're a large-cap value investor, you have a tough row to hoe. You're competing against thousands of other institutional value investors who are looking at the same information as you.

So, my solution is to focus on value where very few other people can find it. In the small cap space, we're typically among the first people to find undervalued securities - for the simple reason that these companies are too small for institutional investors to invest in.

There's less institutional investment, and there's less coverage as well. So if you do the nitty-gritty work and find an undervalued company, you are literally in on the ground floor.

It's Graham-Dodd analysis taken to a grass-roots level.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

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