Streetwise for Friday, May 26, 2017
If the rarefied air of today’s stock market has you wondering if or how or when to invest then this is a good time to revisit the underpinnings of value investing as it originated in the 1930s through the comprehensive research carried out by Benjamin Graham.
Graham was very straight forward in his advice. His mantra was that if you invest in a profitable, low-debt company, whose shares were trading below the value of its assets, then over time you will achieve a superior return on your investment.
Moreover, Graham directed his ideas at investors, not speculators. He felt that speculation, while fascinating and enjoyable, remained so only while you were ahead. If you wanted to speculate, set aside a small portion of your capital for this purpose. Never mingle your speculative and investment funds…even in your mind. This sound advice is applicable in any investment climate.
Graham studied the historical patterns of various financial markets, sometimes going back several decades. He was a firm believer that if you did not pay attention to the past then you would fail to correctly grasp future opportunities. He pointed out that the art of investing has a characteristic that is not generally appreciated. Specifically, a creditable but perhaps unspectacular return can be achieved with a minimum of effort and capability.
To improve upon that easily attainable return requires substantial effort and more than a trace of wisdom. A little extra knowledge and cleverness is unlikely to produce the expected increase in performance. Ironically, just the opposite may occur. Moreover, there are no sure and easy paths to riches on Wall Street, or any other Street. Graham would often illustrate that point with the following bit of history.
John J. Raskob, a former head of finance for General Motors, gave an interview to Samuel Crowther for the Ladies Home Journal in which he extolled capitalism in an article titled, “Everybody Ought to be Rich.” His thesis was that $15 per month invested in good quality common stocks, combined with dividend reinvestment, would produce an estate of $80,000 in twenty years, against total contributions of only $3,600. The article arrived at newsstands just two months before the Crash of 1929.
If the General Motors tycoon was right then he had indeed found the Holy Grail of investing. How right was he? Graham made a rough calculation based on an assumed investment in the 30 stocks comprising the Dow Jones industrial average.
If Raskob’s prescription had been followed during the period of 1929 to 1949, the portfolio would have been worth approximately $8,500. That is a far cry from the promise of $80,000. However, as Graham pointed out, the return over those 20 years would have exceeded an 8 percent compounded annual rate of return, even though the Dow Jones industrial average began the evaluation period at 300 and ended in 1948 at a closing level of 177.
While Wall Street is unlikely to make you rich, Graham’s investment methodology should provide you with a sufficient degree of enjoyment, profit and excitement. For anyone wanting to follow in Grahams’ footsteps, here are eight key characteristics of his investment philosophy:
1. A price-to-book ratio less than or equal to 1.
2. Substantial working capital, defined as current assets minus current liabilities
3. Free cash flow-per-share greater than earnings-per-share
4. A solid profit margin
5. Debt less than 33 percent of total capital
6. A share price below net-net value, which is working capital minus long-term debt divided by the number of shares outstanding
7. A five-year per-share profit growth rate divided by the five-year per-share revenue growth rate greater than 1
8. Stocks that trade at the lower half of their five-year high P/E ratio
Always remember that desired stock parameters can only produce investment candidates. From there, you will have to burrow into the depths and crevices of the available data to find the true gems you are looking for.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.