Warren Buffett made his fortune, not on high growth stocks, but with value investing. Curious which ratios make excellent stock market picks?
So, there’s this guy you may have heard of… Warren Buffet (pictured above). Why does that name ring a bell? Probably because he happens to be one of the greatest value investors who ever lived. In 2008 he was the richest man in the world worth an estimated 62 billion dollars!
Want to know his secret? Read on.
Choosing Value Over Growth
There are two major stock trading camps: value and growth. Instinctively, most people think that the quickest growing stock will provide the largest returns over time. Counter-intuitively, Warren Buffet has made his fortune in deep value stocks, not high growth companies. OK, great.. but what, exactly, is a value stock?
Oddly enough, there is no formal definition of what constitutes a value or growth stock. We can, however, speak in generalities. A value stock should have some of the following elements:
- Low Annual Revenue Growth These stocks usually show less than 15% revenue growth annually.
- High Percentage of Net Equity Value companies generally have a higher percentage of their share price made up of net equity (cash and assets minus liabilities) than the stock market average.
- P/E Ratio Value stocks prices per share generally trade at a multiple less than 20 times their annual earnings per share.
Here’s another way to think about it:
When a publicly traded company first starts out, they are usually considered a growth stock. The company has big dreams of aggressively attacking the market, increasing its market share, and becoming a giant. In the early stages, this is much easier since the business is going from newborn to toddler. As the company grows, triple-digit growth becomes much more difficult as they may face stiff competition, or simply market saturation. In turn, it becomes a value company. Value companies can still earn high profits, but the year-over-year growth of the retained earnings is less than that of some others.
Lack of Growth Does Not Equal Lack of Profit
Remember, the fact that a company is not growing drastically does not mean you can’t profit immensely.
For example, if a company has $1 billion dollars worth of sales and generates $200 million dollars worth of profit, you may not care whether profitability grows. You are earning 20% return for your investment, and as long as this remains static you are happy.
How do you get this profit from the company?
- Dividends If the business has expended most of its lucrative growth opportunities, they will often return profits to shareholders in the form of a dividend. Not all value stock companies do, however, as they may choose to re-invest the retained earnings. In fact, Warren Buffett prefers dividends not to be paid since this can not only help avoid paying some income tax, but it will also allow the company to pursue investing opportunities that are far superior to paying out profits in cash.
- Increased Share Price Even if the company chooses to simply keep its profits in cash and not reinvest it or pay it out to shareholders in the form of dividends, the value of the company has still increased 20% since last year. The share price should at least partially reflect this increase.
The Profitability of Value Investing
How much profit can you potentially make with value investing? For that answer we need to look over some research papers:
Statisticians and researchers in the business world have conducted numerous tests to calculate how much profit can be generated from value investing. A study by Fama and French found that certain value investing techniques earned 7.6% more than growth stock investing. Joseph Piotroski ran his value theories over 20 years worth of data and was able to generate 23% annual profits. From 1965 – 2009 Warren Buffett has been able to create 20.3% annual returns for his shareholders, or a total return of 434,057%!
Keep in mind that these men are theorists or master tacticians. Someone just learning about value investing and fundamental analysis will most likely not be able to create these sort of returns. Still, if we borrow a few techniques from such profitable investors, our stock portfolios will be sure to thank us in the long run.
- Look For Low Price To Book Ratios
The price is what the market is willing to pay per share. The book value is the net asset value of the company once liabilities are deducted. In theory, if the company was liquidated, this is the amount left over for shareholders to divvy up. The closer the trading price is to book value per share, the deeper value or intrinsic worth the shareholder has. This should provide some stability in share price since, even if the company went bankrupt, the shareholder is given back much of his capital.
Some large stocks currently trading close to their net asset values are Bank of America Corporation (BAC), The Travelers Companies Inc.(TRV), JPMorgan Chase and Company (JPM), and Alcoa Inc. (AA).
- Pick Companies With Low Debt
High debt can hurt a company when interest rates rise in good economies or when credit is tight in bad ones. The debt to equity ratio is a quick way to determine how well the weight of a company’s debt compares to its financial muscles. A ratio of 1 means that they have equal amounts of debt and equity. Obviously, the lower this ratio is, the better off you are.
- Reasonable Price To Earnings Ratios
Price to earnings is a ratio created by taking the share price and dividing it by the annual earnings per share. So, if the company earns $1 per share and the market price is $10 per share, the price to earnings ratio is 10.
Very low PE ratios often carry higher risk since investors will punish an under-performing stock, or one with a poor economic outlook, to low valuations. Very high PE ratios are indicative of growth stocks and also have higher earnings risk. While every industry has a different PE average, make sure yours is not on the high end since it will likely mean you are not trading value stocks. Stocks paying out large dividends typically have lower PE ratios than those that choose to re-invest earnings.
The Electric Utilities industry group, known for being a group of value stocks that typically pay dividends, has an average P/E of 13.5. Compare this to the Semiconductor Equipment and Materials industry group with a P/E of 60.
- High Return On Equity
This simple ratio reveals how much return the company makes based on shareholder equity. This number is important to determine how well the company is using your money. Do they sit on your cash or are they actively generating profits from all assets and equity? Compare ROE between similar companies and try to pick businesses that are comparatively higher than, or at least above, the industry average.
As an example, the Water Utilities industry group has a 7.2% return on equity. However, some companies have a much higher rate. Northumbrian Water (NWG.L) has a return on equity of 44%, and Aqua America, Inc (WTR) has a rate of 10.98%.
Big money producing value stocks has made the ‘Oracle of Omaha’ wealthy. His secret is to pick wonderful stocks with great management and good valuations. This is no easy task, but there are rewards awaiting those willing to dig into the fundamental analysis of a company. So, the next time you think about buying a stock, consider whether you prefer to buy the dream with the potential for high growth, or follow after Warren Buffet with a deep value investing mentality.