From the July 1998 issue of Entrepreneur

Looking for transportation to a place where few investors have gone before? With the stock market hurtling along at warp 9 to new galaxies almost daily, you may have to find a stable investment wormhole to rocket you to another universe. No clue where to find such a channel? You may want to consider a strategy that's worked since the earliest days of the Federation: If you'll agree to travel at a lower warp, value investing could be your ticket to the stars. And you won't be alone out there. Some rather noteworthy value investors have preceded you--strategist Benjamin Graham, mutual fund manager John Neff, and the Oracle of Omaha, Warren Buffett, to name a few. Join us on the bridge and get ready to go. Lock in your coordinates--engage!


Lorayne Fiorillo is a financial advisor at Prudential Securities Inc. Past performance is no guarantee of future returns. For more information, write to Lorayne in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.

Vulcanize Your Portfolio

Any Vulcan will assure you, logic is all; emotion, nothing. If you expect your portfolio to live long and prosper, selecting a strategy and sticking to it is vital to your success. Whether you're in it for a quick score or the long haul, there are two generally accepted styles of equity investing: growth and value.

Growth investors seek companies whose earnings are compounding at a rate greater than other companies in their own industry and greater than that of whatever index to which they are compared. Such stocks need to keep their momentum going to keep their prices rising; therefore, they must sustain above-average earnings growth. Investors who favor this investing style often pay a high price for the stocks, especially when compared to the company's earnings or book value. They anticipate future earnings will grow enough to justify not only current prices but considerable future price increases. Some people call this investing style "the greater fool method": You buy at a high price, hoping to later sell at an even higher price to a greater fool. Growth companies are often found in flamboyant sectors, such as technology, consumer services, health-care and consumer staples, and anyone who invested in these sectors during the past several bull market years was anything but a fool.

Value investors, on the other hand, measure what a company's stock is worth now, then try to buy it at a price lower than this value. Value companies are characterized by a stock price lower than that of the companies' earnings and book value. These stocks pay relatively higher dividends than do growth stocks and are more often found in mature industries, including utility, energy, consumer cyclicals (such as retail and home building) and financial companies. While both stock-selection styles have their devotees, for many, value investing has a logic even Spock couldn't dispute.

To find value stocks, chartered financial analysts Marvin I. Kline and Richard E. Buchwald of Berwind Investment Management LP in Philadelphia suggest narrowing your universe to stocks that fall into a few of these eight categories:

1. Each has a price-to-earnings (P/E) ratio that is at a significant discount to the market's.

2. Each has a low price-to-cash-flow ratio. (Some value enthusiasts value this more than P/E ratio.)

3. Each sells at a low price compared to its value.

4. The stock's dividend yield is greater than that of the market.

5. Each can be purchased for less than 50 percent to 60 percent of its estimated private market value.

6. Each can be purchased at two-thirds of its current net liquidation value (current assets less total debt).

7. Each has a high level of insider buying.

8. The company has implemented a stock repurchase plan.

While only a few stocks meet all these criteria, a reasonable number can meet three or more.

Beam Me Up, Scotty

Value investing may be logical, but does it get results? While past performance is no guarantee of future returns, Kline and Buchwald cite a 1976 study by Benjamin Graham, the father of value investing, in which he concludes that applying value investment principles resulted in an average annual rate of return of approximately 19 percent over the 50-year period from 1925 to 1975--well above that of the general market. Tom Jackson, a Prudential Investments portfolio manager, agrees: "If you follow the value style over the long term, you could outperform [the rest of the market]."

In a study done by Jackson, one dollar invested in 1970 in the S&P 500 (with all dividends reinvested) would have been worth $30.20 at the end of last year, representing a compound annual rate of return of 12.95 percent. The same dollar invested in low price-to-book-value stocks would have been worth $73.27, representing a compound annual rate of return of 16.57 percent. Had that same dollar been invested in a low P/E ratio value stock, it would have grown to $92.66, for a compound annual rate of return of 17.56 percent. (Taxes and fees are not considered in this example.) Jackson notes that these returns aren't garnered every quarter or even every year but that three- to five-year periods may see such returns. Value investing seems to put the probability of long-term success in the investor's corner.

But like all things in life, value is relative. "A value investor," says Janet Lowe, author of Value Investing Made Easy (McGraw-Hill), "should study the work of Benjamin Graham." Lowe condenses Graham's ideas for racking up relatively safe, high profits into six rules:

1. Don't pay too much attention to the overall market. It's easier to find good buys when share prices are generally low, but you can still spot a few bargains even when the market is high.

2. Buy a stock as if you were buying the whole company.

3. Look for signs of specific value (below-average P/E ratios, above-average yields, and earnings that have doubled since 1985 with no more than two annual declines of more than 5 percent).

4. Focus on quality.

5. Diversify with both stocks and bonds.

6. Above all, think for yourself and be patient.

The Next Generation

So where do you go to find value? You don't have to graduate from Starfleet Academy or survive the wrath of Khan to find good stocks at attractive prices. In larger company stocks, Jackson likes paper products, tobacco companies and financial services companies, including banks, insurance companies and brokers. Warren Spitz, a portfolio manager with Prudential Investments, suggests that investors looking for values in the mid-cap sector check out financial services companies, real estate investment trusts, consumer cyclicals and industrial materials companies (such as aluminum and steel). On the small-cap level, Jay Kaplan, also a Prudential Investments portfolio manager, suggests that investors focus on cash flow instead of earnings. "Cash pays bills; earnings don't," says Kaplan. He likes companies involved in textiles, apparel, auto parts, restaurants, energy exploration and production, and suppliers to aircraft manufacturers.

Does selecting stocks have you so baffled you're thinking of using your disrupter? Relax. You don't have to do it all on your own. Transport to your nearest Morningstar report for a list of value funds in each sector. Whether you're looking for large-cap, mid-cap or small-cap funds, there are plenty to choose from--and you don't have to leave the neutral zone to do it. Just consult your financial advisor and read the prospectus and annual report before you invest.

Kling-on To Your Profits

To make the most of their investment dollars, value investors buy when stocks are out of favor and prices are low. Experts are used to a buy-and-hold strategy, sometimes holding and holding and holding, while it seems like the momentum investors are having all the fun. For some value investors, it's almost a point of honor, like not leaving the field of battle until you've won. So when do you sell? There's an old adage on the street of dreams: Buy on the bad news and sell on the good. For value investors, this adage should become a mantra, though many lack the nerve to do more than chant it. Jackson notes that if you can identify a cheap stock, you should be able to verify appreciated value. "If you're buying stocks at 50 cents on the dollar, when [the stock's value] gets to dollar-for-dollar, sell," he says.

Are the principles of value investing alien to you? No one is suggesting the value style should be the only one determining your portfolio. Like a good starship crew, diversity breeds satisfaction. What kind of investor are you? Kirk Kazanjian, author of Wall Street's Picks for 1998 (Dearborn Financial Publishing), says: "You can spot a value investor a mile away buying what everyone else is trying to sell. They look for stocks making new lows instead of those making new highs. Value permeates their lives--they don't spend a lot on cars, houses or clothes." If this describes your lifestyle, maybe value investing is right for you.

Nonetheless, where the market is headed is anyone's guess. Falling interest rates, slowing economic growth and lower corporate profits are conditions that generally favor growth over value. Big earnings increases and economic expansion generally favor value over growth. Not sure what the world is coming to? Don't choose sides: Diversify between sectors and styles. In the long run, you may save yourself a lot of headaches.

Contact Source

Berwind Investment Management LP, (215) 575-2346, mkline@berwind.com