Stock Trek

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.

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This article was originally published in the July 1998 print edition of Entrepreneur with the headline: Stock Trek.

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