The 3 Most Timeless Investment Principles

Warren Buffett is widely considered one of the greatest investors of all time, but if you were to ask him whom he thinks is the greatest investor, he would probably mention one man: his teacher, Benjamin Graham. Graham was an investor and investing mentor who is generally considered thefather of security analysis and value investing.

His ideas and methods on investing are well documented in his books, "Security Analysis" (1934), and "The Intelligent Investor" (1949), which are two of the most famous investing texts. These texts are often considered requisite reading material for any investor, but they aren't easy reads. In this article, we'll condense Graham's main investing principles and give you a head start on understanding his winning philosophy.


Principle #1: Always Invest with a Margin of Safety

Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities, but also to minimize the downside risk of an investment. In simple terms, Graham's goal was to buy assets worth $1 for 50 cents. He did this very, very well.

To Graham, these business assets may have been valuable because of their stable earning power or simply because of their liquid cash value. It wasn't uncommon, for example, for Graham to invest in stocks where the liquid assets on the balance sheet (net of all debt) were worth more than the totalmarket cap of the company (also known as "net nets" to Graham followers). This means that Graham was effectively buying businesses for nothing. While he had a number of other strategies, this was the typical investment strategy for Graham.

This concept is very important for investors to note, as value investing can provide substantial profits once the market inevitably re-evaluates the stock and ups its price to fair value. It also provides protection on the downside if things don't work out as planned and the business falters. The safety net of buying an underlying business for much less than it is worth was the central theme of Graham's success. When chosen carefully, Graham found that a further decline in these undervalued stocks occurred infrequently.

While many of Graham's students succeeded using their own strategies, they all shared the main idea of the "margin of safety."

Principle #2: Expect Volatility and Profit from It

Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments. Graham illustrated this with the analogy of "Mr. Market," the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote at which he would either buy an investor out or sell his share of the business. Sometimes, he will be excited about the prospects for the business and quote a high price. Other times, he is depressed about the business's prospects and quotes a low price.

Because the stock market has these same emotions, the lesson here is that you shouldn't let Mr. Market's views dictate your own emotions, or worse, lead you in your investment decisions. Instead, you should form your own estimates of the business's value based on a sound and rational examination of the facts. Furthermore, you should only buy when the price offered makes sense and sell when the price becomes too high. Put another way, the market will fluctuate - sometimes wildly - but rather than fearing volatility, use it to your advantage to get bargains in the market or to sell out when your holdings become way overvalued.

Here are two strategies that Graham suggested to help mitigate the negative effects of market volatility:

Dollar-Cost Averaging

Dollar-cost averaging is achieved by buying equal dollar amounts of investments at regular intervals. It takes advantage of dips in the price and means that an investor doesn't have to be concerned about buying his or her entire position at the top of the market. Dollar-cost averaging is ideal for passive investors and alleviates them of the responsibility of choosing when and at what price to buy their positions.

Investing in Stocks and Bonds

Graham recommended distributing one's portfolio evenly between stocks and bonds as a way to preserve capital in market downturns while still achieving growth of capital through bond income. Remember, Graham's philosophy was, first and foremost, to preserve capital, and then to try to make it grow. He suggested having 25-75% of your investments in bonds, and varying this based on market conditions. This strategy had the added advantage of keeping investors from boredom, which leads to the temptation to participate in unprofitable trading (i.e. speculating).

Principle #3: Know What Kind of Investor You Are 

Graham advised that investors know their investment selves. To illustrate this, he made clear distinctions among various groups operating in the stock market.

Active Vs. Passive

Graham referred to active and passive investors as "enterprising investors" and "defensive investors."

You only have two real choices: The first choice is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn't your cup of tea, then be content to get a passive ( possibly lower) return but with much less time and work. Graham turned the academic notion of "risk = return" on its head. For him, "work = return." The more work you put into your investments, the higher your return should be.

If you have neither the time nor the inclination to do quality research on your investments, then investing in an index is a good alternative. Graham said that the defensive investor could get an average return by simply buying the 30 stocks of the Dow Jones Industrial Average in equal amounts. Both Graham and Buffett said that getting even an average return - for example, equaling the return of the S&P 500 - is more of an accomplishment than it might seem. The fallacy that many people buy into, according to Graham, is that if it's so easy to get an average return with little or no work (through indexing), then just a little more work should yield a slightly higher return. The reality is that most people who try this end up doing much worse than average.

In modern terms, the defensive investor would be an investor in index funds of both stocks and bonds. In essence, they own the entire market, benefiting from the areas that perform the best without trying to predict those areas ahead of time. In doing so, an investor is virtually guaranteed the market's return and avoids doing worse than average by just letting the stock market's overall results dictate long-term returns. According to Graham, beating the market is much easier said than done, and many investors still find they don't beat the market.

Speculator Vs. Investor

Not all people in the stock market are investors. Graham believed that it was critical for people to determine whether they were investors or speculators. The difference is simple: an investor looks at a stock as part of a business and the stockholder as the owner of the business, while the speculator views himself as playing with expensive pieces of paper, with no intrinsic value. For the speculator, value is only determined by what someone will pay for the asset. To paraphrase Graham, there is intelligent speculating as well as intelligent investing - just be sure you understand which you are good at.

The Bottom Line

Graham served as the first great teacher of the investment discipline and his basic ideas are timeless and essential for long-term success. He bought into the notion of buying stocks based on the underlying value of a business and turned it into a science at a time when almost all investors viewed stocks as speculative. If you want to improve your investing skills, it doesn't hurt to learn from the best. Graham continues to prove his worth through his disciples, such as Warren Buffett, who have made a habit of beating the market.

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Warren Buffett: How He Does It

Did you know that a $10,000 investment in Berkshire Hathaway in 1965, the year Warren Buffett took control of it, would grow to be worth nearly $30 million by 2005? By comparison, $10,000 in the S&P 500 would have grown to only about $500,000. Whether you like him or not, Buffett's investment strategy is arguably the most successful ever. With a sustained compound return this high for this long, it's no wonder Buffett's legend has swelled to mythical proportions. But how the heck did he do it? In this article, we'll introduce you to some of the most important tenets of Buffett's investment philosophy.

Buffett's Philosophy 

Warren Buffett descends from the Benjamin Graham school of value investing. Value investors look for securities with prices that are unjustifiably low based on their intrinsic worth. When discussing stocks, determining intrinsic value can be a bit tricky as there is no universally accepted way to obtain this figure. Most often intrinsic worth is estimated by analyzing a company's fundamentals. Like bargain hunters, value investors seek products that are beneficial and of high quality but underpriced. In other words, the value investor searches for stocks that he or she believes are undervalued by the market. Like the bargain hunter, the value investor tries to find those items that are valuable but not recognized as such by the majority of other buyers.

Warren Buffett takes this value investing approach to another level. Many value investors aren't supporters of the efficient market hypothesis, but they do trust that the market will eventually start to favor those quality stocks that were, for a time, undervalued. Buffett, however, doesn't think in these terms. He isn't concerned with the supply and demand intricacies of the stock market. In fact, he's not really concerned with the activities of the stock market at all. This is the implication this paraphrase of his famous quote : "In the short term the market is a popularity contest; in the long term it is a weighing machine."

He chooses stocks solely on the basis of their overall potential as a company - he looks at each as a whole. Holding these stocks as a long-term play, Buffett seeks not capital gain but ownership in quality companies extremely capable of generating earnings. When Buffett invests in a company, he isn't concerned with whether the market will eventually recognize its worth; he is concerned with how well that company can make money as a business.

Buffett's Methodology 

Here we look at how Buffett finds low-priced value by asking himself some questions when he evaluates the relationship between a stock's level of excellence and its price. Keep in mind that these are not the only things he analyzes but rather a brief summary of what Buffett looks for:

1. Has the company consistently performed well? 

Sometimes return on equity (ROE) is referred to as "stockholder's return on investment". It reveals the rate at which shareholders are earning income on their shares. Buffett always looks at ROE to see whether or not a company has consistently performed well in comparison to other companies in the same industry. ROE is calculated as follows:

= Net Income / Shareholders Equity

Looking at the ROE in just the last year isn't enough. The investor should view the ROE from the past five to 10 years to get a good idea of historical performance.

2. Has the company avoided excess debt? 

The debt/equity ratio is another key characteristic Buffett considers carefully. Buffett prefers to see a small amount of debt so that earnings growth is being generated from shareholders' equity as opposed to borrowed money. The debt/equity ratio is calculated as follows:

= Total Liabilities / Shareholders Equity

This ratio shows the proportion of equity and debt the company is using to finance its assets, and the higher the ratio, the more debt - rather than equity - is financing the company. A high level of debt compared to equity can result in volatile earnings and large interest expenses. For a more stringent test, investors sometimes use only long-term debt instead of total liabilities in the calculation above.

3. Are profit margins high? Are they increasing? 

The profitability of a company depends not only on having a good profit margin but also on consistently increasing this profit margin. This margin is calculated by dividing net income by net sales. To get a good indication of historical profit margins, investors should look back at least five years. A high profit margin indicates the company is executing its business well, but increasing margins means management has been extremely efficient and successful at controlling expenses.


4. How long has the company been public? 

Buffett typically considers only companies that have been around for at least 10 years. As a result, most of the technology companies that have had their initial public offerings (IPOs) in the past decade wouldn't get on Buffett's radar (not to mention the fact that Buffett will invest only in a business that he fully understands, and he admittedly does not understand what a lot of today's technology companies actually do). It makes sense that one of Buffet's criteria is longevity: value investing means looking at companies that have stood the test of time but are currently undervalued.

Never underestimate the value of historical performance, which demonstrates the company's ability (or inability) to increase shareholder value. Do keep in mind, however, that the past performance of a stock does not guarantee future performance - the job of the value investor is to determine how well the company can perform as well as it did in the past. Determining this is inherently tricky, but evidently Buffett is very good at it.

5. Do the company's products rely on a commodity? 

Initially you might think of this question as a radical approach to narrowing down a company. Buffett, however, sees this question as an important one. He tends to shy away (but not always) from companies whose products are indistinguishable from those of competitors, and those that rely solely on a commodity such as oil and gas. If the company does not offer anything different than another firm within the same industry, Buffett sees little that sets the company apart. Any characteristic that is hard to replicate is what Buffett calls a company's economic moat, or competitive advantage. The wider the moat, the tougher it is for a competitor to gain market share.

6. Is the stock selling at a 25% discount to its real value? 

This is the kicker. Finding companies that meet the other five criteria is one thing, but determining whether they are undervalued is the most difficult part of value investing, and Buffett's most important skill. To check this, an investor must determine the intrinsic value of a company by analyzing a number of business fundamentals, including earnings, revenues and assets. And a company's intrinsic value is usually higher (and more complicated) than its liquidation value - what a company would be worth if it were broken up and sold today. The liquidation value doesn't include intangibles such as the value of a brand name, which is not directly stated on the financial statements.

Once Buffett determines the intrinsic value of the company as a whole, he compares it to its current market capitalization - the current total worth (price). If his measurement of intrinsic value is at least 25% higher than the company's market capitalization, Buffett sees the company as one that has value. Sounds easy, doesn't it? Well, Buffett's success, however, depends on his unmatched skill in accurately determining this intrinsic value. While we can outline some of his criteria, we have no way of knowing exactly how he gained such precise mastery of calculating value.

Conclusion 
As you have probably noticed, Buffett's investing style, like the shopping style of a bargain hunter, reflects a practical, down-to-earth attitude. Buffett maintains this attitude in other areas of his life: he doesn't live in a huge house, he doesn't collect cars and he doesn't take a limousine to work. The value-investing style is not without its critics, but whether you support Buffett or not, the proof is in the pudding. As of 2004, he holds the title of the second-richest man in the world, with a net worth of more $40 billion (Forbes 2004). Do note that the most difficult thing for any value investor, including Buffett, is in accurately determining a company's intrinsic value.

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Top 5 Books for Young Investors

It's imperative for young adults and professionals to start investing early. One of the main reasons for doing so is to obtain the power of compound interest; by holding long-term investments, one can allow his or her assets to generate more returns. Investing just a few years earlier could translate into tens of thousands, if not hundreds of thousands, of additional funds for your retirement nest egg.

But while it is important to invest early, it is also important to invest wisely. Let's take a look at five classic investing books that can provide indispensable business and finance insights for young investors - and they're a good read, too!

"Rich Dad, Poor Dad" (2000) by Robert Kiyosaki

This classic is a must-read for young investors. Kiyosaki's view is that the poor and middle class work for money, but the rich work to learn. He stresses the importance of financial literacy, and presents financial independence as the ultimate goal and a way to avoid the rat race of corporate America. The author points out that while accounting is important to learn, it can also be misleading. Banks label a house as an asset for the individual, but because of the required payments to keep it, it can really be a liability in terms of cash flow. Real assets add cash flow to your wallet.

Kiyosaki advocates investments that produce periodic cash flow for the investor while providingupside in terms of equity value. Real estate and stocks that provide dividends are viewed favorably. The author advises that America's educational system is designed to keep people working hard for the rest of their lives, and that the school system does a poor job of teaching people to create enough wealth so they won't have to work anymore. Kiyosaki also highlights the importance of tax planning.


"The Essays of Warren Buffett: Lessons For Corporate America" (1997) by Warren Buffett

In his essays, Warren Buffett - widely considered to be modern history's most successful investor - provides his views on a variety of topics important to corporate America and shareholders. Young investors can get a glimpse of the interface between a company's management and its shareholders, as well as the thought processes involved in enhancing a company's enterprise value.

Buffett's essays include discussions on corporate governance, finance and investing, alternatives to common stock, common stock, mergers and acquisitions, accounting and valuation and accounting policy and tax matters. Buffett outlines his basic business principles, and as the steward of Berkshire Hathaway, informs the shareholders of the company that their mutual interests are aligned. He has a philosophy of bringing in talented managers at portfolio companies and leaving them alone. He advocates purchasing shares of businesses at times when these stocks are trading at a discount from their inherent value. He opposes following investing trends.

"Beating the Street" (1994) by Peter Lynch

Peter Lynch is one of the most successful stock market investors and hedge fund managers of the 20th century. He started out as an intern at Fidelity Investments in the mid 1960s. Nearly 11 years later, he was tasked to manage the Magellan Fund, which at the time had close to $18 million inassets. By 1990, the fund had grown to a whopping $18 billion in assets with nearly 1,000 stock positions. During this time, the fund boasted average returns of more than 29% per year.

"Beating The Street" allows the reader to peek into Lynch's mind and thought processes in terms of deciding whether to buy or sell a stock. Lynch believed that an individual investor could exploit market opportunities better than Wall Street, and encourages investors to invest in what they know.

"The Intelligent Investor" (1949) by Benjamin Graham

This book was written in 1949 and has been hailed by Warren Buffett as the best investing book ever written. Benjamin Graham is considered the "father of value investing," a paradigm that advocates the purchase of stocks that appear underpriced relative to their inherent value, which is determined through fundamental analysis.

Graham delves into the history of the stock market, and informs the reader on conducting fundamental analysis on a stock. He discusses various ways of managing your portfolio including both a positive and defensive approach. He then compares the stocks of several companies to illustrate his points.

"Think and Grow Rich" (1937) by Napoleon Hill

"Think And Grow Rich" was written by Napoleon Hill during the Great Depression, and has since sold more than 30 million copies worldwide. Hill conducted extensive research based on his associations with wealthy individuals during his lifetime. At the suggestion of Andrew Carnegie, Hill published 13 principles for success and personal achievement from his observations and research. These include desire, faith, specialized knowledge, organized planning, persistence and the "sixth sense." Hill also believed in brainstorming with like-minded people, whose efforts can create synergistic energy.

This book conveys valuable insights into the psychology of success and abundance, and should be considered a priority read given this age's emphasis on shock-value entertainment and negative news.

The Bottom Line

The best investors did not emerge overnight, but honed their skills through years of thought, research and practice. Reading these respected tomes will help you begin your journey into investing on the right foot.

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Take On Risk With A Margin of Safety

When investing, it is well accepted that one of the main things you should focus on is risk. However, modern investment theory mainly focuses on the volatility of an asset in its treatment of risk. Themargin of safety theory is a little different - it argues that downward spikes of volatility make stocks less risky. This is an important concept to grasp in depth, because common risk theories can lead to missed opportunities. Investing gurus Benjamin Graham and Warren Buffett were instrumental in developing margin of safety. Read on to find out how this theory helped propel their portfolios to meteoric heights.

Beta's Misgivings

In general, people do not like surprises. More precisely, people do not like adverse surprises. Because investors are assumed to be more averse to losing money than gaining it, modern investment theory views the volatility of an asset, as measured by its beta, as the main component of risk. The theory implies that investors should pay less for an asset with a higher beta.

One problem with beta is that it implies that if an asset's value suddenly drops, even due to irrational market behavior, that it becomes more risky because it will have a higher beta. We'll poke some holes in this view in moment, using an example from Warren Buffett.

An Alternate Strategy of Risk

Introduced by the father of value investing, Benjamin Graham, and notably implemented by Warren Buffett, margin of safety was presented as a different view of risk and how to protect against it. Graham's concept is not new. He first presented his investing style with David Dodd in 1934's "Security Analysis" and later with his more accessible book, "The Intelligent Investor", which was first published in 1949.

Graham characterized volatility as "Mr. Market" coming each day to buy from you or sell to you. Graham hoped to buy assets that Mr. Market would sell to him with a 50% margin of safety. This, essentially, would be like trying to buy a dollar for $0.50.

Graham discussed how companies all have an intrinsic measurable value. When Graham first pitched and practiced this idea, information on companies was not nearly as easy to access. He would search through the financial statements and look for what he called net-nets, or companies trading below their liquidation values.

Graham would take a company's current assets with considerable deductions, and subtract all of the liabilities on the balance sheet. At its heart, Graham's net-net investing is the most conservative value approach, and involves very little risk if done right.

Example - Finding A Company\'s Net-Net
ABC Company has the following balance sheet and market capitalization:
Cash $250
Cash Equivalents $50
Accounts Receivable (A/R) $100
Inventories $100
Total Liabilities $300
Share Price $62.50

Cash and cash equivalents are good to go, we have $300 there. Next, we turn to A/R, some of which will not be paid. Usually we have a net A/R number on the balance sheet, indicating the amount of receivables the company expects to recover. If we have it, this net number is based on the company's history of collecting receivables, and is a good indicator, but we would still discount it a little for added safety.

In this scenario, we have a gross A/R number. Again we don't expect to recover it all, but ABC is known to have a fairly reliable client base and we could easily anticipate recovering around 80% of A/R - to be even more conservative we will only factor in recovering 75%. Many investors may want to take a look at the company's allowance for doubtful accounts in their financial statements as a method for gauging an accurate recovery percentage, but in this case, we'll value A/R at $75 ($100 x 0.75). Finally, there is ABC's inventory. ABC has competitors, which we could assume, at the very least, would buy the inventory for half its value. So we take the inventory's value at $50 ($100 x 0.5).
We end up with marked down current assets of $425 ($300 + $75 + $50), and total liabilities of $300.

This net-net is worth $125 ($425 - $300), not even accounting for any real estate or other long-term assets the company might have. With the company selling at only $62.50 in the market, this is a net-net with a 50% margin of safety. Paying half of a company's net-net value was Graham's goal, and at most, he would pay two-thirds of a company's net-net value, for a 33% margin of safety. In our example, we have a 50% buffer between the market value of the company and our conservative valuation of the company's current assets. By only buying at a steep discount to our valuation, this margin of safety provides its own built-in measure against the risk of mistakes in our calculations.

Let Volatility Be Your Friend

This process of investing did not guarantee success, but with research and hard work, finding one of these scenarios was about as close to a sure thing as you could get. A lot has changed, and Graham's net-nets have essentially disappeared in the modern market. With the quick and widespread dissemination of information, markets have become somewhat more efficient.

While net-nets are disappearing, investors can see that the market provides sales on assets quite often. The concept of buying companies with an adequate margin of safety still remains, and has been practiced with great success by many value investors, most notably Warren Buffett.

Example - Taking the Value of Long-Term Assets Into Account
In the ABC example, we gave absolutely no value to the company\'s long term assets. Let\'s return to the example and suppose that that the company\'s share price is now at $200. We calculated its net-net worth at $125, so according to that it would not be a good value, but we note that ABC also has the following assets on its books:
Plant, Property, & Equipment $200
Long-Term Bonds $100

We notice from some research that the plants on the company's balance sheet have likely appreciated because property values have gone up in that area. However, we will remain very conservative in this example and still value it at $200. Next, with the company's long-term bonds, we may worry about the market value if the bonds need to be sold quickly. We will only accept 75% of the value, and value the bonds at $75 ($100 x 0.75). We end up with an asset value of $400 (net-net worth of $125 + $200 + $75). Again, we can buy the stock of this company with a 50% margin of safety at its current market price of $200.

This again seems like a home run of an investment. We are still being conservative, and we ignored any assets that could be off ABC's books, such as the appreciated value of its real estate. Other hidden assets are brands, exceptional management, competitive advantages, etc. There is much to be said about the market value of hidden assets, but the point will remain the same.

Don't Run From Beta

Now looking strictly at beta, let's say ABC had a beta of 1.5. After all of our work, we decide to go to bed and buy tomorrow. However, the next day, "Mr. Market" decides to take the price of ABC down to $150, while the rest of the market stays pretty flat. This sharp 25% decline in ABC stock makes it riskier according to beta.

However, according to Warren Buffett in his 1993 letter to shareholders this altered perception of risk is misleading:

"Under beta-based theory, a stock that has dropped very sharply compared to the market - as hadWashington Post when we bought it in 1973 - becomes "riskier" at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?"

What this means is that volatility is our friend in this scenario. We did the work to value the company, and now Mr. Market is just offering it to us at a steeper discount and a higher margin of safety. If we had already made the purchase before the decline, we might kick ourselves for bad timing, but according to our research, an investment in ABC is still worth much more than what we paid.


Take a Page From the Masters

The concept of margin of safety as practiced by Warren Buffett is not that complicated. These are fairly simple ideas, and should teach us all not to rely simply on volatility as a judge of risk. Many common theories of risk make volatility out to be a bad thing, and if a stock's sea becomes choppy, some investors may sail for calmer waters. But take a cue from Warren Buffett. He, and other value investors, get excited in volatile and down markets. If you invest carefully, and with an adequate margin of safety, Mr. Market's mood swings can lead to great opportunities.

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5 Must-Have Metrics For Value Investors

If you're a value investor, there's no "right way" to analyze a stock. Even so, any successful investor will tell you that focusing on certain fundamental metrics is the path to cashing in gains. That's why you need to keep your eye on the metrics that matter.

As a value investor, you already know that when it comes to a company's health, the fundamentalsare king. Fundamentals, which include a company's financial and operational data, are preferred by some of the most successful investors in history, including the likes of George Soros and Warren Buffett. That's no surprise, as knowing the ins and outs of a company's financial numbers - like earnings per share and sales growth - can help an in-the-know investor weed out the stocks that are trading for less than they're worth.

But that doesn't mean that all metrics are created equal – some deserve more of your attention than others. Here's a look at the five must-have fundamentals for your value portfolio.


1. Price-to-Earnings Ratio

While the price-to-earnings ratio (also known as the P/E ratio or earnings multiple) is likely one of the best-known fundamental ratios, it's also one of the most valuable. The P/E ratio divides a stock's share price by its earnings per share to come up with a value that represents how much investors are willing to shell out for each dollar of a company's earnings.

The P/E ratio is important because it provides a measuring stick to compare valuations across companies. A stock with a lower P/E ratio costs less per share for the same level of financial performance than one with a higher P/E. What that essentially means is that low P/E is the way to go.

But one place where the P/E ratio isn't as valuable is when you're comparing companies across different industries. While it's completely reasonable to see a telecom stock with a P/E in the low teens, a P/E closer to 40 isn't out of the line for a high-tech stock. As long as you're comparing apples to apples, though, the P/E ratio can give you an excellent glimpse at a stock's valuation.

2. Price-to-Book Ratio

If the P/E ratio is a good indicator of what investors are paying for each dollar of a company's earnings, the price-to-book ratio (or P/B ratio) is an equally good indication of what investors are willing to shell out for each dollar of a company's assets. The P/B ratio divides a stock's share price by its net assets, less any intangibles such as goodwill.

Taking out intangibles is an important element of the price-to-book ratio. It means that the P/B ratio indicates what investors are paying for real-world tangible assets, not the harder-to-value intangibles. As such, the P/B is a relatively conservative metric.

That's not to say that the P/B ratio isn't without its limitations; for companies that have significant intangibles, the price-to-book ratio can be misleadingly high. For most stocks, however, shooting for a P/B of 1.5 or less is a good path to solid value.

3. Debt-Equity

Knowing how a company finances its assets is essential for any investor – especially if you're on the prowl for the next big value stock. That's where the debt/equity ratio comes in. As with the P/E ratio, this ratio, which indicates what proportion of financing a company has received from debt (like loans or bonds) and equity (like the issuance of shares of stock), can vary from industry to industry.

Beware of above-industry debt/equity numbers, especially when an industry is facing tough times – it could be one of your first signs that a company is getting over its head in debt.


4. Free Cash Flow

While many investors don't actually know it, a company's earnings almost never equal the amount of cash it brings in. That's because companies report their financials using GAAP or IFRS accounting principles, not the balance of the corporate checking account. So while a company could be reporting a huge profit for its latest quarter, the corporate coffers could be bare.

Free cash flow solves this problem. It tells an investor how much actual cash a company is left with after any capital investments. Generally speaking, it's a good idea to shoot for positive free cash flow. As with the debt-equity ratio, this metric is all the more significant when times are tough.


5. PEG Ratio

The price/earnings to growth ratio (or PEG Ratio), is a modified version of the P/E ratio that also takes earnings growth into account. Looking for stocks based on their PEG ratios can be a good way to find companies that are undervalued but growing, and could gain attention in upcoming quarters. Like the P/E ratio, this metric varies from industry to industry.

Going Beyond the Numbers

When it comes to investing, the numbers aren't everything. There are times when low valuations are justified, and there are qualitative metrics – like management quality – that also factor into a company's valuation. Just because a stock seems cheap doesn't mean that it deserves to increase in value.

Ultimately, the only way to improve your fundamental analysis skills is to put them into practice. With these five must-have fundamentals under your belt, you're well on your way to finding the most undervalued stocks on the market.

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The Value Investor's Handbook

Value investing, and any type of investing for that matter, varies in execution with each person. There are, however, some general principles that are shared by all value investors. These principles have been spelled out by famed investors like Peter Lynch, Kenneth Fisher, Warren Buffet, John Templeton and many others. In this article, we will look at these principles in the form of a value investor's handbook.


Buy Businesses

If there is one thing that all value investors can agree on, it's that investors should buy businesses, not stocks. This means ignoring trends in stock prices and other market noise. Instead, investors should look at the fundamentals of the company that the stock represents. Investors can make money following trending stocks, but it involves a lot more activity than value investing. Searching for good businesses selling at a good price based on probable future performance requires a larger time commitment for research, but the payoffs include less time spent buying and selling and fewer commission payments.

Love the Business You Buy

You wouldn't pick a spouse based solely on his or her shoes, and you shouldn't pick a stock based on cursory research. You have to love the business you are buying, and that means being passionate about knowing everything about that company. You need to strip the attractive covering from a company's financials and get down to the naked truth. Many companies look far better when you judge them on basic price to earnings (P/E), price to book (P/B) and earnings per share (EPS) ratios than they do when you look into the quality of the numbers that make up those figures.

If you keep your standards high and make sure the company's financials look as good naked as they do dressed up, you're much more likely to keep it in your portfolio for a long time. If things change, you'll notice it early. If you like the business you buy, paying attention to its ongoing trials and successes becomes more of a hobby than a chore.

Simple Is Best

If you don't understand what a company does or how, then you probably shouldn't be buying shares. Critics of value investing like to focus on this main limitation. You are stuck looking for businesses that you can easily understand because you have to be able to make an educated guess about the future earnings of the business. The more complex a business is, the more uncertain your projections will necessarily be. This moves the emphasis from "educated" to "guess."

You can buy businesses you like but don't completely understand, but you have to factor in uncertainty as added risk. Any time a value investor has to factor in more risk, he has to look for a larger margin of safety - that is, more of a discount from the calculated true value of the company. There can be no margin of safety if the company is already trading at many multiples of its earnings, which is a strong sign that, however exciting and new the idea is, the business is not a value play. Simple businesses also have an advantage, as it's harder for incompetent management to hurt the company.


Look for Owners, Not Managers

Management can make a huge difference in a company. Good management adds value beyond a company's hard assets. Bad management can destroy even the most solid financials. There have been investors who have based their entire investing strategies on finding managers that are honest and able. To quote Buffett, "look for three qualities: integrity, intelligence, and energy. And if they don't have the first, the other two will kill you." You can get a sense of management's honesty through reading several years' worth of financials. How well did they deliver on past promises? If they failed, did they take responsibility, or gloss it over? (Find out more about Buffett's investing inWarren Buffett: How He Does It.)

Value investors want managers who act like owners. The best managers ignore the market value of the company and focus on growing the business, thus creating long-term shareholder value. Managers who act like employees often focus on short-term earnings in order to secure a bonus or other performance perk, sometimes to the long-term detriment of the company. Again, there are many ways to judge this, but the size and reporting of compensation is often a dead give away. If you're thinking like an owner, you pay yourself a reasonable wage and depend on gains in your stock holdings for a bonus. At the very least, you want a company that expenses its stock options.

When You Find a Good Thing, Buy a Lot

One of the areas where value investing runs contrary to commonly accepted investing principles is on the issue of diversification. There are long stretches where a value investor will be idle. This is because of the exacting standards of value investing as well as overall market forces. Toward the end of a bull market, everything gets expensive, even the dogs, so a value investor may have to sit on the sidelines waiting for the inevitable correction. Time, an important factor in compounding, is lost while waiting, so when you do find undervalued stocks, you should buy as much as you can. Be warned, this will lead to a portfolio that is high-risk according to traditional measures like beta. Investors are encouraged to avoid concentrating on only a few stocks, but value investors generally feel that they can only keep proper track of a few stocks at a time.

One obvious exception is Peter Lynch, who kept almost all of his funds in stocks at all times. Lynch broke stocks into categories and then cycled his funds through companies in each category. He also spent upwards of 12 hours every day checking and rechecking the many stocks held by his fund. As an individual value investor with a different day job, however, it's better to go with a few stocks for which you've done the homework and feel good about holding long term.

Measure Against Your Best Investment

Anytime you have more investment capital, your aim for investing should not be diversity, but finding an investment that is better than the ones you already own. If the opportunities don't beat what you already have in your portfolio, you may as well buy more of the companies you know and love, or simply wait for better times. During idle times, a value investor can identify the stocks he or she wants and the price at which they'll be worth buying. By keeping a wish list like this, you'll be able to make decisions quickly in a correction.

Ignore the Market 99% of the Time

The market only matters when you enter or exit a position; the rest of the time, it should be ignored. If you approach buying stocks like buying a business, you'll want to hold onto them as long as the fundamentals are strong. During the time you hold an investment, there will be spots where you could sell for a large profit and others were you're holding an unrealized loss. This is the nature of market volatility.

The reasons for selling a stock are numerous, but a value investor should be as slow to sell as he or she is to buy. When you sell an investment, you expose your portfolio to capital gains and usually have to sell a loser to balance it out. Both of these sales come with transaction costs that make the loss deeper and the gain smaller. By holding investments with unrealized gains for a long time, you forestall capital gains on your portfolio. The longer you avoid capital gains and transaction costs, the more you benefit from compounding.


The Bottom Line

Value investing is a strange mix of common sense and contrarian thinking. While most investors can agree that a detailed examination of a company is important, the idea of sitting out on a bull market goes against the grain. It's undeniable that funds held constantly in the market have outperformed cash held outside the market, waiting for a down market. This is a fact, but a deceiving one. The data is derived from following the performance of indexes like the S&P 500 over a number of years. This is where passive investing and value investing get confused.

In both types of investing, the investor avoids unnecessary trading and has a long-term holding period. The difference is that passive investing relies on average returns from an index fund or other diversified instrument. A value investor seeks out above-average companies and invests in them. Therefore, the probable range of return for value investing is much higher. In other words, if you want the average performance of the market, you're better off buying an index fund right now and piling money into it over time. If you want to outperform the market, however, you need a concentrated portfolio of outstanding companies. When you find them, the superior compounding will make up for the time you spent waiting in a cash position. Value investing demands a lot of discipline on the part of the investor, but in return offers a large potential payoff.

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Warren Buffett's Frugal, So Why Aren't You?

Warren Buffett, perennially ranked among the world's richest men, lives a lifestyle that hasn't changed much since before he before he made his billions. He is often referred to as the world's greatest investor, and his long-term track record suggests the title is well deserved. He is also legendarily frugal, residing in the same house in Omaha, Nebraska, that he bought in 1958 for $31,500. He is well known for his simple tastes, including McDonald's hamburgers and cherry Coke, and his disdain for technology, including computers and luxury cars. Underlying his legend is one simple fact: Buffett is a value investor. It's the hallmark trait of both his professional and personal success.

The Personal Underpinnings of Value

Warren Buffett has a clear strategy for making money. He often says, "The first rule of investing is don't lose money; the second rule is don't forget Rule No. 1." It's a strategy he employs in his personal life as well as in his profession. It begins by living far below his means.

Despite a net worth measured in billions, Warren Buffett earns a base salary of $100,000 a year at Berkshire Hathaway. It's a salary that has not changed in 25 years. A man of simple tastes, including watching sports on television and eating junk food, Buffett easily supports his modest standard of living with this salary.

His definition of personal success and luxury, which he revealed during an interview with CNBC, provides additional insight into his philosophy. "Success is really doing what you love and doing it well. It's as simple as that. Really getting to do what you love to do everyday - that's really the ultimate luxury…your standard of living is not equal to your cost of living." And what Buffett loves to do everyday is work at Berkshire Hathaway.

In keeping with his views, Buffett is not an accumulator of toys or other trappings of wealth. He views the maintenance and expense associated with these things as a burden. It's a view that he extends to cellular telephones and computers, too.

When CNBC asked him what the one thing he believed young people should be doing about money, his primary advice was to "stay away from credit cards." Paying interest on credit cards not only suggests that you are living beyond your means, but it also means that you are losing money. Both courses of action run contrary to Buffett's philosophy.

As a value investor, Buffett is always looking for a bargain. Even his wedding was a simple affair rather than a celebrity-studded gala. A man who could have chosen any venue in the world got married in 2006 in Omaha at a private ceremony held at his daughter's house. The ceremony lasted just 15 minutes.

Different Than You 

Warren Buffett loves his job. He often says that nothing is more fun than running Berkshire, so he doesn't spend a lot of money on relaxation, travel and other ways to forget the misery of his day job. He had the ambition to start his own company rather than complain about the one he works for, so he took the necessary steps to put himself in a position where he would be happy. If you find yourself dreading the idea of going to work everyday, do something about it. Put a few resumes in the mail or contact a recruiter.

Buffett is also happy with what he has in terms of his modest standard of living. He isn't interested in a bigger house, a newer car or owning his own island. He simply doesn't care about the Joneses and what they have.

Warren Buffett also pays attention to ongoing expenses. Cell phones, internet access, real estate taxes and maintenance expenses for toys are things he avoids to the best of his abilities.

The Bottom Line

For most people, a billion-dollar fortune seems light years away - but Warren Buffett's frugal habits are likely to seem nearly as remote to many people. If you aren't sitting on a fortune and are letting what you have slip away in discretionary spending and unnecessary expenses, you're as far from future wealth as anyone can be. As it turns out, most people can learn a lot from the Oracle of Omaha - and his legendary investing strategy is just the tip of the iceberg.

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Hetty Green: the Witch of Wall Street

When we think of the movers and shakers of Wall Street, the captains of industry and the titans of finance, we generally visualize formidable men in suits. It's often thought that women have yet to produce a towering figure in Wall Street lore. This idea couldn't be more wrong. We will look at the life of Hetty Green, the richest woman of her era and a pioneering value investor who more often goes by the title the "Witch of Wall Street."


Growing Up on the Docks

Hetty Green, born Henrietta Howland Robinson (Nov. 21, 1834), showed an early aptitude for finance. She opened her first bank account at eight and received much of her education reading the financial pages to her near-blind grandfather, discussing each stock and bond in detail. Green's father, Edward Robinson, was believed to have married her mother, the bed-ridden heiress of the Howland fortune, for the seed money needed to build up a whaling business. Robinson was a ruthless businessman and Hetty was his bookkeeper, as well as his companion, as he strolled the docks making deals.

Edward Robinson kept Green from receiving her inheritance upon the death of her mother, so it was not until his death in 1864 that 30-year-old Green received the family fortune of $7.5 million. On his deathbed, Edward Robinson told her that he had been poisoned by conspirators and warned her that they would come for her. Not surprisingly, Green came out of her childhood and early years with a certain amount of eccentricity that later events only reinforced.

Shortly after her father's death, her wealthy aunt died. Green's aunt had agreed to leave her fortune to Hetty, but the will had been changed over the last years that Hetty's aunt spent as an invalid. Hetty fought the will that only gave her a tiny fraction of the inheritance promised, instead spreading the $2 million among caretakers, the doctor and distant cousins. Hetty came forth with another will denouncing the first and was embroiled in legal battles, including accusations of forgery.


Buy Cheap, Sell Dear

Hetty took her money to Wall Street. She had actually been investing for years with the allowance from her father, but her larger capital base opened up new realms of finance. She made full use ofcompounding, low-risk investments and tax protection (bordering on evasion), combining this formidable trio with incredible frugality. She bought up bonds and real estate at severe discounts in every financial panic. When everyone was running out of the market, Green would buy in. She always kept a large war chest for crashes and panics, both for snapping up investments in fire salesand providing high-interest emergency loans to desperate bankers. When markets recovered, Green would call in the loans, plus interest, and sell off the investments as the markets heated up again.

Her only miscalculation came when she married Ned Green, a successful speculator. Hetty Green's investment character was the exact opposite of her new husband, but she was prudent enough to get Ned to sign a prenuptial agreement keeping their finances separate. The newly-christened Hetty Green hated speculation and margin, preferring to carefully choose each investment. In November 1905, she told the New York Times: "I buy when things are low and nobody wants them. I keep them until they go up and people are anxious to buy."

Hetty Green was thorough, reading everything she could find about various railway stocks and bond offerings before buying. She was not a value investor of the buy and hold type, however, as she stated, "I never buy anything just to hold it. There is a price on everything I have. When that price is offered, I sell." In short, Hetty Green was a disciplined investor.


Family Troubles

Hetty Green's frugality and discipline soon clashed with her husband's freewheeling speculation. She had to bail out her husband several times before unofficially separating from him. They had two children, a daughter and a son, and both went to live with their mother. When her son, Edward Green, nicknamed Ned, injured his leg sledding, his mother tried to take him to a charity hospital to get free care. The leg was improperly treated and had to be amputated, as gangrene had set in. Green's relationship with her children was strained and would remain so until her death. Her daughter left after marrying, and her son worked unpaid for years as her clerk - instantly recognizable because of his cork leg.

For most of the 1800s, Green kept a constantly rotating number of houses in different districts to avoid taxes in any single one. In 1885, however, her main bank attempted to seize her assets to cover her husband's trading debts. Green withdrew all her money and went to the Chemical National Bank, opening an account as well as an unofficial office in the back.


The Chemical Bank Magician

Green had an encyclopedic knowledge of the market and her own finances. She constantly updated a list of prices at which she would buy into or sell out of investments, keeping it all in her head for fear of lawyers getting their hands on written documents. Her distaste for lawyers and judges grew over the years, and she was accused of pulling her gun on one over a dispute about a tax assessment. Many of her inheritance troubles were centered around a Chicago judge, so Green bought up all the demand notes for railroads terminating Chicago. She then called all the notes. The railroad treasurers panicked and quickly agreed to Hetty's unique terms - they moved the judge up and out of the district, bringing a more receptive judge in and Green let the notes be.

Green's reputation for hard-nosed business was further solidified when speculators attempted bear raids on her holdings. When these men attempted to short her investments, Hetty Green would use her war chest to buy up all the outstanding stock and corner whole groups, extracting a high price from them before allowing them to close out their positions. She had several famous battles of this type with railroad baron Collis P. Huntington. Green would buy up small but essential railroads and charge a high price for selling them to consolidators like Huntington. Huntington disliked having to pay out to anyone, let alone a woman, and went to Green's office at the Chemical Bank. He threatened to have her son jailed by Texas courts on his payroll. Hetty Green responded by pulling her gun on him and Huntington bolted from the office in fear.

It was in 1907, however, when Green made her most commanding move. Sensing an overvalued market, she called in all her loans and sold off many of her stocks and bonds. When the panic of 1907 broke, Green was among the very few who were absolutely liquid and she went bargain hunting in the aftermath. She picked up pre-bankruptcy stocks and shares and profited fromreorganization like vulture funds do today. She also demanded land leases and solid assets ascollateral for many of her loans.


Eluding Taxes, but Not...

Hetty Green, 70 at the time of the panic, continued investing right up until her death. She groomed her son Ned to replace her, but curiously did little for her daughter Sylvia. Hetty died in 1916, with an estimated $100 million in liquid assets, and much more in land and investments that her name didn't necessarily appear on. She had taken a $6 million inheritance and invested it into a fortune worth upwards of $2 billion today, making her by far the richest woman in the world. Her son squandered some of the fortune, but after his death Sylvia still received $100 million. When she died, more than half of the estate was taken by taxes, the rest was left to charity.


The Bottom Line

Carnegie was a man of steel and iron, Vanderbilt was the commodore and figures like Rockefeller and Morgan were so respected that their names became new buzzwords for power and wealth. Yet, Hetty Green, the richest woman and most astute investor of her time - astute as opposed to manipulative - is remembered as the witch of Wall Street. Today, one would like to think we'd see her as at least the grand maven of investing, but the chances are that Hetty Green didn't care a halfpenny either way. Photographs of Hetty Green show an austere woman. Her signature black dress and the tight bun of her hair are secondary to the iron gaze that one can easily imagine intimidating every desperate banker negotiating for float loans. The beauty of Hetty Green is found in the shrewd, and, judged by the standards of the times, upright investing strategy she pioneered. In a very real way, Hetty Green was one of America's first value investors.

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Sell Growth Stocks The IBD Way

Did you see the Dan Aykroyd-cum-Eddie Murphy flick "Trading Places"? If so, you may recall the scene in which a pair of commodity futures kings realize they have made a huge bet on orange juice that is souring badly. Randolph and Mortimer Duke rush down to the trading floor and urge their trader to "Sell, sell!"

Their decision was too late. Since they were the bad guys, they didn't get saved by a Hollywood ending.

As stock investors, we would be mortified to be in the Duke brothers' shoes. Stocks are wealth generators, yes. But they can turn into a financial quagmire as well. As long as a free market exists, the risk of taking a big loss - or letting a big profit deflate like a pricked balloon - is here to stay.

How can individual investors avoid the same fate as the Duke siblings? Simply follow three easy steps:

- Step 1: Learn a set of smart sell rules.

- Step 2: Follow them in every move you make in the market.

- Step 3: Never stop following those rules.

Many successful stock investors will tell you that to make good sell rules work, you first need a good set of buy rules. No question. Whether you follow the path of growth-stock trading or value-style investing, you need to buy right.

Doing so takes time, patience and hard work. But after you've made a good buy, the job is not even half done. You're perhaps only a third of the way there. Next comes watching the progress of the stock and finally selling shares when the stock's rally is through.

William O'Neil, founder of Investor's Business Daily, has helped individual investors for decades by presenting a complete system of buy and sell rules to find the greatest growth stocks in a bull market. This article will focus on some of the most important of those sell rules. Those who wish to learn all of O'Neil's major rules can read Chapters 9 and 10 in the latest edition of his book "How To Make Money In Stocks". Steps 4 and 5 in O'Neil's 2004 book "The Successful Investor" will also help investors hone their selling skills.

Sell Rule No. 1 - Cut Losses at No More Than 7% to 8%

The first and most important sell rule can be the most difficult to follow for many investors. After all, one of the most difficult things to do for many people is admit that they're wrong. But in the market as in life, everybody makes mistakes. The key to investing successfully in the market is to recognize when you've made a mistake and bail out to minimize the damage. That's where the 7% sell rule comes in.

IBD market research shows that 40% of all big winners return to or near their pivot points after breaking out. That same research shows that far fewer go on to big gains once down 7-8% from the pivot, however. Don't sweat the few that do bounce back. In the long run, you'll do better by consistently keeping your losses small. A quick math lesson shows the impact of escalating losses. Say you sell a stock down 7% from your buy point. You need only make 7.5% on your next trade to get back to even. Let it drop to 25% from your buy point, and you need a 33% gain to return to square one. If it tumbles to a 50% loss, you need to double your money just to start from scratch. Given how rare gains of 100% or more can be, that's a valuable lesson in keeping losses small.

Bottom line: always sell a stock if it falls 7% or 8% below the price you paid for it. Don't worry about taking a small loss when you're wrong. When you're right on a big winner, you'll more than make up for it.


Sell Rule No. 2 - Sell Your Shares into a Climax Run

There are plenty of ways great stocks form a peak and slide all the way back down to the base of their mighty climbs. One of the most common ways is when it seems everyone wants a piece of the company. The stock, after climbing 100% or more from its proper buy point, suddenly takes off. It rises 25-50% or more in a matter of a week or two. Viewed on a chart, the stock appears to be going vertical.

Sounds great, right? Sure. But in that moment of euphoria, that's the time to sell. The stock has entered what IBD calls a "climax run". It usually won't go up any more because no one else is willing to bid shares higher. All of a sudden, huge demand turns into a huge overhang of supply. According to IBD research of the biggest winners during bull markets over the past 50 years, practically all stocks that go into a climax run never reach their price peaks again. And if they do, it might take 10 to 20 years.

Sell Rule No. 3 - Make Your Exit When a Stock Makes New Highs on Low Volume

A winning stock's price run is no more than a tale of supply and demand. When the rally is fresh, a market leader typically roars to new highs on heavy volume. Now, what is "heavy volume"? Simple: when volume on a given day is heavier than its average daily volume over the past 50 sessions. Institutional investors - namely mutual funds, banks, insurers, hedge funds and other big players - are falling over themselves to grab shares and accumulate a meaningful position in the stock. They're willing to grab shares at high prices because they want to get in before their rivals do.

After a long run-up, stocks get tired. They may edge up to all-time highs, but volume dips below average. Now the rally is getting stale. Fewer investors - especially the institutional players such as mutual funds, banks and insurers - are willing to snap up shares. Supply is beginning to creep up on demand and eventually more people are willing to sell than buy. A series of new highs on low volume often signals this turning point.

Sell Rule No. 4 - Nail Down Most Gains at 20%

Not every stock will be like Home Depot was in the 1980s or Cisco Systems was in the 1990s. That's why growth investors should take profits when their stocks rise 20% from their proper buy points. If you take gains at 20% and cut losses at 7%, you can be wrong three out of four times and not get badly hurt in the market.

IBD founder O'Neil has one exception to the above rule: If a stock rallies 20% or more from its breakout point in just one, two or three weeks, don't sell right away. Hold it for at least a total of eight weeks. Why? Such a fast gain may mean the stock has the power to produce a 100% or 200% gain, or even more. So holding it for at least eight weeks gives the stock a chance to prove itself.

Sell Rule No. 5 - Get Out When a Stock's Breakout from a Late-Stage Base Fails

Everyone knows the four seasons: spring, summer, fall and winter. Great stocks behave in a similar cycle. They go through stages of rallies, forming bases (narrow price ranges over a period of time following a price run-up of at least 20%) in between each stage.

The more bases a stock forms, generally speaking, the bigger the climb it's made. This also increases the risk that the stock has peaked and is beginning a sharp drop. Usually, earnings and sales growth are looking handsome at the peak. But stock prices tend to reflect the future. No wonder stocks tend to peak well before the company's growth slows down fast.


It's All About Following the Rules

Stocks and the stock market in general all operate according to rules. The key to selling stocks properly lies in simply following them without exception. Always be armed with a sound set of sell rules whenever you buy a stock, and be ready to follow those rules when the time comes. They will not only help you avoid big losses, they will also guide you toward taking a profit to keep your portfolio growing.

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Value Investing + Relative Strength = Higher Returns

One needs to look no farther than Warren Buffett to see that value investing works. Many others have applied these same principles to amass lesser, but still sizable, fortunes. But despite its successes, this strategy is challenging for many investors to follow because it can take a great deal of time for the market to recognize that a particular stock's valuation is too low.

At other times, stocks that appear cheap keep on declining due to fundamentals that continue to deteriorate. As such, fundamental analysts should consider adding a simple technical tool to their stock selection criteria to help them to avoid these common "value traps": relative strength. Read on to find out how to combine this discipline with a value investing strategy for superior results.


Value in the Stock Market

Fundamental analysts use the data available in a company's financial statements to determine a theoretically fair price for a company's stock. When the market price is lower than the fair value, these analysts rate the stock a "buy". Specific criteria they look at includes common items like the price-to-earnings ratio (PE ratio) or dividend yield, as well as more obscure ratios such as the price-to-cash-flow ratio.

Quite a few studies have been done by the academic community to determine whether value investing works. To complete these studies, researchers usually divide the universe of stocks into different groups based solely on different valuation-based ratios. These studies consistently demonstrate that value investing works well and generally outperforms the market averages over the long term.

Among the first studies was a paper published by Eugene Fama and Kenneth French in 1992 called "The Cross-Section of Expected Stock Returns". This study showed that stocks with low price-to-book (PB) ratios have higher average annual returns than growth stocks, which are defined as those with high PE ratios.

To implement a value investing methodology, an investor could buy a group of stocks with the lowest PE ratios from a broad index like the S&P 500. In theory, market-beating results are achievable over longer time horizons because eventually, the market will realize that these stocks are underpriced, and as more investors recognize this fact the stock price will increase.


The Value Trap

While a stock with low valuation may be an undiscovered gem, it may also be a company racing toward bankruptcy. Famed investor Peter Lynch summarized this situation with a single question, "If it's gone down this much already, how much lower can it go?" The answer, he noted, is that any stock can fall to zero. Determining the future prospects of a company is one of the core challenges confronted by value investors.

This dilemma is the value trap. Value investing requires a long-term time horizon because the investor is betting that the market will eventually recognize the mispricing.

It may take years for the market to find this value and the stock can stay priced at these undervalued levels for extended periods. While dividends provide some measure of comfort to many investors, by tying up their capital in a stock that's going nowhere, even value investors are missing out on better opportunities to profit.


Timing Value-Based Buys

In "What Works on Wall Street" (1998), James O'Shaughnessy tested more than 60 investment strategies involving various fundamental criteria. His results showed that some fundamental filters beat the stock market as a whole. His test period began with data from 1951 and ran through 1996. For this test, the portfolio consisted of the top 50 stocks determined by the criteria and was revised annually. A summary of these test results is in Figure 1. He found that the price-to-sales ratio (P/S) offered the best results.

Strategy	Average Annualized Return without Relative Strength
Low P/E Ratio	11.18%
Low P/B Ratio	14.38%
Low P/S Ratio	15.42%
--	--
Market Average	14%

Figure 1: These results show that value investing can work, even when applied in its simplest form.

O'Shaughnessy also tested each of these filters with relative strength. The idea behind relative strength is to find the strongest stocks, or the ones that are going up the most in price. For these tests, O'Shaughnessy calculated relative strength by looking at the stocks' returns over the past year. Those with the greatest returns and the lowest fundamental valuations were selected for the portfolio. These results are shown in Figure 2.

Strategy	Average Annualized Return without Relative Strength	Average Annualized Return with Relative Strength
Low P/E Ratio	11.18%	16.66%
Low P/B Ratio	14.38%	17.27%
Low P/S Ratio	15.42%	18.14%

Figure 2: These results demonstrate how relative strength can be combined with value investing to improve performance, as all three strategies outperformed the broad market\'s 14.77% annualized return.

The results that O'Shaughnessy obtained demonstrate the importance of testing market wisdom. The P/E ratio is the most widely followed fundamental measure of a stock's value, and is frequently mentioned by commentators when they discuss a stock. Of the three ratios tested, it delivered the worst performance. The returns obtained from using only the P/E ratio to make investment decisions actually trailed the market.

O'Shaughnessy found that using only relative strength to select stocks also beat the market. The 50 stocks with the highest rate of change were held in a portfolio that was reviewed annually. While superior to the market return, Figure 2 shows that combining relative strength with fundamental filters may provide even better results. Buying the strongest stocks with the best valuation ratios clearly beat the market.


Conclusion

Value investing has been shown to work. Adding relative strength to this investing style can improve returns by buying value stocks that are currently moving higher. This timing element improves returns by avoiding the problem of waiting for the market to recognize the undervaluation. Applying this straightforward approach can greatly minimize the risk of value investing.

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