In the past, I reviewed the other two books in the “Little Book” series: The Little Book Of Common Sense Investing covers in detail the investing philosophy of buying and holding low-cost index funds, and The Little Book That Beats The Market, which describes the investing philosophy of buying individual stocks based solely on return on capital and earnings yield. I quite enjoyed them both – they both started out at a level where a person who didn’t know the first thing about investing could jump right in and follow along to the point of understanding the basics of an investing philosophy.
Since I enjoyed both of those so much, I almost couldn’t wait to read The Little Book of Value Investing. Value investing is the term used to describe the general investing philosophy of Warren Buffett and his mentor Benjamin Graham – it seeks solely to find companies whose stocks are undervalued compared to the strength of the company itself. I envisioned this book to be a lighter, easier to read version of Benjamin Graham’s classic The Intelligent Investor (which I’m currently rereading for a future review on The Simple Dollar), a book which Warren Buffett himself describes as “by far the best book on investing ever written.”
Does The Little Book of Value Investing really live up to its potential? Is it a good book for the average investor to read, or should they just read The Intelligent Investor instead? Let’s dig in and find out.
A Little Look At The Little Book of Value Investing
Chapter 1 – Buy Stocks Like Steaks … On Sale
The Little Book of Value Investing opens with the idea that buying stocks is often analogous to shopping in the supermarket. Some investors buy the sexy, well-packaged glamour products – and sometimes they pay off and have something delicious inside. On the other hand, others go in and look for items that are on sale and present the best value for the dollar. Growth investors are people who buy the products that have “buzz;” value investors are the people comparing the cost of green beans. Growth investing is more glamorous, but value investing pays off, slowly but surely.
Chapter 2 – What’s It Worth?
A growth investor sits back and waits for opportunities to buy stocks for less than what they’re worth and sell stocks for more than what they’re worth. It doesn’t matter how fast the company is growing or anything else – if it’s a value, one should buy it; if it’s overpriced, one should sell it. That’s the growth investment philosophy in a nutshell.
Chapter 3 – Belts And Suspenders For Stocks
Warren Buffett is quoted as saying, “Rule number 1: Never lose money. Rule number 2: Never forget rule number 1.” However, investing in stocks is risky, even if you’re quite confident of your investing philosophy and criteria. The way around this is to buy a lot of different stocks that match your criteria in a lot of different sectors – in other words, diversify. The book recommends a portfolio of at least ten stocks, something that is recommended by many different investment philosophies.
This chapter also talks about the concept of “margin of safety” investing; in other words, if you can figure out what the actual price of a stock should be, how much below that does the stock have to be before you buy it? Benjamin Graham, the father of this philosophy, had a two-thirds margin of safety, meaning that a stock had to be priced at one third or less of the expected value of the stock – that margin is basically impossible to find today, but a one half margin or a one third margin is quite doable.
Chapter 4 – Buy Earnings On The Cheap
The first basic tenet of identifying value stocks is to look at their earnings and compare them to the current price of the stock. This is often quoted as the P/E ratio, as can be seen on information on Cisco’s (CSCO) stock at Google Finance. The regular P/E refers to the price-to-earnings ratio between the company’s most recent report and the current price; the forward P/E refers to the price-to-earnings ratio between what analysts estimate the company to earn in the next report and the current price. Generally, the forward P/E is more useful, but it’s not highly accurate. The lower the P/E is, the better the value of the stock is, in general.
Chapter 5 – Buy A Buck For 66 Cents
Another powerful technique is to seek out stocks that are selling below the book value of the company. In other words, multiply the number of shares outstanding by the cost of the stock (sometimes listed as the market capitalization of the stock) and compare that to the book value of the company (which you can usually find with a bit of research). Currently, Cisco has a book value of about $32 billion but it has a market capitalization of a bit over $180 billion, which means that under this criteria, Cisco is far from a value.
Chapter 6 – Around The World With 80 Stocks
This is a very brief chapter that basically says that the principles of value investing work with stocks all around the world, not just domestically. The only difficulty with this is that the data for international companies may not be as rich as they’re not required to do SEC filings like United States companies are, but values exist in every market all around the world.
Chapter 7 – You Don’t Need To Go Trekking With Dr. Livingston
Continuing the idea that one can invest in stocks abroad with value principles, The Little Book of Value Investing recommends sticking largely with nations that have stable economies – don’t put your money in a stock of a company primarily based in a nation without a stable government. As a rule of thumb, the book recommends all of Western Europe, Japan, Canada, New Zealand, Australia, Singapore, and non-Chinese stocks in Hong Kong – the book’s rather adamant about avoiding China.
Chapter 8 – Watch The Guys In The Know
Another useful tool for finding value is to watch what the insiders at a particular company do. Anyone that holds a significant portion of a company’s stock has to reveal their investment moves publicly, which you can easily follow by carefully researching the company online. If you see that one of those insiders made a sell, it’s not that big of a deal – if you see one making a buy, though, that’s likely an indication that there’s something very positive going on that’s not quite publicly known yet. If you find a potential value company that you’re interested in and you see that the company’s insiders are buying the company’s stock, that’s a sure sign that you should buy in, too, because when the reason that the insiders are buying becomes public, there are likely lots of people who are going to want to buy in – meaning profits for you.
Chapter 9 – Things That Go Bump In The Market
The absolute best time to look for and buy value stocks is when the market is going down. During a bull market, people are often buying everything, making values much harder to find, but during a bear market, there are more sells than buys, thus prices go down and values become exposed. The author, Christopher Browne, uses numerous examples from recent downturns (1987, 1989, 2001-2002) that show this phenomenon to be true.
Chapter 10 – Seek And You Shall Find
So how do you find stocks that meet these criteria? Use the internet! I use the stock selection tools at Yahoo! Finance regularly to find stocks that meet certain criteria. Filter for stocks that are trading below book value, ones that have a very low P/E ratio (below 10), and ones that have seen some insider trading recently. Save them all in Excel and start looking for ones of interest to you. Ones that appear on multiple lists are usually good ones to start with.
Chapter 11 – Sifting Out The Fool’s Gold
Some of the companies on these lists will show up there for bad reasons, like Enron did in 2002. That means that once you find candidates you’re interested in, you need to make sure they’re not fool’s gold. Make sure the company doesn’t have much debt. Also check and see how stiff the company’s competition is by looking at other companies in similar businesses. The best choices are in companies that you can understand – if you can’t really comprehend how this business does business, don’t buy the stocks.
Chapter 12 – Give The Company A Physical
Now that you’ve found a few companies to look at in detail, start by looking at a company’s balance sheet. Things you want to see are at least some liquid assets on hand (cash, short term bonds) and debt that’s not overwhelming – if you don’t see either, red flags should be popping up. Basically, the less debt you see, the better, especially in comparison to the assets. Think of it this way: a person making $60,000 a year with $5,000 on a credit card is in better shape than a person making $12,000 a year with $5,000 on a credit card.
Chapter 13 – Physical Exam, Part II
Next, you should examine a company’s income statement (all of this stuff is pretty easy to find at Yahoo! Finance). The big things you want to see is steady, stable growth in revenue and a stable gross profit margin over time – and the longer the timeframe, the better. You should also look at ROC – return on capital – which indicates how the company is reinvesting in itself. If it is steady (or even better, increasing over time), that’s good – if it’s dropping, that’s bad.
Chapter 14 – Send Your Stocks To The Mayo Clinic
This is perhaps the best chapter in the book, asking sixteen researchable questions that you should know about the company you’re about to put your money into. Most of them can be found out with some internet searching, reading of company reports, and so on – they’re not complicated, just very useful in helping you figure out how good of a company you’re looking at. If the answers make you feel confident in the company, it’s time to buy – if not, back off.
Chapter 15 – We Are Not In Kansas Anymore! (When In Rome…)
After all that, it’s also important to note that accounting practices in other countries often result in things like P/E ratios that are incompatible with comparison to American companies. The author uses a comparison between several candy conglomerates to demostrate this, showing that sometimes a comparison between an American P/E and a non-American P/E isn’t exactly fair because expenses have different meanings in different nations.
Chapter 16 – Trimming The Hedges
Another important aspect to consider with investing in stocks in foreign nations is the currency you’re using to buy the stock. Let’s say, for example, one buys a British company – effectively, not only are you investing in that company, you’re also investing in the British pound, the currency that’s used to trade the company in London. So, if you bought British Company X in 2003 when a British pound was worth $1.70, it stayed completely even, then you sold it in 2006 when a British pound was $2.00, you made some significant profit (not even counting the dividends).
Chapter 17 – It’s A Marathon, Not A Sprint
Another vital tenet is that you’re buying for the long term, and that short term market timing is a fool’s game. If you believe that a company is a good deal now, stay in that company until you no longer believe that to be the case, regardless of what the market does. It should be based on the company itself, not on the broader market’s direction. Buy when a particular stock is a value, sell it when it isn’t.
Chapter 18 – Buy And Hold? Really?
Buy and hold works, but only for the long term – ten years or more. If your timeframe is shorter, you should buy bonds – if it’s even shorter than that, you should keep it in cash in a savings account. The market goes up and down all the time, and the closer you get to the time you want to use the money, the more stable it should be. Bonds are pretty stable – cash is even stabler. This way, you know what you have right as you approach the day of destiny and a sudden short-term market downturn can’t derail you.
Chapter 19 – When Only A Specialist Will Do
If you decide to hire a money manager, realize that most of the stuff they’ll tell you is unimportant hogwash. Instead, ask them what their investment approach is. If they can’t explain it to you in easy-to-understand terms, get out. Then ask them to show you how they’ve applied it over a long period. Again, if they can’t, get out. Then ask for their track record – the track record of the person actually managing your money, not the history of the fund or the brokerage. If it’s not good, get out. Finally, ask the person what they do with their own money – if they do anything different than what the fund does, there’s something fishy going on.
Chapter 20 – You Can Lead A Horse To Water, But…
Value investing has several psychological tick marks against it – it’s not sexy, it can be boring, and overconfidence can derail you from making good choices. Just stick with the numbers and you’ll make money over the long haul – it’s when you start breaking from those numbers that is the problem. Also note that compared to many other investment options, you won’t completely outshine the market during a bull run – the sexy stocks are the ones that will spike. It is during a down market when value stocks shine – you can find bargains and quite often value stocks ride through a storm with no problems. This is why if you look at value stock returns from 2003-2006, it won’t shine as brightly as some overall market indicators, but in 2001 and 2002, value stock portfolios generally had a positive return while other portfolios were tanking.
Chapter 21 – Stick To Your Guns
The book concludes that no matter whether you believe in value investing or other investing philosophies, you should stick to your guns and consistently apply those principles. It’s when you abandon principles and make unbased decisions that things can get very shaky. This is spectacular advice.
Buy or Don’t Buy?
If you’re looking for a soft introduction to the concepts of value investing, something you can read a few pages of a night for a month and get the basics down cold, The Little Book of Value Investing is well worth reading. It discusses the broad philosophy without getting bogged down in much detail at all and is quite easy and enjoyable to read.
It really is a shortened and less detailed version of The Intelligent Investor. It’s organized far differently and the ideas are presented in something of a different order (and in much less detail), but the concepts are basically identical.
My feeling is this: if you’re interested in investing but have no idea what value investing is, stop at a bookstore and start reading The Little Book of Value Investing. If you find that it’s answering the questions you have, it’s well worth picking up. On the other hand, if the information is really intriguing to you and you want more detail and breadth, put this one back and get The Intelligent Investor instead.
My feelings about this book are much like the others in the series: they’re great introductions to specific investing philosophies and if you have no idea about investing at all, these books are all very good. If you really want to learn about that specific philosophy in depth, though, there are other books that are better worth your time.
The Little Book Of Value Investing is the forty-second of fifty-two books in The Simple Dollar’s series 52 Personal Finance Books in 52 Weeks.