Value Investing in 30 Seconds

I often get asked, “What does it mean when you say you are a value investor?”. I thought it would be easiest to provide you with an example. In the next thirty seconds, you should understand how the value investing strategy works and why some people find it attractive as a philosophy for managing their portfolio. Personally, I cannot imagine putting money to work with any approach other than value investing because it is the only thing that lets me sleep at night.

Value Investing with the J.M. Smucker Company

Let’s start with a business everyone knows: Smucker. As of September 9th, 2010, The J.M. Smucker Company (ticker symbol SJM) had roughly 119,500,000 shares outstanding. That means that the company, which makes everything from peanut butter and pancakes to cupcake frosting and coffee, is divided into 119,500,000 “pieces”, each of which represent 1/119,500,000th ownership in the business. If you owned every single share of stock, you would own the entire company. Other than a few minor adjustments (such as convertible securities, which are way beyond anything a new investor should worry about), it really is that simple.

Last year, the company generated $4.6 billion in sales and made roughly $790 million in pre-tax profit. The Board of Directors decided to mail $166 million or so to the stockholders as a cash dividend, and used virtually all of the remaining money to pay off debt, most of which was the result of buying the Folgers Coffee Company from Procter & Gamble.

A value investor is someone who looks at a share of J.M. Smucker and doesn’t see a stock or a piece of paper that wiggles around in value based on what happens on the stock exchange. Instead, a value investor sees 1/119,500,000 of a business. He tries to value the entire company and asks, “What would I pay if I could afford to buy the entire firm and I wanted to earn [x]% rate of return on my money?” He then takes his answer and divides it by 119,500,000 shares. That is the price he can pay.

Value Investing Demands a Margin of Safety

Most value investors will knock 33% off the answer they come up with to leave a “margin of safety”. If the stock trades below that level, they buy it. It doesn’t matter to them if the market crashes further – as long as they are convinced their analysis is sound, they keep buying shares and may hold them for 5 years, 10 years, or even longer.

To put it in concrete terms, as a value investor, if a company that earns $100 million per year, has no debt, and only 3% growth, I might be willing to pay $1 billion for it. If the company has 20,000,000 shares outstanding, I would take $1,000,000,000 divided by 20,000,000 and get $50 per share. To add in my margin of safety, I would knock 33% off the price to get to $33.33. The result: If the stock falls to $33.33 or lower, I’ll buy it. The more it falls, the better for me as long as it is still expected to earn $100 million per year and avoid issuing new shares to dilute my ownership.

A value investing approach means that you might reject 99 out of every 100 stocks you consider buying. It means you don't invest in anything you don't understand. It really is simple, straight-forward business-like investing - you look at stocks just like you would buying an apartment building in your hometown. When you think prices are attractive, you buy. Otherwise, you collect your dividend income and ignore the stock market. Not everyone agrees with this approach and it certainly appeals to a certain type of personality. Only you and your financial adviser can decide if it is right for you.