Most of us tend to ignore the hypothesis that traditional value-investing criteria have become obsolete, because we have heard it before. Seasoned investors have undoubtedly heard the argument that Benjamin Graham’s value investment criteria are no longer relevant, dozens of times and in many different forms.
Despite that, a very good case can be made that the markets have changed so dramatically in the past two generations; that the characteristics of a value investment have changed. New technologies; the advent of a global equities market and the dominant position enjoyed by institutional investors, have changed the stock market beyond recognition.
Are value-investing criteria created in an era when paper stock certificates were sold on street corners, still relevant in an age of digital trading and worldwide markets? The answer is “yes” basic value-investing theory is still sound; but it must be applied in different ways in today’s market.
Classic Value Investing Criteria
The criteria of a classic value stock can be summed up as:
A company that generates a lot of cash.
A simple; or at least easy to understand, business model.
A company that has a lot of float – in other words it keeps a lot of money in the bank.
A sound business with a proven track record of making a lot of money.
A low or at least realistic stock price.
A business that is ignored or underappreciated by the market.
Not every value investor follows these criteria; Warren Buffett will famously pay a premium for companies that he likes. Many modern investors ignore some companies that generate a lot of cash, because they operate in sectors they do not like or understand. Buffett has ignored such Silicon Valley cash cows as Apple (NASDAQ: AAPL) and Alphabet (NASDAQ: GOOG), because he dislikes tech.
Buffett’s experience demonstrates that investors can be very successful by modifying the traditional criteria. Uncle Warren also likes to take serious risks of the kind, Graham would have avoided. An excellent example of this risk taking would be Berkshire Hathaway’s (NYSE: BRK.B) stake in the shaky; but wealthy, US financial institution Bank of America (NYSE: BAC).
Using the Classic Value Investing Criteria in today’s Market
The classic value criteria are still relevant but investors should use them as a guide rather than a set of rules. Many investors fail because they treat the classic value criteria like the Ten Commandments; a rigid set of rules that must be followed at all costs.
An even more destructive tendency is to use the value criteria to justify one’s own prejudices. Many value investors stay away from tech because they do not like the sector or distrust it.
The first rule of using value criteria is the same today as it was back in Benjamin Graham’s day: read the company’s financial reports. Instead of forming an opinion about a company, study the earnings report and the charts and see how it is actually doing.
I learned this lesson the hard way from Facebook (NASDAQ: FB), I disliked and distrusted the social network because it was a social media company. Then I studied the financial reports and discovered that Facebook was generating a lot of cash. It reported a profit margin of 28.06%, a net income of $4.686 billion (€4.1 billion), a free cash flow of $1.851 billion (€1.62 billion), $9.882 billion (€8.64 billion) cash from operations and $20.62 billion (€18.04 billion) cash and short-term investments for the first quarter of 2016.
Instead of being the risky social-media venture I had suspected; Facebook actually displays some serious value criteria. It generates a lot of cash; and more importantly has a lot of float.
Value Investments in Silicon Valley
There are actually a number of companies in Silicon Valley that demonstrate what I consider value criteria. There’s Alphabet (NASDAQ: GOOGL); the company formerly known as Google, which reported $75.26 billion (65.83 billion) in cash and short-term investments on Mach 31, 2016, for example.
Tech even has some highly-undervalued companies including Oracle (NYSE: ORCL); which reported a net income of $8.843 billion (€7.74 billion) and $50.77 billion (€44.41 billion) in cash and short-term investments for first quarter 2016. Yet Oracle was trading at just $39.41 (€34.47) a share on May 6, 2016.
Another intriguing value in tech that Benjamin Graham might have liked is Microsoft (NASDAQ: MSFT). Despite all the reports of its troubles, the software giant had an incredible amount of float; $105.55 billion (€92.33 billion) in the bank, on March 31, 2016. Microsoft can be considered a classic value investment because it is an unfashionable company disliked by the market that makes a lot of money.
Many investors like to write Microsoft off, after reading all the tech press stories about its obsolescence. Those people missed out on a 12.75% return on equity and a 2.66% dividend yield. They also turned their backs on a company with an 18.29% profit margin and a free cash flow of $8.361 billion that was trading at $50.39 (€44.08) a share on May 6, 2016.
The traditional value-investing criteria are still very relevant in today’s world, especially to those planning to buy and hold. Companies that display them such as Alphabet, Facebook, Oracle and Microsoft are still making a lot of money. The difference is that these companies operate in sectors that traditional value investors have been taught to disdain.
Today’s investor needs to keep an open mind and understand the big picture. Value investments are still out there, they are just hiding in different places.