Thoroughly Modern Value Investing

Carr CTA Index-3.85%-3.85%10.45% Managed Futures

Estimates as of 10/31/2002

Ask most Wall Street wannabes the name of the most successful value investor, and the most likely response would be Warren Buffett. Then ask Warren Buffett the same question and he’ll most assuredly have a different response–Benjamin Graham.

Graham popularized the use of fundamental measurements such as price-to-earnings ratios, current assets, and book value for making investment decisions. His mantra was clear: buying cheap assets over time will lead to exceptional returns.

After observing the devastating 1929 stock market crash, Graham sought to develop techniques that investors could use to protect their wealth. From 1929 to 1956, an era spanning the Great Depression, World War II, and more than a few market gyrations, Graham’s strategy produced a stunning 17% annualized return.

Graham conceived a clear definition for a value stock–one that trades for less than two-thirds of net current assets per share. A stock that meets Graham’s definition must give investors the chance to buy a dollar’s worth of current assets for less than 67 cents–a sweet deal, if you can find one.

These days, you rarely can. A slew of companies in Mr. Graham’s day met his parameters, but in recent decades it has been unusual for even a handful to do so. As an example, take Microsoft. The software powerhouse known for its glut of cash and absence of debt has seen its stock price drop by more than 60% in the last few years. It now trades at around $52 per share. But by Graham’s definition, Microsoft would have to plummet below $5 per share before it would be worth purchasing as a value stock.

That doesn’t mean that the case for value investing is moot. Value and growth stocks perform differently than one another: when one is in favor, the other is out (see Value vs. Growth chart below). Allocating one’s portfolio between the two groups makes a lot of sense, and is one of the most time-tested ways to add diversification during both bull and bear markets.

The market rally of the last few weeks is an even more dramatic illustration of the contrast between growth and value stocks. As of November 1, the S&P 500 stood 17% higher than at its low point on October 10, with growth stocks enjoying much more appreciation than value over that period.

It’s hard to say if the current rally will mark the end of value’s three-year domination over growth. But stocks are exhibiting an impressive amount of momentum. If the credit spread can manage to reverse direction and head lower, thereby signaling an easier borrowing environment for businesses, growth stocks may be in for a sustained rebound. (See chart at http://www.investmentadvisor.com/images/alpha1102.gif)