Value investing, or looking for shares that are undervalued, can be both the simplest and the hardest discipline to master. How difficult can it be to sift through companies and identify those that are ostensibly cheap, buy their undervalued shares and wait for them to be outed by the market?
The greatest exponent of this technique was Benjamin Graham, who mastered the art of unearthing undervalued "cigarette butt" companies, which he believed had a few puffs left in them. Value investing has moved on since, but many of his principles remain. It is important, for example, to target companies that are unreasonably cheap. If there are valid reasons for a share to be cheap because, say, the firm may go bust, then that's not value. That's just rubbish.
There are four key criteria. One, shares should be valued at less than two-thirds of the market average. Two, the dividend yield should be above the market average. Three, they should trade at below the net book value: if the business were to liquidate investors would receive a share of the spoils. Four, there should be little or no debt.
You may need to relax one or two of these criteria. For instance, the UK market is today valued at around 12 times earnings and yields around 3 per cent. So, only three FTSE 100 companies are in value territory.
Miner Rio Tinto is one. It is valued at seven times profit; its prospective dividend yield is 3.3 per cent. It also has net cash. But, its shares trade above its book value. That said, the shares have fallen as a result of write downs and by a possible slowdown in China, one of its main markets.
BAE Systems is another. It is valued at eight times prospective earnings and yields 6 per cent. Although it is sitting on a cash pile, the shares are trading at more than twice their book value.
An oft asked question is how long it will take for a value share to be outed – akin to asking how long is a piece of string. That's why many value investors expect dividends while they wait.
Another query is what to do once the value is outed. Graham's followers will sell. But Warren Buffett is happy to hold and enjoy the dividends. The choice is yours.
David Kuo is director of fool.co.uk
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