Invest Like a Legend
Ben Graham and Philip Fisher, two of the greatest investors ever, applied a few simple (but stringent) rules. You can do the same
(MONEY Magazine) – Every decent high school coach labors —often in vain —to teach his players something called "fundamentals." In basketball, that means you've got to work on defense and passing before you perfect your glorious three-point shot. Coach knows that without practiced technique and consistent execution, even a talented team will be sunk before the half-time buzzer.
Fundamentals are every bit as important in investing. Unfortunately, most of us are just chucking balls from the three-point line. How much did you really know about the true worth of that "value" stock you bought after it hit its 52-week low? (Did you even have a dollar figure in mind?) Can you explain how that hot tech stock you're interested in might actually achieve the 18% annual earnings growth that Wall Street analysts are counting on? The sad fact is, even many investing pros can be hazy on this basic-sounding stuff.
But that doesn't mean you can't do better. Two early masters of the game, value investor Benjamin Graham and growth maven Philip Fisher, wrote down their playbooks for anyone to see decades ago. Graham looked for companies trading at great prices, and his skeptical, by-the-numbers approach is still a perfect model for anyone who wants to avoid getting smacked by a stock that doesn't live up to expectations. Fisher, on the other hand, was all about expectations. He wanted to find the next great company at a good price —he was one of the first investors in a little business called Texas Instruments —and his story can teach you how to take a risk without just taking a flier. In the pages that follow, we'll boil down the essentials of both men's thinking and show you how to apply their insights to today's market. We'll also point you toward stocks that we think might pass their ultrarigorous tests.
GRAHAM: THE LESSONS OF FAILURE
Graham had a remarkable record as a stock picker. From 1936 to 1956, his mutual fund racked up a compounded average return of at least 14.7% a year vs. 12% for the overall market. (If that doesn't sound like a big difference, consider that an initial investment of $10,000 in Graham's fund would have earned roughly $60,000 more than the average.) But he developed his key investing principles only after surviving some memorable disasters. One of Graham's early picks, in 1919, was a company called Savold Tire. He bought the stock in April on its first day of trading and made 250% on the initial public offering; by October the company was exposed as a fraud and its shares were soon worthless. In order to avoid similar mistakes, Graham tried tirelessly researching every company in which he placed his own or his clients' money. That wasn't enough either. The crash of '29 hit, and over three years Graham's portfolio lost some 70% of its value.
Graham knew that there had to be a better way. His two major books, Security Analysis (written with David Dodd) and The Intelligent Investor, lay out a strategy built around three major points.
GET A MARGIN OF SAFETY Investors, Graham decided, spend too much time trying to imagine a company's future. Graham reasoned that no matter how carefully you research your investments, it is impossible to eliminate the risk that a company will prove to be worth less than you thought. So investors ought to search for stocks with a "margin of safety" —a price so low that you can make money even if some part of your analysis turns out to be wrong. In fact, he found, if you buy cheap enough, a lot of research may be redundant. "Graham wouldn't do much investigation into the companies he invested in," says John Spears, a managing director of Tweedy Browne, which was Graham's broker for years.
YOU CAN LOOK IT UP Okay, so cheap is good. But what does cheap mean, exactly? Graham had something very specific in mind: In the classic version of his approach, you'd buy a stock when it trades for less than what it would be worth if the company were liquidated today. For example, if a company has assets like cash and inventories worth about $10 a share and no debt, you'd have a nice margin of safety if you bought it at $6. Of course, you'll never bag a Microsoft with a strict rule like this. In fact, a true Graham follower has to be resigned to buying companies that the rest of the market thinks are lousy. "We buy blemished fruit," says Kahn Brothers president Thomas Kahn, a money manager whose father, Irving, worked with Graham.
Graham's approach has another virtue besides safety: There's little guesswork, because all the numbers you need are in the company's balance sheet. You can easily run a screen, using investment software or even free websites, to come up with a short list of stocks that could be cheap in Graham terms. (For more on how to find the numbers and other information we cite in this story, see page 118.) For example, if you screen for large and mid-size companies trading for significantly less than their book value, you can get a manageable list of about 30 stocks to investigate. (Book value is simply the value of a company's assets minus its debts.) But while that number is a start, Graham would have demanded that you dig a little deeper into the company's balance sheet. Which brings us to our third point.
THROW OUT THE TRASH Not everything that a company says is an asset is really worth counting, Graham said. Cash, often the first item listed on the balance sheet, is probably the only asset that's worth exactly what the company says. Accounts receivable and inventories may be worth less than printed numbers, but they're in the right ballpark. Near the bottom of the list on a corporate balance sheet you'll find something called goodwill, which can include a lot of soft stuff like brand value. That's a paper asset worth nothing to Graham. So if you are looking at a company with a low price-to-book ratio and you find that most of its assets are goodwill, move on.
Clearly we're doing a lot more than "buying on the dips" here. Even poor old AT&T, down more than 45% since the beginning of 2003, would have to drop at least another 25% to get anywhere near Graham territory, since its market capitalization of $12 billion is still higher than its $9 billion in tangible assets. (Market capitalization is the stock price times the number of shares outstanding.)
So what would Graham like? We screened for stocks with market values of $500 million or more and prices 20% below their book value. (Graham favored stocks trading for just two-thirds of their true liquidation value, not book value, but such companies are thin on the ground in 2004.) Of the 34 stocks that met this test, three seem especially attractive now.
DYNEGY (DYN). It's not hard to see why this stock is cheap. Houston-based Dynegy, which produces electricity in the Midwest and Southern California and owns natural gas pipelines, had an aggressive energy-trading operation and got caught up in an accounting scandal. One former exec was recently sentenced to prison. But after closing its trading operations and jettisoning its top executives, Dynegy has begun turning a profit. The company owes about $11 billion, but it has $13 billion in assets. That net value of $2 billion compares with a market cap of just $1.5 billion, based on shares trading at $4.
UNUMPROVIDENT (UNM). The nation's largest disability insurer has been stung by a flurry of lawsuits accusing it of unfairly denying claims. Worse, the complaints have triggered a multistate investigation into its practices. But changes are in the works: Chief executive Tom Watjen, who took over in March 2003, has changed the claims process for policyholders, and the company has boosted the reserves it keeps to cover policy claims. Even if the company had to pay out all of those reserves and all its other liabilities, it would still have $6.2 billion in assets left, more than its market value of $4.8 billion.
TOYS R US (TOY). The nation's largest toy store is also an enormous landowner, and that's why Graham would be interested. Toys R Us owns 314 of its 685 stores —and not just the buildings but the land they sit on. What Wall Street has focused on is its lousy performance: More and more people are buying their toys at Wal-Mart rather than making a special trip to Toys R Us. But at just $16 a share, the company has a market cap of $3.5 billion, just below the value of its tangible assets, including all that real estate.
FISHER: BUY WHAT YOU REALLY KNOW
Phil Fisher is a lot less well known these days than Graham, which is ironic because the stock-picking approach Fisher described in his 1958 bestseller Common Stocks and Uncommon Profits is actually closer to what most of us try to do —except that Fisher did it a lot better. Fisher was the prototype for growth investors: Whereas Graham cared about a company's value today, Fisher bought a stock based on his expectations about how the business behind it would grow in the future. He invested in some of the fastest-growing corporations of his age. Fisher first bought Motorola, for example, in 1955, and held it until his death at the age of 96 this past March —a holding period that would have turned a small investment into millions.
To find such companies, he did intensive research into the basics of the business, collecting "scuttlebutt" from competitors, customers and employees. "Fisher may have been the first to recognize that companies are living and breathing organisms, not just pieces of paper," says Stanford Graduate School of Business professor Jack McDonald. Even Warren Buffett, the latter-day investing legend who arguably did more than anyone else to popularize Graham, admired Fisher. The Berkshire Hathaway chairman recently wrote: "It's been over 40 years since I integrated Phil's thinking into my investment philosophy. As a consequence, Berkshire Hathaway shareholders are far wealthier than they otherwise would have been."
The only difficulty with following Fisher is that his strategy can't be reduced to simple quantitative rules like "buy when margins are growing x% and the price is less than y." The secret to Fisher's success was discipline —emotional self-control and a dogged attention to detail when making buy and sell decisions. Here are four key lessons from Fisher's writings and career.
GO TO GROWTH INDUSTRIES Fisher wanted to buy companies that could keep increasing their profits for years and years. In a competitive world, the best way for a business to do that is to have a product that's genuinely new and tough for competitors to knock off. Fisher invested in DuPont, for example, when the blasting-powder maker was developing cutting-edge products like nylon, cellophane and Lucite. And Motorola, which was just one of a slew of radio manufacturers in the mid-1950s, piqued Fisher's interest when it started moving into two-way communications for truckers, taxis and police. So where would you find such transformative businesses today? You can safely ignore mature industries like auto manufacturing or fadprone businesses like retailing or food service. (Fisher would never have fallen for Krispy Kreme.) More promising places to look now would be health care or technology.
STAY OUT OF THE HEAT Like most technology-focused investors today, Fisher didn't mind owning companies that traded at a high price relative to their earnings. Still, he made it a rule to shun the hot stocks everyone was talking about. He was also suspicious of initial public offerings. After all, if the business is so wonderful, why is it suddenly for sale? So forget about Google for now.
RESEARCH ISN'T SOMETHING A BROKER SELLS It's something you do. Many growth investors buy a stock because it seems reasonably priced based on, say, the five-year growth projections printed in Wall Street research reports. The trouble is, analysts get those numbers wrong all the time. If those projections are the main reason you bought a company, you'll be tempted to bail out at the slightest disappointment —which very possibly will be exactly the wrong time. (More on this in a moment.) Fisher wanted to get a 360° view of any business he owned. He did this using tools once available only to professionals: company visits, industry contacts, visits to trade shows, and so forth. But in the age of the Internet, there's enough information out there to allow you to get detailed answers to questions like these: Who are the company's customers, and why do they need this product? What is the company doing that its competitors are not? What else can the company sell when its main product is no longer in demand?
Because Fisher understood that buying a stock means buying a business, he also asked some questions even the most plugged-in analysts have a bad habit of ignoring. "My father put a great emphasis on people," notes Fisher's son Kenneth, CEO of Fisher Investments. So Phil Fisher always needed to be satisfied that a company was run by people of "unquestionable integrity." (A red flag: managers who hand themselves loads of stock options.) He also wanted to see signs that management cultivated a healthy relationship with its employees.
BUY AND HOLD...AND HOLD...AND HOLD Fisher rarely sold a stock once he picked it. Early in his career, he invested in two stocks in the same industry. One he traded in and out of to try to take advantage of price swings; the other he tucked away. Years later, he observed that his gains from the stock he simply held vastly exceeded those from the one he traded. The fact is, as simple as the nostrum "buy low, sell high" sounds, it's nearly impossible for most of us to outsmart the market in the short run. An even worse idea, in Fisher's view, would be to sell a stock just because everyone else is bailing. Companies often report disappointing profit numbers when they are investing in plants or new business lines. If you've done your research, you'll come to recognize when those declines are actually an opportunity to buy more shares.
Fisher was so selective that he never held more than about 30 stocks at any one time. In that spirit, we set out to identify just one stock that Fisher might consider today. Let's be frank —Fisher would be horrified at the thought of anybody buying a stock only on a magazine's say-so. But we certainly think he'd find it worthwhile to start collecting some scuttlebutt on Xilinx (XLNX). Its stock currently sits at $27, down from $45 earlier this year, so there's no question of its being too hot.
The company has 50% of the market for semiconductors known as programmable logic devices (PLDs), which go into everything from routers to laptops to mobile phones. The profits on this product are impressive —Xilinx's gross margin hovers around 60% —and there's plenty of growth ahead. Right now, PLDs are a $3.5 billion industry, and the chips are slowly but surely replacing another product called fixed logic devices, which have worldwide sales of $12 billion. People-minded Fisher would also have liked the fact that Xilinx survived the recent tech downturn by cutting salaries across the board —the CEO took a 27% hit —instead of resorting to mass layoffs.
SO ARE YOU A PHIL OR A BEN?
The key difference between Graham's and Fisher's techniques is stark. Fisher firmly believed that it was possible to make a smart guess about a company's growth prospects, while Graham deemed the future unknowable and invested accordingly. (He did, however, give Fisher a tip of the hat in a footnote to The Intelligent Investor.) Which model you choose depends in part on how much time you want to devote to investing. If you'd rather not learn a hundred little things about each stock you pick, Graham's your man. If you enjoy the intellectual challenge of trying to predict what's coming around the bend, you might follow Fisher. But it's also about your attitude toward risk and reward: You are less likely to make a costly error using the Graham method, but home runs will be rare too.
On the other hand, it is telling that Warren Buffett cites both men as influences. If Fisher and Graham are opposites, it is in the sense of being two sides of the same coin. They understood that investing wasn't about guessing the future price of a stock but determining the ultimate value of a business. Once you understand that, you are already ahead of the game.
We think Ben and Phil would like these
NOTE: As of Aug. 31. SOURCE: Thomson/Baseline.