My strategy is philosophically simple (but behaviorally hard) and inspired by the ideas of Benjamin Graham. I purchase common stocks that I believe are trading at a discount to their intrinsic value. I do not utilize leverage of any kind. I don’t sell short. As John Maynard Keynes put it, “Markets can stay irrational longer than you can remain solvent”. With a long position that isn’t leveraged, I can wait out irrationality. That isn’t an option when you are short or using borrowed money to buy stocks. The issues I purchase generally fit into the below overlapping categories.
- Companies with high earnings yields (low P/E ratios). I prefer companies and industries that make people either yawn or recoil. My preferred measure of value is simple: the inverse of the P/E ratio, or “earnings yield”. As Ben Graham recommended, I buy companies when their yield doubles that of a AAA corporate bond. In addition to low P/E’s and high earnings yields, I also prefer stocks with low valuation metrics such as price/sales and enterprise value/operating income.
- Companies that are conservatively financed. I tend to prefer firms that have a debt to equity ratio that is below 50%. For larger capitalization stocks, I will tolerate a bit more leverage (around 100%). If a company is utilizing significant leverage, they may be able to produce great results in the short run, but one mistake will kill the firm. I believe that the best way to minimize the risk of the portfolio is to focus on the balance sheets of the companies in the portfolio. Debt is danger.
- Spin-offs. I will sometimes pursue spin-off special situations if the idea hits me over the head and the investment has an acceptable margin of safety.
- Companies that trade below their liquidation value. Sometimes companies will trade at a significant discount to their liquidation value. This strategy can be extremely risky at an individual level, so it is best to buy them in sufficient quantities. They are typically only available in large numbers during recessions.
- Companies that are based in the United States. I shy away from international investments. I understand GAAP accounting principles. I trust the SEC will limit most but not all accounting shenanigans. I generally have an optimistic view on the long-term economic prospects of the United States economy. We have our problems, but who doesn’t? I am sure that there are amazing value opportunities in other markets, but I stick to what I know and what I have the time to research.
- Country indexes with low CAPE ratios. While I won’t invest in individual foreign companies for the reasons described above, in October of 2017 I decided to devote a portion of my portfolio to entire country indexes that currently have low CAPE ratios. My thinking on this subject is covered in this blog post. I thought it was important to get some international diversification while US stocks are at extremely high valuations and this was an efficient way to do so. It also helps me remain within a deep value style (i.e., I’m buying countries instead of companies that are trading at “cigar butt” prices.)
PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings. Read the full disclaimer.