In my opinion, the current market plunge has created plenty of opportunities. This is especially true for investors holding piles of cash. But where to invest?
For guidance, we can look to Benjamin Graham, teacher of Warren Buffett. Graham explains his approach to value investing in The Intelligent Investor.
I summarise Graham’s tips here.
According to Graham, investment should be safe and lead to an “adequate return“. The best way to achieve this is through “thorough analysis“. In Graham’s view, all other investing styles are speculative.
According to Buffett, Graham’s most capable student, only long-term investing is worthy of the name. Short-term investing is speculating.
Buying low and selling high is the main principle of value investing. This means an intelligent investor avoids increasing high-risk positions when they get too popular. The example of a shoeshine boy wanting to buy stocks comes to mind.
Buffett’s favourite way of measuring whether the stock market is overbought is total stock market capitalisation to GDP. I am sure that Buffett would embrace this stock market crash by buying more high-quality companies that are currently undervalued.
Undervalued companies have low price-to-earnings (P/E) ratios, preferably below 25. Moreover, you can buy them at reasonably low price-to-book (P/B) ratios. An ideal P/B is one or below.
So, what are high-quality companies?
A sound company should have a good balance sheet and be able to easily pay its current liabilities. This means that its current ratio must be substantially above one. Ideally, its working capital should allow the company to pay its short-term liabilities. Another common measure is the debt-to-equity ratio. Divide total liabilities by shareholders’ equity to calculate this.
A great company should also be profitable. The best way to judge profitability and efficiency is by looking at the net profit-to-sales ratio. You could also use the net profit-to-shareholders’ equity measure.
It is also essential that a company keeps increasing its sales revenue and earnings almost every year. An intelligent investor prefers stability over record growth. For example, Graham would avoid a technical company whose earnings grew by 70% in year 2018 but fell by 40% in year 2019.
If you are still unsure after having worked all these things out, than I’d recommend looking at credit rating agencies’ opinions. They only issue high ratings for healthy companies.
Buffett considers these things to be important too
First of all, Buffett prefers investing in dividend-paying companies with sustainable and increasing dividends. A dividend cover ratio of at least 1.5 is a good measure for this. Graham and Buffett prefer cash dividends over stock buybacks.
It is also important that a company have good management that responds appropriately to risks. As an example, a company might lower production costs during a recession by shutting less profitable operations. Good management receives only reasonable, performance-related compensation. It is disgraceful if management is paid excellent bonuses for bad performance.
Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.