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Why I'm a value investor

Some people love shoes. They snap up the latest sneakers and amass a library of loafers.

For my part, shoe shopping gives me hives. I find it hard to get the right fit.

So let me say I'm sympathetic when people tell me they can't find an investing approach that suits them. If locating the right shoes ranks as a minor annoyance, discovering a market strategy that feels comfortable looms as a major challenge.

Over the years, I've discovered that value investing is the strategy that fits me best. I'm not going to suggest that a value approach is right for everyone, but - at the risk of sounding like a shoe salesman - let me suggest you slip it on, at least for a while.

Even if value turns out to be less than a perfect match for you, many of its lessons are widely applicable. Adding a dollop of value to dividend, growth, momentum or index investing can help boost your returns and lower your risk.

Value investing is all about finding stocks (and other securities) that are both cheap and relatively safe. The two are intimately related because buying at a low price is inherently safer than buying at a high price, everything else being equal.

Benjamin Graham, the late, great Wall Street financier who many consider to be the father of value investing, instructed investors to look for a margin of safety. The idea is that you should first calculate how much a business is sensibly worth, then look for chances to buy it at a big discount. This cushion of value is important because it gives you a buffer against unexpected calamities - as well as the much more mundane problem of being overly optimistic.

When it comes to determining what a company is worth, value investors like to put themselves in the shoes of a level-headed private buyer who wants to purchase the whole company. That way they can focus on the firm's value rather than its current market price. After all, the market has a tendency to go to extremes as we've witnessed over the last couple of decades. Wise investors are prepared for the mood swings and try to take advantage of them.

As you might expect, uncovering the best bargains involves controlling your emotions. Value investors don't like to pay up for rosy prospects or optimistic projections. They prefer hard assets and clear situations that don't require hugely complicated calculations.

Mr. Graham wrote a series of articles in the depths of the Great Depression that highlight the idea behind value investing. Given the bleak times around him, he began by suggesting that investors use an extremely parsimonious measure to evaluate what a business was worth. His procedure was to tote up a firm's current assets (cash and things that are expected to be turned into cash in the next year) then subtract all of the company's liabilities. He then looked for stocks trading at less than two-thirds of the value this rigorous approach would indicate they were worth.

If you had the wherewithal to buy up such cash-rich companies, you could liquidate them and quickly pocket a nice gain. Even better, many of these business still generated profits. In these cases you could buy the company, extract the excess cash, and still have a profitable business on the side.

Unfortunately, such bargains tend to be scarce in normal times. But the core idea is there. Step one is to calculate a conservative estimate of a firm's value. Step two is to buy it for a much lower price.

Practically speaking, most value investors are willing to use less severe measures than Mr. Graham when calculating a firm's value. After all, a solid operating business that generates profits year in and year out is objectively worth more than just the cash on its balance sheet.

For instance, Warren Buffett, who was Mr. Graham's protege, is willing to pay a reasonable price for a very high quality business that is likely to maintain a sustained competitive advantage. He likes firms that have wide moats around their businesses which they can use to fend off competitors. That's why many well-known brand-names such as Coca-Cola, American Express and IBM appear in his portfolio.

Value investing, as you can see, comes in many styles. It will be my pleasure to introduce you to some of these styles and a few of the colourful characters that have made value investing what it is today. I hope a value approach will click with you because it can be quite profitable - and might even enable you to buy that library of loafers after all.

First published in the Globe and Mail, September 16 2012.

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