Suit Yourself

 | Feb 02, 2013 | 12:00 PM EST  | Comments
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Here at Chez Melvin, we indulge in several ongoing discussions. In addition to vital subjects such as the American League East, Robert Parker vs. John D. MacDonald and the critical choice between beer and wine, one of the more frequently covered topics is how to pick stocks. The debate over value vs. growth and fundamental vs. technical analysis has raged on for the better part of two decades now.

Of course, the best way to pick a stock is determining the method that best fits your personality and temperament. Although I am a value guy at heart, I have friends who only buy stocks with blistering earnings growth, and they have done quite well over the years. While I hold stocks for years, I have many associates who trade short-term positions and have also done very well for themselves. The question is not which approach is best, but which approach is best for you.

Over the years, I have looked at and tried many approaches, but value investing fits me best. I vastly prefer sitting with a stack of annual and quarterly reports, and searching footnotes for value, to sitting in front of a screen watching stocks trade by trade or tick by tick. I am a bit of a geek by nature, and I also treasure time away from the screens to do other things I enjoy. Long-term ownership of cheap stocks allows me that flexibility.

I am also a cheapskate at heart, so the idea of buying anything at a premium price just goes against my basic nature, no matter how bright the future may appear. In short, I prefer to deal in absolutes instead of maybes.

I take the value approach one step further and focus almost entirely on the balance sheet of the companies I buy. Through my account balance, I have learned the painful lessons of how easily an income account can be manipulated to paint a pretty but ultimately false picture. The denominator of the price-to-earnings ratio (P/E) can change quickly, and a once-cheap stock may become expensive in a flash. The value of such things as cash, real estate and machinery changes far more slowly. Ultimately, real sustained earnings will show up in the balance sheet to increase the value of the company, so I keep my focus on that side of the ledger.

When I look at stocks, I focus my research efforts on two questions. Is it cheap and can it survive? The "cheap" issue can be addressed through a search for stocks that trade at a discount to tangible book value. I also discard any intangible or uncertain assets from my valuation. For the "survival" question, I look at credit and fundamental scoring measurements, such as the Altman Z score and Piotroski F scores. In general, I also prefer companies with low debt levels and high current ratios, as this can provide an additional margin of safety. The other survival question has to do with the future of the business. I try to avoid the buggy-whip stocks -- unless the companies are in liquidation and the shares are trading at a steep discount to their terminal value.

The other big reason I prefer the value approach is that is has been proven to work. Buying cheap stocks at the point of maximum pessimism has been the secret to the success of legendary investors, including John Templeton, Seth Klarman and Walter Schloss. In addition, the academic evidence in favor of purchasing stocks below book value is overwhelming. The work of Eugene Fama, Josef Lakonishok, Joseph Piotroski and others all show a powerful value bias in the stock market over time.

Of course, as with any strategy, there are some drawbacks to this approach. Focusing on deep value will prevent you from being a big fund manager. There simply are not enough truly cheap stocks to sustain a multibillion dollar fund. This strategy also requires both patient and discipline. Many cheap stocks will go down for a period before they go up. I have owned many stocks in my career that went from $7 to $3, and then to $20 or more. You have to have the discipline to stay focused on the value the company, and not the price of the stock. Price movements exist to allow you to scale in and out of positions over time.

While asset-based value investing is not for everyone, I do think it is the best approach for individual investors to adopt. If you run a business and have a family, there is not enough time in a day to swing trade short-term movements or monitor a portfolio of high-multiple momentum stocks. One afternoon at a Little League game could destroy your portfolio. Value-investing research can be done at a slower pace and take years to play out, so the day-to-day market action is not as critical to investment success.

The mission of a long-term investor is to survive in order to thrive. Asset-based value investing gives me the best chance of achieving that lofty goal.

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