Buy low and sell high. This is one of the oldest rules around for investing in anything, but particularly in stocks. A more recent variation, buy high and sell higher shifts attention from low to higher price since quality usually attracts a higher price.

While both versions promote the basic principle of getting more than you paid when you sell an asset, they both encourage the investor to focus on price over value, which in the long term may not contribute to the wealth creating and sustaining power of the asset or of the portfolio.

When it comes to equities, a value investor should be concerned more about the fundamentals of a business than the current price of its stock. In so doing, the investor can better determine a stock's worth as opposed to its price. Value investors don't rely on the market to tell them what a company or its stock should be worth.
Intrinsic Value

Over 50 years ago, Benjamin Graham, the father of value investing and the mentor of Warren Buffett, laid out a methodology for arriving at a company's or a stock's true worth in his book, The Intelligent Investor. He promoted the concept of intrinsic value - the value of a security as contained in the security itself or, "the value of a security that is justified by the company's assets, dividends and definite prospects".

Graham described the Net Current Asset Value (NCAV) technique for arriving at a stock's intrinsic or fair value. Identify the company's current assets (cash, cash equivalents, accounts receivable and inventories). Subtract the company's total liabilities and divide by the number of shares outstanding, which will yield the company's NCAV per share. So, Benjamin Graham's intrinsic value can be reduced to a number. It is the number that is left after a company pays off all its debts.

Say, for example, a company has $2.5 billion in current assets with $2 billion in total debts, leaving an NCAV of $500 million. If that company had 25 million shares outstanding, each share would have an NCAV or true worth of $20. The stock would be undervalued if it is being traded below that and over-valued if the market price is greater.
Margin of Safety

Allied to Graham's concept of intrinsic value is his dogma of margin of safety which Warren Buffett refers to as the three most important words in any investment. The margin of safety is the gap between price and value. It is the price at which a stock can be bought with minimal downside risk - that extra cushion of value that minimises the effects of underperformance.

For Graham, this could be somewhere between one half and two-thirds of the stock's true worth or intrinsic value. In my earlier example, this would be anywhere between $10 and $13.33. Buy when the stock is within this range. Thereafter, track the company's value, not its stock price. Always seek a higher margin to compensate for higher levels of uncertainty and risk.

Graham also proposed a benchmark method for determining intrinsic value whereby a stock's value would be compared to the yield of the lowest risk investment available, usually government securities.
Today, there is no universally accepted method of determining intrinsic value. Some value investors rely heavily on the Discounted Cash Flow method (DCF). Others look at the company's Projected Earnings Growth (PEG). Still others incorporate the value of the company's intangibles such as brand name, copyrights and trademarks.

Intrinsic value investment guidelines
In one of his Owner's Manuals to shareholders of Berkshire Hathaway, Warren Buffett defined intrinsic value as, "the discounted value of cash that can be taken out of a business during its remaining life." In order to assist in determining this, Buffett examines ratios such as return on equity (ROE); return on assets, (ROA); return on capital employed (ROCE); and the ratio of debt to equity (Leverage). In addition, he seeks answers to questions such as:
What is the company's capacity for generating earnings?

. What is its economic moat, that is, what gives the company a clear advantage over others and protects it against incursions from competitors?
. How adaptive is the company to changing times and challenges?
. Is the management wise and rational?
Here are some other guidelines, gathered from a variety of international sources, of what value investors should look for in a potential investment:

. A price earnings ratio (P/E) in the bottom 10% of its sector
. A projected earnings growth of less than one, which may indicate that the stock is undervalued
. A debt to equity ratio of less than one
. A price to book ratio of one or less
. Strong earnings growth in the 6% - 8% range over 7 to 10 years.

Investment discipline

However, more than a series of formulas, the search for intrinsic value is a discipline that should compel the investor to know the business they are investing in; ascertain the company's long-term prospects; understand their own risk appetite; invest within their area of competence; and to develop the patience, courage and wisdom to wait until true value of the asset they invested in is realised or surpassed.

Buying and selling stocks on the basis of price only can lead investors to watching daily stock price results eagerly, day after day, in pursuit of a price advantage, often at the expense of paying attention to the real business of investing.
We, as your investment advisors, are here not so much to guarantee you windfall profits but more so to assist you to avoid making costly mistakes.

Gary Peart is the Chief Executive Officer of Mayberry Investments Limited
gary.peart@mayberryinv.com

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