Isn't the Graham number unreliable with tech and growth stocks? I just read a bit on the Graham Number, and it seems to be excellent criteria for defensive investors in choosing defensive stocks. But the formula involves book value, which could give misleading numbers for tech stocks. There aren't any reliable methods for gauging the value of Apple. Apple is a good example of why Graham recommended to avoid growth stocks (unless it's at a reasonable price).
You seem to be very experienced. Do you stay away from growth stocks? How would you analyze whether a growth stock's price becomes reasonable? All I could think of is examining financial stability and its competitive position in the industry. Good entry point would be during over-pessimism (this year?). There seems to be an overreaction due to EPS growth breaking down.
I wish I could boil down my approach in a post, but anyone who promises that they can is probably selling you snake oil. But I'll try to summarize as best I can. I don't look at what the market is doing or why, because people tend to behave stupidly when in herds. That's just a general truth about life.
What I look for, and I focus on it unflinchingly, are:
1. A wide competitive moat. This is not just reflected in operating results but the national or global position of the brand within its industry. People will say "Apple's the most recognized brand" .... but one can find moats with companies that aren't necessarily popular/familiar to everybody. The company needs have a competitive advantage in its particular business, regardless of whether everybody on Earth has heard their name or not.
2. Soundness of management. This is the fuzzy math. I don't know a lot of these people as well as someone like Warren Buffett who can make a decision quicker because he already knows a lot about the people steering the ship. But their history of decision making has to be marked by long-term thinking, and not short-term profit taking. Also reasonably determined compensation that shows a track record of them being at the job because they love it, not because they got absurdly high compensation out of proportion with their performance.
3. Operating value. I'm not interested in total tangible book value because how many gold toilets an executive office has doesn't tell me how good they are at doing what they specialize in. But their working capital plus years of stable operating cash flows does. Earnings is comprised of more than operating cash flows, so I ignore it... because earnings can be buffered in bad years by other activities that have no bearing on how good of a job the company is doing at selling their core product.
The two other things that are critical to me are:
1. manufacturing oriented businesses. People often love to make things harder for themselves, and I'll never understand it. I like to keep things as simple as possible for myself. I stay focused on manufacturing because companies that make and sell widgets are easy to value. I don't know how one places a value on web advertising, or level 3 derivatives... so I stay away from banks and internet ventures and the like. But I can easily tell if a company is good at selling widgets, how many widgets they're selling, and what kind of profit they're generating from said widgets. Keeps the math very very simple... and the valuation takes less than 15 minutes.
2. Value. Buffett has said "price is what you pay, value is what you get." Like him, I will never understand the propensity for people to think that paying $5 for an asset worth $1 is more rewarding than paying 60 cents for that same asset. Either people immediately grasp this concept or they don't. Does it mean that my investments pan out all the time? Not always, but much more often than not... and it's far easier to get off a slow moving train without hurting yourself (or your pocketbook).
If you've done your homework on all the above, it's fairly easy to tell apart companies that are genuinely dogs versus those that are solid , whose operating results have not gone south, but for some other unrelated reason they are temporarily priced well below their value.
If the sensible price to pay to acquire a company from an M&A perspective is well below what the market full of yahoos is currently pricing it at, then don't make it hard on yourself by hoping that the $15 dollars you paid for an asset worth only $2 is going to go to $16 or $17. Hope is not a strategy.
One other thing I have taken into consideration is dividends. My ideal situation is one where I find a company that passes all the above tests and pays out a good dividend, so if the market is unfair to them I still get paid.
But if your degree of certainty (what Graham called the margin of safety) is lower on a security, then either avoid it or risk less money on it... Sure, if you don't bet big you can't win big. But it's not about winning big a few times. It's about winning small so often that the results compound over time.
Any number times zero is still zero. And by that I mean if chasing after unrealistic gains wipes out your principal, 26% ROI on zero principal is still zero.... Think of every dollar of principal that you lose as a dollar plus 30 years of compounded returns that you will never get back.
Now if you're uncertain enough times that you can't do better than the 30 year average of the S&P (9.3% annually compounded) then don't make it hard on yourself... An index fund doesn't have the cool factor, but would you rather be broke and talking it up at the watercooler, or boring and financially set for life?
