Valuation
Where Should We Look for Good Investment Opportunities?
If you are an active investor trying to outperform the market, your first question may not even be — Which stock should I buy?
A better question is: What kind of strategy should I use to search?
There are thousands of companies in the market. Studying every one of them in depth is neither possible nor necessary. What matters more is knowing where situations may arise in which there is a wide gap between the market price and the underlying value of the business.
Benjamin Graham approaches the active investor’s problem in much the same way — by asking where worthwhile opportunities are most likely to be found. In his framework, the activities of an enterprising investor in common stocks can broadly be divided into four areas.
From this perspective, there are essentially four ways to go “fishing”:
- Buy when the overall market is cheap and sell when it becomes expensive;
- Look for exceptionally fast-growing companies;
- Look for companies trading significantly below their underlying value;
- Look for special situations — mergers and acquisitions, liquidations, restructurings, and similar events.
Graham calls the third category “bargain issues of various types” and the fourth “special situations.”
At first glance, all four approaches sound reasonable. In practice, however, their reliability is very different.
Timing the Market
The most natural idea is simple: buy during a crisis and sell during a boom.
The problem is that saying this is easy. Knowing when the market is genuinely cheap and when it has already become too expensive is much harder.
There is no simple formula that works consistently. A market that already looks expensive can continue rising for several more years. The same applies in the opposite direction — a cheap market can become even cheaper.
Graham himself was highly skeptical of mechanical market timing. In his view, consistently taking advantage of market swings would require a special kind of trading “feel,” rather than the type of investment analysis on which his philosophy is built.
So market timing may be useful as an additional tool, but it is difficult — if not impossible — to build a consistently successful investment strategy around it.
Fast-Growing Companies
The second approach looks much more attractive. Find companies that are growing quickly, have strong businesses, large markets, and promising futures.
It sounds logical. But there is one major problem:
If you can see that a company is growing exceptionally well, the market can probably see it too.
And that is exactly why the stock of such a company is often already very expensive. You may be completely right about the business. Revenue may rise. Earnings may rise. Market share may expand — and you may still earn an average or even poor return for the simple reason that you paid too much in the first place.
This is one of Graham’s most important warnings about growth investing: correctly identifying a company’s future does not necessarily mean that you bought the stock at an attractive price.
A good company and a good investment are not the same thing.
The Real Fishing Ground — Bargain Stocks
Now we get to a much more interesting area.
Instead of trying to predict the future better than everyone else, we can search for situations where today’s price is already clearly below what the existing facts suggest the business is worth.
This gets much closer to the heart of Graham’s investment philosophy: instead of trying to predict the most promising future, look for a clear gap between price and value.
At the same time, “cheap” does not simply mean a low P/E ratio. A stock can have a low P/E and still not be cheap. A cyclical company, for example, may temporarily be earning peak profits. In that case, an apparently low P/E can be misleading.
The interesting situation arises when a conservatively estimated value of the business is clearly above its market price.
Within this fishing ground, there are several different places to look.
1. Unpopular Large Companies
Sometimes a good, large, and fundamentally viable company runs into temporary trouble.
Earnings decline. The industry enters a weak phase. Management makes mistakes. Investors lose interest. The stock price falls.
Markets have a tendency to exaggerate both good news and bad news. So a temporary problem can sometimes be priced as if the company’s future has been permanently destroyed.
This is why Graham specifically discusses “unpopular large companies.” A large company can temporarily fall out of favor, while still having the resources necessary to survive the problem and recover.
Large companies often have an important advantage in these situations: they usually have financial resources, brands, customers, assets, and the ability to change management.
If the problem is temporary while the price already assumes permanent disaster, an opportunity may exist.
2. Net-Net — The Extreme Bargain
A net-net is a more extreme case.
Imagine a company whose market capitalization is so low that its current assets — cash, receivables, inventories, and similar assets — still exceed the entire market value of the company even after all liabilities are deducted.
In simple terms:
Current Assets − Total Liabilities > Market Value
This is one of Graham’s best-known bargain methods. He was particularly interested in companies selling below their net current asset value — situations in which long-term assets were effectively being assigned little or no value by the market.
In such a case, it is almost as if the company’s factories, land, equipment, and other long-term assets come for free.
Of course, this does not mean every net-net is a good investment. Some are genuinely bad businesses. Some are burning cash. Some carry inventories worth less than their accounting value. Some may not survive at all.
That is why diversification is an important part of this approach.
The idea is not to find one “miracle” stock. The idea is to buy a group of such companies at a sufficiently large discount.
Graham’s own experience with this strategy was also based on a diversified group approach rather than betting everything on a single net-net.
3. Silver Medalists Outside the Spotlight
A third interesting source of opportunities is smaller or mid-sized companies that are not the leaders in their industries.
Graham calls these secondary companies — businesses that are not dominant players in an important industry and therefore often receive less attention from the market.
Investors naturally tend to prefer industry leaders.
Large companies are better known, more liquid, followed by more analysts, and usually appear safer. But the other side of this preference is that smaller companies can sometimes become excessively cheap.
Graham argues that the market’s attitude toward secondary companies can become unrealistically pessimistic, creating significant undervaluation.
The market may treat them as if failing to be the industry leader is already a serious flaw. In reality, an entirely ordinary company may operate successfully for decades and continue earning a reasonable return on its capital.
If we can buy such a business at a sufficiently low price, several things may work in our favor.
The company may pay a strong dividend. It may reinvest part of its earnings and gradually increase intrinsic value. Temporary problems may be resolved. The market may simply revalue the company. Or a larger competitor may eventually acquire it at a much higher price.
Interestingly, Graham points to many of these same mechanisms: high dividend yields, the effect of retained earnings, normalization of the market valuation, improvements in business conditions, and acquisition by a larger company.
Again, the important point is not that the company is small.
The important point is that the market’s lack of interest may have pushed the price significantly below the underlying value of the business.
That is why unpopular large companies, net-nets, and secondary companies really belong to the same family.
In all three cases we are asking the same question:
Why might the market be paying too little for this business?
Special Situations — A Slightly Different Game
This strategy may look similar to bargain investing from the outside, but the logic of the analysis is different.
A company may be in the process of being acquired. It may be undergoing liquidation, restructuring, or bankruptcy.
There may be a specific transaction under which shareholders or bondholders will receive a certain amount if the event is completed.
Graham discusses merger arbitrage, liquidations, reorganizations, and other situations in which a specific corporate event creates a gap between the current market price and the potential final value.
Here the main question is no longer simply:
What is this business worth over the long run?
Instead, the more important questions are:
What happens if the event is completed, what is the probability of completion, and how much do we lose if the deal fails?
With a normal bargain stock, we may simply wait while the business continues operating and the market gradually corrects the price.
In a special situation, there is often a specific event — an acquisition, liquidation, restructuring — that determines the outcome.
Graham treats this as a more technical and specialized area. In his view, exploiting these opportunities requires specific experience and judgment.
So it is worth saying clearly that this is a more specialized activity and generally requires more expertise.
So Where Is the Most Interesting Place to Fish?
If we reduce Graham’s reasoning to one central idea, this is where its strength becomes clear:
Our edge should not depend on believing that we can predict the future better than everyone else. A more durable edge may exist when today’s price already contains a sufficiently large mistake.
That, to me, is the most interesting part of this approach.
You should never say:
“I know exactly what will happen.”
It is better to say:
“I don’t know exactly what will happen — so I want to pay a price that does not require me to know everything.”
That last sentence is not a direct quotation from Graham, but it captures the logic of his approach very well: instead of relying on a perfect forecast of the future, buy with enough of a discount that you do not need one.
And that is probably where the true idea of a Margin of Safety begins.
Source
Benjamin Graham, The Intelligent Investor: A Book of Practical Counsel, Revised Edition, Chapter 7 — “Portfolio Policy for the Enterprising Investor: The Positive Side.”
The core ideas discussed in this article — market timing, growth stocks, bargain issues, unpopular large companies, net-current-asset stocks, secondary companies, and special situations — are developed in this section of the book.
Related reading: The Active Investor — Mistakes to Avoid.