Invest Wisdom

This is the last in a four-part series on value investing. It follows a story I wrote for Money magazine in this month’s issue. Leading up to this post, I wrote about what value investing is, how to use a price-to-earnings ratio, and how to pick companies that will continue to grow earnings.

To finish off my series on value investing, I’m going to talk about a couple additional things value investors should do in this market that might not have been a focus in the past.

So did you understand how AIG made money? Be honest.

1) Buy businesses you can understand, and

2) Make sure the company doesn’t have a lot of debt that comes due soon.

Neither of these things are really “new”. Any value manager worth his salt should have done this before the credit crisis, but when earnings were rolling in and credit flowed freely, it might not have seemed urgent at the time.

Understand the business

You probably thought you knew how banks and insurance companies made money. But needless to say, most of the companies that are in deep trouble right now were the same ones that found “innovative” profit centers during the boom. AIG, for example, had plenty of vanilla insurance products that you’d recognize from its cheesy and now laughable commercials. But unfortunately for investors, it delved into credit default swaps, which basically bankrupted the company.

Before you invest in any company, pull their most recent annual and quarterly reports, which you can find in “Investor Relations” at the company’s websites, and read them front to back, including footnotes. If there’s anything that you don’t understand, research the topic until you do understand it or don’t invest at all.

AIG’s failure was spectacular, but mistakes can be made on a less dramatic scale. Warren Buffett famously avoids investing in most tech companies, not because he doesn’t think they have potential, but because he doesn’t understand how the companies work. He prefers investing in companies like Coca Cola and See’s Candies (which isn’t a public company), which make profits in very understandable ways. His companies’ profits can still go down, but at least that risk was known before the investment.

For me, personally, that means no investments in banks, insurance companies, and companies that rely on new technology. I do, on the other hand, know a lot about media properties and real estate companies, by virtue of the business I work in and the businesses I’ve covered in my career. (I also know enough to see that there aren’t many great investments in those areas). Your expertise is probably completely different.

Check a company’s debt structure

This is probably the most complicated thing I’ll talk about in this series, but it’s also one of the most important and is unique to this crisis.

Several years ago, companies had no trouble borrowing money. If they had bonds that matured (which means that they have to pay back the millions of dollars that they had initially borrowed), the companies could just roll over (i.e. refinance) that debt without a problem. But now, even companies with good credit history are having trouble refinancing large amounts of debt. If they are able to refinance, they’re having to pay very high interest rates.

That kind of a problem can bankrupt or seriously cripple an otherwise healthy company. And for that reason, make sure the company doesn’t have a bundle of debt coming due in the next three years. Hopefully, by 2012 or sooner the credit markets will have completely loosened up. But until then, take nothing for granted.

To make sure that a company isn’t about to face a refinancing problem, follow the steps detailed in my value investing story for Money in the last section. Again, this might not be a huge issue once the credit markets finish thawing, but right now, it most definitely is.

Well that’s it for now. Even in a few thousand words, this is really only a basic outline of some of the things value investing encompasses. If you don’t have the time or inclination to continue studying the subject, stick with an index fund or an actively managed fund that focuses on value stocks. (For a list of funds that Money magazine recommends, click here.)

Thanks again for reading.

- Joe Light