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V alue investing is an investment paradigm attributed to Benjamin Graham. In their definition ofinvestment , Graham and Dodd [1934] stated that "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative" (Graham and Dodd [1934, p. 54]; see also Graham [2005, p. 3]). The Graham and Dodd definition has three distinct requirements that a valid investment operation must satisfy:
1. It must be based on thorough analysis;
2. It must promise safety of principal; and
3. It must promise satisfactory return.
In addition to defining investment, the other main contribution by Benjamin Graham is the introduction of the concept ofmargin of safety . Margin of safety is the discount of the market price of a company relative to its intrinsic value. According to Graham and Dodd, an investor should only buy a stock at a price below the estimated intrinsic value. Specifically, they state that the aim of the security analyst should be to select stocks for "which the market price falls far short of reflecting intrinsic value" (Graham and Dodd [1934, p. 613]).
The thesis of this article comprises two main ideas. First, we present a heuristic for making value investing decisions. Second, we examine the efficacy of this heuristic in successfully avoiding financially distressed companies. We hypothesize that if the heuristic works well, it should not only be able to choose stocks of good companies, but it should also be able to reject 100% of all stocks that later become financially distressed. We designed an experiment to conduct the test and present evidence that, using financial statement information covering a 15-year period, the heuristic successfully avoided 100% of companies that, subsequent to the portfolio selection decision, either became insolvent or experienced some form of financial distress. 1
VALUE INVESTING HEURISTIC
Although value investing can be successfully practiced in different ways, the central unifying concept of all value investment decision making ismargin of safety . The lower the price of a stock, the better the chances that it will have a good margin of safety. Obviously, not every stock that is selling below its intrinsic value is investment worthy. Margin of safety, the strength of...