One of the least discussed secrets of great practitioners of the value investing strategy is the use of cash, cash equivalents, and bonds to augment returns. From Benjamin Graham and Warren Buffett to Wallace Weitz and Marty Whitman, intelligent use of excess funds has as much to do with growing your capital over the long run as does selecting individual common stocks. We’re going to look at some of the techniques that have been used by value investors to manage their reserves, and the role played in the overall portfolio.
The focus value investing strategy is different from traditional, Benjamin Graham value investing strategy because it is based upon the idea of putting money into more of an investor’s “best ideas”, as Warren Buffett put it. Some value investors despise focused investing, while others swear by it. I’m always very hesitant to talk about this particular strategy on Investing for Beginners where I publish my investing articles for total newbies, mostly because some lazy person may not study far enough and realize that focused value investing is only possible when someone has diversified income sources. Done wrong, it can be financially devastating.
Peak earnings are a common value investing trap that most often hurts inexperienced investors who look only at the earnings per share and not the underlying driver of those profits. The last big round of peak earnings value traps occurred at the end of the housing bubble. By knowing what to look for, you’ll be better equipped to spot value traps, lowering the chances your portfolio will be damaged by them.
Many famous portfolio managers that practice a value investing strategy have said they think of stocks as “equity bonds”. Instead of receiving a fixed rate of return, like you would when you buy a traditional bond, you receive a variable return based on the company’s underlying profit. This approach makes it easier to value a business. The most common starting point for the valuation process is calculating a financial ratio known as earnings yield. In this article, you will learn what the earnings yield ratio is, how to calculate it, and why it is important to so many value investors.