Book Review – “Money Machine: The Surprisingly Simple Power of Value Investing” by Gary Smith
Bottom Line Up Front (BLUF): Value investors see stocks as “money machines” that churn out dividend payments. Buy stocks based on how much those dividend payments are worth to you over the long run.
Gary Smith’s book, “Money Machine: The Surprisingly Simple Power of Value Investing,” discusses the benefits of value investing and methods for putting it into action. Where Gary Smith’s book diverges from his value investing peers is his mindset. He views stocks as money machines whose whole purpose is to churn out dividend payments. Instead of being concerned about the stock’s value going up (so you can sell it for a profit), instead you should ask how much you would pay to get those dividend payments. This is the opposite of speculative investments (like growth stocks and cryptocurrency), where you are often buying in hopes that the sale price will go up.
“Our Favorite Holding Period Is Forever.” - Warren Buffett
Keeping this in mind changes how you view stocks. If you pretend that you’re going to hold onto the stock indefinitely, the only reason you would buy stocks is for the cash they generate (i.e. dividend payments).
Though the book meanders through several different topics, I’ll highlight just a couple of my favorites in this post. For the rest, you’ll need to read it yourself.
Don’t chase the news… the stock market is (mostly) efficient
Value investors don’t follow the news, as the stock market is (mostly) efficient. If you read something in the news about a hot new stock, that published information will already be factored into the stock’s price. However, the market does sometimes overcorrect, especially with bad news. For example, when bad news happens (i.e. the CEO of a company is fired, etc.), investors will often sell without considering whether the company’s earning potential is likely to drop significantly. Because the stock drops in price, even more will stampede towards the exits and drive the price even lower.
Situations like this cause value investors to believe that the stock market isn’t completely efficient, because investors influence each other. Their shared error causes them to collectively overvalue or undervalue stocks. This means that sometimes stocks are much cheaper than they should be (based on their assets and profit potential) when investors are pessimistic… making those stocks to go on sale. Alternatively, bargains are not found when investors are optimistic.
“Buy when everyone else is selling, and hold until everyone else is buying.” - J. Paul Getty
Value investors take advantage of these opportunities to buy good companies that are trading at a discount, then buy and hold them long term.
Technical Analysis (or why watching stock charts is worthless)
One common practice that leads many astray is technical analysis, or the practice of looking for patterns in a stock chart that supposedly predict the future price. But, no one can predict the future, and the charts are mostly worthless in this regard.
Dr. Malkiel, author of the esteemed book “A Random Walk Down Wall Street”, said that “Technical analysis is most akin to astrology.” Though there is a bit of truth that the charts can show momentum of the price, the stock price charts are just a look in the rear-view mirror. There are a number of books that highlight why you can’t use technical analysis to predict price.
Instead, value investors don’t try to predict future prices. Instead, they determine if a stock’s price is a good value (based on the company’s assets, debts, and earnin potential), and then hold them until they
Calculating Value of Stocks:
He outlines the equations used to calculate the true value of stocks:
In the book, he recommends starting with each year’s Forbes “Most Admired Companies” and then calculating whether they are a valuable investment by calculating their true value w/ the following models/equations:
Bogle model: Stock return = dividend yield (%) + annual growth of earnings + annual change in Price/Earnings ratio
- This is good for estimating dividend yields over a 10 year horizon
John Burr Williams (JBW) equation: Total annual return = ( annual dividend / current stock price) + annual rate of growth of dividends
- He recommends using 5% for the annual rate of growth
Schiller’s Cyclically adjusted price earning ratio: Take the P/E ratios of the last 10 years (adjusted for inflation), then take their average to see their adjusted P/E.
Some other things to look at before you buy
There are a number of things to consider before you buy a stock, even if the previous calculations make it seem like a good investment. Using the financial statements that companies must submit to the SEC, you can review a company’s finances to determine their value. Here are a few suggestions of what to look for from Gary Smith’s book:
- Companies should own twice as much as they owe (current assets vs. liabilities). Compare their assets vs. liabilities against other companies in the same industry
- Check whether their assets vs. liability ratio is getting better or worse
- Determine whether the company has a “moat” (i.e. an advantage that would keep them from losing their market share)
- Track whether insiders (CEOs, COOs, etc.) are buying large amounts of stocks. If so, it could show that they believe in the company’s earning potential enough to invest their own money.
Review
I have pages of notes from reading this book (and hope to read it again soon). This book is a treasure trove of value investing knowledge, and can help you think about investing in the right way. My only complaint about it is that as an audiobook, it was exceptionally difficult to understand how to actually calculate the value of a stock.
If you are a beginner investor, I’d recommend steering towards something like Danielle Town’s “Invested” before trying to tackle this material.
In truth, I’m just beginning my value investing journey (I’m invested nearly 100% in index funds). I’m intrigued with the idea of investing in individual companies. However, hopefully this shows that value investing requires a significant amount of research to do correctly.
As I learn more, I’ll continue to refine (and perhaps simplify) this post.