RSS feedAs you may be able to tell from the focus of my recent posts, I’ve been bitten by the value bug. After suffering a string of losses as a result of poor discipline and a several poor trading weeks, I came to the realization that I would feel much more comfortable investing in stocks with some fundamental support for my decision to put money into it. So, what is value investing?
Value investing is the application of fundamental analysis in order to identify investment opportunities in stocks which provide, hence the name, value investing. The idea is to use an analysis of financial statements and relevant financial ratios in order to identify that a stock’s price currently undervalues the company in question. As with all investments based on fundamentals, these positions are taken with a longer horizon than many technical based picks as it usually takes some sort of event or news to change market sentiment and allow the stock to reach its correct value (a catalyst).
The origins of value investing are attributed to Benjamin Graham who first proposed the idea of attempting to buy stocks in companies when the stock’s market cap was less than the intrinsic value of the company the stock represents. Ben Graham developed this method after the Great Depression when nearly every stock in the market was hit hard even though some companies may not have actually deserved to be sold as hard as they were. As a result, there were many stocks which traded at below their intrinsic value. Graham defined intrinsic value was the liquidation value of the company which represents the amount of money a company could get if all of its assets were to be sold today. The idea behind this was that if a stock were to trade under a price representative of the assets it represents, then it was probably due to some misperception by the market and the stock would almost necessarily have to correct back up. Afterall, what would stop someone with appropriate resources from quickly buying all of the company in question’s stock and then proceed to liquidate the company’s assets for a quick profit?
Unfortunately, Graham’s strategy is not quite as relevant these days. Companies trading under their liquidation value or their net current asset value are few and far between. Now when this happens, it is no longer representative of a market misperception/inefficiency but likely as a result of very poor and rapidly declining performance. Not the type of stock anyone wants to make an investment in. As a result, the new school of value investors focus on a plethora of new strategies for valuing companies. These valuation techniques are not quite as accurate nor quite as set in stone as the calculation of the liquidation value of assets and instead often times rely on the projected value of future earnings or cash flows. These techniques, while helpful, leave valuation based value investors with the burden of making qualitative judgment calls on the company they are hoping to invest in. For example, are the company’s current earnings sustainable? Or, other than a buyout and liquidation, what would it take for the market to re-value this stock to a more appropriate level?
Valuation and business analysis may not be your thing. Even after the last few posts on how to perform analysis on financial statements, I would be surprised if someone having read this site would be able to properly value a company. This, however, is not a necessary prerequisite for finding value in stocks. Many value stocks tend to share certain characteristics which are represented in simple financial ratios. For example, low price-to-book ratios are a sign of a stock who’s market cap might currently be below its current asset value. Low price-to-earnings ratios are a sign that a company’s current earnings power is worth paying for.
It may be unlikely that you will be able to use ratio analysis to reach solid conclusions like, “Because this stock trades at low price-to-earnings and price-to-book ratios, I anticipate that this stock ought to appreciate 15%.” Instead, using price ratios for discovering potential value is more of a strategy for finding relative value. That is, you can use price-to-earnings and price-to-book to compare similar companies and get a feel for whether one is a better value than the other. Price ratios are a measure of how much you get for what you are paying for a stock. (i.e. how many dollars of earnings or how many dollars of the company’s assets you are entitled to for each dollar you spend to acquire stocks) Will this be as accurate or as consistently successful as knowing how to construct financial models and attempt to anticipate corrections in a stock’s valuation? Truth be told, for a small investor, it might be.
Since a small investor will never have the resources to outright acquire a company he is interested in, he will rarely have an opportunity to take advantage of the pricing inefficiencies discovered through valuation analysis. For example, if you found a stock trading well under net current asset value and decided to buy a few shares. You could never acquire enough shares to force a change - like liquidating the company’s assets - that would allow you to exploit the mis-pricing you found. In this sense, it is no use to work so hard to find this mis-valuations and, instead, it is best just to identify the best relative value that you can find and hope that sooner or later some sort of catalyst exposes the stock’s underpricing and causes the market to push the stock’s price up. This is the name of the game for a value investor. Those who can discover stocks which are mis-valued and can either accurately anticipate events or create events which will bring this mis-valuation to the market’s attention will more than likely find themselves on the winning end of their stock picks.
