A Guide To Value Investments

Accountancy Resources

A Guide To Value Investments

Investing Author: Admin


The way you select investments ultimately determines how successfully you will manage your portfolio and create future profits. The concept of value investing appeals to many people, especially the more conservative, because it bases decisions on analysis of the basic financial strength of a company, combined with the search for bargain prices of shares. This is the equivalent of buying a car by comparing ratings and performance, and then looking for an attractive discount. The alternative “buying a car based solely on its appearance” is a popular but less successful method.

The alternative, based on predicting the future and then trying to find companies most likely to grow into the assumed scenario, might succeed but it is much less scientific than applying the principles of value investing. The technique of trying to anticipate the future is flawed in the sense that such assumptions are rarely accurate. It may also ignore or overlook some of the basic facts about a company’s financial strength, competitive position, product or service trends, and economic forces that are going to affect future value.

Key Point

Seeking investments conforming to assumptions about the future may ignore the basic facts about a company’s strength or growth potential.

Those who try to pick investments based on assumptions about the future may actually outnumber value investors, whose emphasis is on analysis of financial fact rather than an attempt to predict future valuation and stock pricing. Value investing does not require you to predict the future or to be concerned with a variety of unknown influences on future prices. The decision to buy a particular company’s stock is based on a study of current value, a history of growth, and application of a few sound fundamental principles (see Chapter ). Returning to the analogy of the car buyer, a value investor goes to the dealership armed with comparative price and performance data, model comparisons and prices, and a very solid idea of the model and price desired. The decision is made ahead of time that if the price is available, they will buy; if that price is not available, they will wait.

The more impulsive car buyer goes to the dealership with little or no information other than what they might have heard about the brand. They end up buying for reasons that make no sense to the value investor. For example, they might buy a red car because it looks so nice . . . without considering the ratings, price, or performance issues.

For stock investors, the same principles apply. Value investors focus on individual companies, review the history of growth, read the annual reports, and decide in advance what is a fair price per share of the stock. It is simple and logical, but it requires more work. Once the true value of a company has been determined, the value investor will look for a buying opportunity. This means they will buy stock in the targeted company only if they can execute an order below the fair value price.

Do bargains arise in the market? Some theories claim that the current price of a share of stock is either efficient or random. (See Chapter .) An efficient price is one that has already factored in all known information about the company, meaning the price is always fair and accurate. A random price is one that changes without any prediction and may move up or down for reasons that cannot be known in advance.

Key Point

If the market were either efficient or random, it would be a 50–50 proposition to ever buy stocks. Under those theories, the current price of stock is always ‘right’ or ‘arbitrary.’

Both of these theories are simply wrong. The market is anything but efficient. In fact, the inefficiencies of the market create may bargains. The ‘market’ as one entity over reacts to all news, both good and bad, meaning prices tend to move too high on good news and fall too low on bad news. These jarring price changes tend to self-correct within a few trading sessions; but once they have fallen, bargains are created in a window of opportunity.

Few people accept the idea that the pricing of stocks is random. Many reject the principles followed by value investors, noting that financial information is always out of date by the time it is published. However, current news about products, earnings, and market perceptions all affect the value of stock very specifically. Rather than believing in the random approach to value, it makes more sense to recognize that there are many things affecting price, some canceling one another out and others confirming the current trend.

Always remember the distinction between a technical trend (price movement) and a fundamental trend (changes in profitability, working capital, or financial strength). These are not the same, although they can be used together in analysis of companies and their stocks. However, even a consistent trend does not mean that short-term markets are efficient by any means. In the long term, a value investment is likely to be efficient in the sense that properly selected companies will experience growth. In the short term, however, the market is extremely inefficient and chaotic.

Key Point

Short-term market trends are extremely random and chaotic. However, long-term trends rely on the fundamentals.

The theories concerning the efficiency of the market or its random nature are comforting to those looking at the market academically. But for people investing real money in shares of stock, these theories are either deceptively comforting (efficient at all times) or depressingly fatalistic (hopelessly random). Neither theory is realistic. The good news is that by applying the concepts of value investing, you can find value and a bargain price. It demands research and patience, but it is one way to build a profitable long-term portfolio. Two precepts every value investor has to be able to accept are:

  1. Inactivity in a stock’s price is not a negative attribute.
  2. The market rewards patience.

It could take months, and in some cases years, for a stock’s value to prove out the theory behind value investing. It is tempting to pay attention to the daily up-and-down changes in a stock’s value, but that is not the way to preserve capital, avoid fast losses, or time decisions well. Value investors are patient and are willing to put in the time to research and analyze a company before buying shares.

Value Investing and Control

Using the principles of value investing to select companies and their stocks is based on a few important rules:

  • Base decisions on a study of the fundamentals (see Fundamental Analysis). Anyone can grasp and master a few important fundamental indicators and trends.
  • Compare companies to rank their quality.
  • Be aware of price swings and volatility.
  • Remember to include dividend yield in your analysis.
  • Once you buy, don’t worry about price changes; remember, the market rewards patience.

How many people truly buy stocks and manage their portfolios based on these simple but practical guidelines? Not many do, unfortunately. It is far more likely that investors, even those who define themselves as ‘fundamental’ or ‘conservative’ in their approach, tend to take the easier path of picking stocks impulsively. Someone tells a friend or relative, ‘You should buy this stock. It’s going to double in value in the next six months.’ A common reaction is to immediately buy shares, but without knowing why.

Key Point

Many investors buy stocks on advice from others, but may not know why that is supposed to be a good idea.

An intelligent approach would be to respond with a question: ‘What criteria did you use to reach that conclusion?’ In other words, why will the stock double in value and how do you know that? You will find that the person giving you the advice either has no criteria to rely upon, or has based the conclusion on a simplistic indicator. For example, the company has been growing at double-digit rates, it is about to introduce a new product, or it is going to benefit from new federal legislation. Those factors might influence stock value, but they do not guarantee anything.

Under the value investing approach, you have control when you apply the rules above and when you ask a series of your own questions:

  • Is the stock currently fairly valued, overvalued, or undervalued?
  • What criteria determine this conclusion about valuation?
  • Is this company dominant in its industry?
  • What is the recent price history and level of volatility?

Asking these questions puts you in control. Buying stock should be approached on the same basis as that used to buy a home. A diligent home shopper looks at many homes and compares prices and features. The decision should not be made rashly or without completely researching the local market, neighborhood, construction quality, and fairness of the price being asked. However, when buying stocks, the same careful homebuyers might make decisions impulsively and without any research at all. That is a mistake.

Value Investing Myths and Facts

The power of value investing is in the control that people take over their own investment decisions. Rather than relying on unsupported claims or promises offered by others, or thinking of the market as a gamble, value investors are able to list out the reasons to buy stock, find companies meeting the requirements, and then act.

Key Point

Value investing places full control in your hands; taking any other approach relinquishes control, either to someone else or to the luck of the draw.

There are a few myths and misconceptions about value investing worth examining and dispelling. These include:

  • Value investing is based on a study of fundamentals, and fundamentals are expensive and difficult to understand. In fact, with the Internet now a dominant force in the market, a vast amount of valuable, free information is available to everyone. A little bit of study and research proves that using a few well-selected fundamental indicators is not complicated. Much of the information you need can be found in a company’s annual report or quarterly financial statement, both of which are usually found on the corporate website. All of the financial indicators you need can be found on a broker’s free research links. For example, Charles Schwab & Co. gives its investors free access to the S&P Stock Reports, which are valuable sources for 10 years of fundamental information.
  • The key to value investing is getting stock at low prices. This is not the case. The price itself is not the key; it is the price versus the value of the company. You would not want to overpay for a new home or for a car, and so you shop and compare prices. Value investors do the same thing with stocks. It is not the price per share that matters, but how that price compares to the true value of the company.A stock worth $15 per share could be overpriced based on an analysis of the fundamentals; and a stock priced at $80 per share could be a bargain. The price per share is a relative value, and value investing is not simply a matter of buying low-priced stocks.
  • The stock market cannot be beaten with any system, not even with value investing. A pessimistic outlook is built from the way that people invest. If you take that ‘hot tip’ and buy into a company without checking anything for yourself, you probably cannot beat the stock market. It is quite unlikely that a free hot tip is also going to work out profitably for you. In comparison, value investing is designed specifically to enable you to eliminate riskier choices, narrow down to a few stocks that meet your criteria, identify when you will sell as those criteria change, and make a decision based on analysis rather than on chance. With value investing, you have the best chance for beating the stock market.
  • Financial statements are too complicated unless you have a degree in finance or accounting. The belief in the complexity of financial statements is true in one respect: To follow and interpret footnotes, especially those concerned with accounting valuations and highly technical matters, does require a great deal of expertise. However, for making investment decisions, you are going to be more concerned with financial ratios than with the details of the statements themselves.
  • These ratios are found on the research services supplied by brokerages and, in fact, are not easily found on the financial statements. The 10-year summary of key financial indicators is of far greater interest than statements themselves, and much easier to find and use.
  • Growth stocks provide better returns than value stocks. The popularity of growth stocks cannot be ignored. A growth stock is one expected to report earnings above the average of all stocks, which should translate to rapidly growing stock prices as well. Growth and value stocks have each prevailed in the market about equally. However, a danger in growth stocks is that they tend to outperform the market during big growth spurts, but to fall hard and fast when they end. The dot.com bubble was one such example of growth stock domination followed by a collapse. Over the long term, value stocks compete with growth stocks equally, but are less likely to crash.

Setting Standards for Buying (and Selling) Stocks

With an impulsive method for buying stocks, you cannot know when to sell. By establishing a clear set of criteria for how and when to get in, you also can monitor those standards and, if and when they change, know when it is time to sell.

Key Point

Setting criteria for buying also defines criteria for selling. Without the first step, you cannot know when or why to sell.

Value investors differ from all others in the sense that they set a number of important rules for how and when to buy. If the status of a company changes, the value investor is supposed to sell the stock. So it is a disciplined approach based on defining and seeking value and keeping the position as long as the company keeps meeting the criteria.

The selection criteria begin with an observation about the short-term and long-term market. In the short term, prices change based on company popularity, fads, rumors, and overreaction to all news. This chaos tells you that trading in and out of positions is a difficult game because you need to time decisions on both sides with near-perfect precision. The swings in price are not consistent, and the chaotic nature of the short-term market points to the importance of a long-term perspective.

In the long term, stock prices tend to move in line with the company’s earnings. It’s really that simple. If you want to identify a company that represents value, look to past earnings trends and determine whether those trends will continue into the future. Companies that see falling sales tend to also experience falling stock prices. For examples, check General Motors, Eastman Kodak, and any large U.S.-based airline from the 1990s through to today.

These four rather obvious (but often overlooked) facts point to the first criterion of value investing:

  • 1. Track earnings trends to find value companies.

Another interesting fact about the market is that industries and companies experience popularity cycles. At certain times, the market is in love with one kind of company, whether that makes sense or not. At other times, the market ignores an entire industry. Value investors look for the company in an out-of-favor sector that has strong fundamentals but is not on many lists of ‘stocks to buy.’

The reason for buying an out-of-favor company is that it is probably undervalued, but assuming the cyclical nature of most sectors and also assuming that the cycle will come around again, a second criterion for value investing is:

  • 2. Look for fundamentally strong companies in sectors that are currently out of favor in the market.

The third rule is that you want to limit your shortlist to companies that have excellent reputations for quality of management, for product, and for competition. A value company is most likely to dominate its industry and has dominated for many years. By definition, this domination is the result of providing value products or services, and working through exceptionally skilled management.

The third value investing rule is:

  • 3. Narrow your list down to companies that offer exceptionally high-quality products or services, are managed expertly, and dominate their industry.

A fourth market reality is that even if prices are set efficiently most of the time, there are times when prices are pushed downward to unreasonably low levels. A company’s earnings might be lower than analysts expected, even if they represent record earnings for the company. It’s irrational, but it is a fact of life. Bargains show up in the market all of the time because of the short-term irrationality of buyers and sellers.

With this in mind, you can look for bargain-priced stock when those prices fall in an exaggerated fashion. This assumes that you first qualify the company based on fundamental strength, exceptional quality, and competitive position within the company’s sector. If you have done that, the fourth rule for value investing is:

  • 4. Identify companies you consider exceptionally well managed, that dominate their industries. Then buy on dips that create bargain stock price levels.

These four standards come down to the central definition of value investing: the selection of stocks in exceptionally well-run companies, available at a price below fair value. The definition of fair value (at times also called intrinsic value) varies. In general, it refers to stocks priced below tangible book value or some other assumption of value based on fundamental analysis. This may also be affected by an exceptionally attractive dividend yield available at the time the purchase is made.

Value stocks tend to perform better than average during market downturns, either declining less than average or even rising. In 2007, when the DJIA lost 2,000 points, several value stocks (such as Altria, Coca-Cola, Exxon-Mobil, Merck, and McDonald’s) rose in value. Even in 2008, one of the worst years on record, Mcdonald’s rose in value while nearly all other stocks saw their prices decline.

Key Point

Growth stocks tend to climb rapidly, but also tend to fall just as quickly. Value stocks tend to accumulate value gradually over many years and in many market conditions.

In comparison, growth stocks tend to rise during volatile markets moving quickly to the upside. But there is a danger. Those same stocks tend to lose value rapidly when the uptrend ends, especially if it is driven by a temporary fad in the market dominated by those industries where growth stocks are found. Consider for example the cyclical rise and fall in technology and IT sector stocks.

This does not mean that value stocks insulate your portfolio from price declines. But well-selected value stocks do tend to outperform the market as a whole over the long term. Within that long term, it is likely that some years will be low-volume and low-growth years for value stocks. However, as a rule, value investing is more conservative and more profitable than speculation or trying to find the next growth stock.

A second source of returns on a portfolio, beyond price appreciation of stock, is dividend income. Most growth stocks do not pay dividends, so growth stock investors have to rely on price appreciation that outpaces not only the change in value investments, but their dividend yields as well. Value investors can make the most of dividend yield by reinvesting dividends in purchase of additional shares rather than taking payments in cash. The reinvested dividends appreciate at compounded rates. Over many years, dividend income on value investments represents a significant share of overall returns on the portfolio, and may also be thought of as offsets to the cyclical price declines that occur in all markets.

The value investor is probably more conservative and more concerned with volatility than growth investors. However, when your emphasis is on how a portfolio is going to perform over many years and not just over the next few weeks or months, value investing is likely to be a more profitable strategy in the market.