After having asked all the necessary questions about our company, we now come on to what we should do with the information that has come from these questions.
Value investing is one of the best known and arguably the most logical of all investment strategies. Warren Buffet, the man who sits at the top of the list of all the world’s richest people follows this strategy (largely). The theory is that you buy a company if its intrinsic value is lower than the current price the company is trading at on the stock exchange. In other words, if a company’s value is not being recognised in its share price, buy it! because before long, the fundamental data about the company will come out and the stock will gain in popularity and its share price will then go up. This method is heavily dependent upon fundamental data, number crunching, knowing everything there is to know about the company and the wider situation in which it sits, asking all the questions you can possible ask about the company and finding the answers. Then and only then, when all the work is done, saying that the company is worth this price, it is only being traded at this price which is lower (undervalued), so in time the stock will go up, hence it is a “BUY!” On the contrary, a stock that has a share price higher than its true intrinsic value is overvalued and thus a no no.
Now there is a difference between a company which is undervalued and a company whose share price is decreasing and seems to be undervalued or “cheap”. This is where hard work and lots of study become important. You cannot simply look at a graph and because the share price is down from a previous high point, say to yourself that it will go back to that high point or beyond and then buy it. There can be a number of reasons why the price has gone down and seldom if ever you can buy a share because it “looks” cheap. In view of all the things that can be said about a company and the effects that can take place on a share price for many different reasons, there is and will never be any excuse to shy away from the hard work of studying a company in order to find its real intrinsic value. One argument against this strategy is that value investing is investing, it is not trading over a short period of time, looking for the daily movements that take place in a stock’s value. It does not figure into its equation, the daily, sometimes hourly movements that can take place in a company’s share price. It does not concern itself or pay attention to the external (technical factors) that can play a role in the share price of a stock. These factors are not seen as having an effect on the overall long term future growth of the company in the mind of a value investor. In my opinion it is a weakness because we can see some major effects on a company’s share price due to external factors. However, value investment has a strong case for it and highlights what I feel is the most important part of being a successful share trader and that is that you must know your company well, inside and out, everything that you can ascertain about the company to see whether it warrants an investment or not. On a practical level, this method generally takes more time, fundamental data about the true undervalue of a company can take time to get attention within the share trading world, even years. If you cannot afford to hold investments for years and years, then maybe you need to look elsewhere. Also a company’s share price may decrease overtime while this dearth of knowledge about the real value of the company takes time to come to the fore. This can be worrying as you see your money dwindling away in the investment. Here emotions come into play, but value investing as a method trusts in the truth about a company, believing all the time that eventually the company will be recognised for what it is and the share price will as a result increase. On a technical level, there is a contradicting theory called the Efficient Market Hypothesis (EMH) that states that all information about a company is always reflected in the price of its share. If a company is actually, according to all your study, worth £20 per share, EMH suggests that the share price WILL BE £20. This does not always happen as we know when talking about “herd mentality” or human emotion. The stock market does not work as efficiently as some would like to think, or indeed hope that it would, otherwise we would not see volatility in the market as much as we do, which is due to human emotion and people often jumping on the “band wagon”.
Where can we find these value stocks? Basically everywhere. In every stock exchange all over the world, you can find companies that are undervalued according to its fundamental data. They exist in every industry from coffee sellers to car markets, from steel makers to shipping. Often you can see undervalued companies within particular sectors that have gone through hard times or have been oversold due to some bad news within the industry itself. It must be stressed again, a decrease in a stock does not mean that it is cheap. It may be cheap due to human emotions that have forced people to sell the stock more than was necessary. For example, the housing market in the UK started to suffer greatly as the mortgage industry had a nightmare time in the summer of 2007. So companies such as Persimmon, Taylor Woodrow and Barrett Homes for example all saw significant declines in their share prices as a result of the general decline in the housing market as a whole. Also you can notice in companies such as Hammerson, British Land and Land Securities who also work in a similar market of buying existing buildings (usually more commercial buildings such as office blocks, shopping malls, etc.) or building new ones, they too suffered as the wider building construction industry took a severe knock. Will they always be this low and has their intrinsic value changed that much in view of the general decline? Possibly yes, probably no. Yes these companies may not be making profits like in latter years, quite in the same way just yet, but will the housing market and wider construction market remain low, absolutely not. Before long, when the general economy of Britain turns a corner, deals with its current credit crisis, these companies will be seen as very cheap and thus rise again.
Here is a list of items that most value investors look for in a stock price. N.B. these are principles, not commandments. They work as guidelines not hard and fast rules which can never be broken or find exceptions to. In share trading there are very few hard and fast rules other than trading on emotion which causes massive loss and the rule of hard work and meticulous study which must be obeyed.
- Share price should be no more than two-thirds of intrinsic worth.
- Look at companies with P/E ratios at the lowest 10% of all equity securities (particularly companies in the same or similar sector).
- PEG should be less than one.
- Stock price should be no more than tangible book value.
- There should be no more Debt than Equity (i.e. D/E ratio < 1).
- Current assets should be two times current liabilities.
- Dividend yield should be at least two-thirds of the long-term AAA bond yield.
- Earnings growth should be at least 7% per annum compounded over the last 10 years.
Other more technical factors such as the Net-Net Theory and the Margin of Safety Theory also play a part in the value investors method. You can follow the links to read about these.
All in all, this is arguably the most productive, most comprehensive and safest method of trading. I have found its application the most productive in my own trading history and though it includes a lot of hard study, times of frustration aka nail biting and a whole lot of patience waiting for the value to come out to the wider investment world, it has served well as the method for the richest man in the world and, well, that’s good enough for me.