basic framework of value investing strategies stock : It was Benjamin Graham and David Dodd who were professors in finance at Columbia University who set out the basic framework of value investing strategies when considering which stocks to pick. It is now the strategy most often thought of when discussing stock selection. The basic concept is to find those companies that are trading at a level below their intrinsic value.
Fundamentals are what it is all about for the value investor to identify the companies that are undervalued based on what their earnings, dividends, cash flow and book value indicate they should be trading at. The idea is that this indicates that there is a potential for market correction on the share price to more accurately reflect the company value.
Find Value:
Whilst on the face of it finding low priced stocks should be quite quick and easy the key point is that the value investor should be looking for quality that is undervalued and not simply those stocks that are selling cheaply. Often there is a good reason for a stock to be priced lower than expected and junk needs to be avoided.
A company that has suddenly dropped in price could have done so for a host of reasons such as management issues causing market concerns, negative publicity, sector issues and so forth. The key to identifying good opportunities is the fundamentals and good indicators that the company is selling below its worth. This is based on the current share price and never the historic value, though reviewing the historical values is an essential part of the overall fundamentals of the company.
For anyone wanting to be sure that value investing really can provide reasonable returns only need look at Warren Buffett. His place is set in history as one of the greatest investors as he made incredible returns which led to him also generating an incredible 13.02% return per annum for his holding company, Berkshire Hathaway. The foundation of Buffett’s stock picking strategy is based on the same principles as value investing even though Buffett does not consider himself to be a value investor.
Company not Stock:
For the value investor the key is always the company and not just to own stock. The whole foundation is based on finding a company, analysing it and identifying it as one that is good to own as it will shift upwards when the market makes a correction to acknowledge the previous undervaluation. For this reason the value investor is not concerned about the day to day market activities, volumes, price variations etc. This is contradictory to the foundation of the market and how it functions with the efficient market hypothesis (EMH) which declares that the stock price is a reflection of the intrinsic company value.
The value investors believe that EMH is a good theory but that the efficiency of the market is just that, a theory. They are interested in looking at the actualities of the market and where it wanders into “inefficiency” as they call it so that a company is not accurately priced. They also ignore the concept of beta or volatility as being an indicator of high risk and therefore an investment to avoid. Instead they will look at the intrinsic value and any drop in share price, which would push up the beta number, demonstrates and even greater opportunity on a mispriced stock. The thing is to have absolute confidence in their intrinsic valuation of the company so when the price drops from $10 to $15 it simply represents an amazing opportunity if the intrinsic valuation of the company is $15.
Value Stock Screening:
Qualitative Elements:
Fundamentals are what it is all about for the value investor to identify the companies that are undervalued based on what their earnings, dividends, cash flow and book value indicate they should be trading at. The idea is that this indicates that there is a potential for market correction on the share price to more accurately reflect the company value.
Find Value:
Whilst on the face of it finding low priced stocks should be quite quick and easy the key point is that the value investor should be looking for quality that is undervalued and not simply those stocks that are selling cheaply. Often there is a good reason for a stock to be priced lower than expected and junk needs to be avoided.
A company that has suddenly dropped in price could have done so for a host of reasons such as management issues causing market concerns, negative publicity, sector issues and so forth. The key to identifying good opportunities is the fundamentals and good indicators that the company is selling below its worth. This is based on the current share price and never the historic value, though reviewing the historical values is an essential part of the overall fundamentals of the company.
For anyone wanting to be sure that value investing really can provide reasonable returns only need look at Warren Buffett. His place is set in history as one of the greatest investors as he made incredible returns which led to him also generating an incredible 13.02% return per annum for his holding company, Berkshire Hathaway. The foundation of Buffett’s stock picking strategy is based on the same principles as value investing even though Buffett does not consider himself to be a value investor.
Company not Stock:
For the value investor the key is always the company and not just to own stock. The whole foundation is based on finding a company, analysing it and identifying it as one that is good to own as it will shift upwards when the market makes a correction to acknowledge the previous undervaluation. For this reason the value investor is not concerned about the day to day market activities, volumes, price variations etc. This is contradictory to the foundation of the market and how it functions with the efficient market hypothesis (EMH) which declares that the stock price is a reflection of the intrinsic company value.
The value investors believe that EMH is a good theory but that the efficiency of the market is just that, a theory. They are interested in looking at the actualities of the market and where it wanders into “inefficiency” as they call it so that a company is not accurately priced. They also ignore the concept of beta or volatility as being an indicator of high risk and therefore an investment to avoid. Instead they will look at the intrinsic value and any drop in share price, which would push up the beta number, demonstrates and even greater opportunity on a mispriced stock. The thing is to have absolute confidence in their intrinsic valuation of the company so when the price drops from $10 to $15 it simply represents an amazing opportunity if the intrinsic valuation of the company is $15.
Value Stock Screening:
Qualitative Elements:
- Value stock opportunities exist in every market and all industries and sectors. There is no barrier on where to look for them, including technology companies.
- The industries that are best to first check out are those which have had some bad publicity recently or are suffering from economic challenges. This also includes those industries that have a cyclical pattern to their operations such as the car industry or swimming pool manufacturers.
- The company that is worth a look is the one that priced at a 12-month low or is only selling at half its 12 month high.
Numerical Elements:
- Share price less than two-thirds of intrinsic worth
- Price/Earning (P/E) ratio in lowest 10% of all the equity securities
- Price Earnings Growth (PEG) should be less than one
- Stock price less or equal to book value
- Debt/Equity (D/E) ratio should be less than one, i.e. debt less than equity
- Assets should be at least twice liabilities
- Dividend yield should be two-thirds or greater of the AAA long-term bond yield
- Earnings growth over past 10 years should be 7% or more per annum compounded
All of these are recommended or guidelines and the decision to invest should be based on the overall picture and not simply one specific number.
Price Earnings – The Ratios:
Value investing is about more than finding low P/E stocks, though under-priced stock will have a low P/E ratio. This enables more direct comparison between companies from the same industry or sector. Those companies that are trading at below the ‘average’ or ‘normal’ will stand out and should be investigated more closely by value investors.
The PEG ratio is an additional calculation that helps identify and show up opportunities. It is calculated by dividing the P/E ratio by the year-on-year earnings growth. Any company with a PEG less than one indicates that it is undervalued and should be investigated.
Further Assessment:
The net-net method is another or additional calculation that is accepted for identifying value stocks. It states that a company that is operating at two-thirds of current assets is the one to pick. The idea being that the assets protect the investment and the intangibles are a bonus element. The downside is that finding such companies is a rarity.
Margin of Safety:Put in the most basic terms the concept with ‘Margin of safety’ is to build in an additional margin just in case the calculations are off a fraction for the intrinsic value. Putting in the margin so it takes those just on the line of acceptable increases the chances of having a pool of strong opportunities rather than risk mix in those that in reality are the other side of the line. Thus if a they calculate the intrinsic value as $25 then putting in a 10% margin means that it is taken as $22.50 and then the assessments made. It may well be that the stock is priced at $15 so it is still a good opportunity but those priced at $20 is too close to risk the investment, though at an intrinsic value of $25 it might have been reasonable opportunity.
Investor Summary:
There are no absolutes with value investing other than that it is essential to take the time to evaluate the various opportunities. It most certainly isn’t at the sexy end of the investment market but just looking at what Warren Buffett achieved should be enough to validate it for potential returns.
Price Earnings – The Ratios:
Value investing is about more than finding low P/E stocks, though under-priced stock will have a low P/E ratio. This enables more direct comparison between companies from the same industry or sector. Those companies that are trading at below the ‘average’ or ‘normal’ will stand out and should be investigated more closely by value investors.
The PEG ratio is an additional calculation that helps identify and show up opportunities. It is calculated by dividing the P/E ratio by the year-on-year earnings growth. Any company with a PEG less than one indicates that it is undervalued and should be investigated.
Further Assessment:
The net-net method is another or additional calculation that is accepted for identifying value stocks. It states that a company that is operating at two-thirds of current assets is the one to pick. The idea being that the assets protect the investment and the intangibles are a bonus element. The downside is that finding such companies is a rarity.
Margin of Safety:Put in the most basic terms the concept with ‘Margin of safety’ is to build in an additional margin just in case the calculations are off a fraction for the intrinsic value. Putting in the margin so it takes those just on the line of acceptable increases the chances of having a pool of strong opportunities rather than risk mix in those that in reality are the other side of the line. Thus if a they calculate the intrinsic value as $25 then putting in a 10% margin means that it is taken as $22.50 and then the assessments made. It may well be that the stock is priced at $15 so it is still a good opportunity but those priced at $20 is too close to risk the investment, though at an intrinsic value of $25 it might have been reasonable opportunity.
Investor Summary:
There are no absolutes with value investing other than that it is essential to take the time to evaluate the various opportunities. It most certainly isn’t at the sexy end of the investment market but just looking at what Warren Buffett achieved should be enough to validate it for potential returns.
