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Value Investing: Bargains With Caveats
Focusing on a Company’s Intrinsic Value
BetterInvesting methodology relies on studying a company’s revenues, earnings and other fundamentals in a search for quality growth companies whose stocks are selling at reasonable prices. Another type of fundamental investing seeks so-called value stocks.
Investors in value stocks typically look for bargains in the stock market that will allow to them to capitalize on the most basic of all investment dictums: Buy low and sell high. But this isn’t as easy as it sounds, despite the fact that Warren Buffett — perhaps the world’s most famous current practitioner of this approach — has amassed a financial empire through value investing.
The initial challenge in becoming an effective value investor is to recognize that many other investors, including those with deep pockets such as managers of mutual funds and pension funds, are also seeking substantial returns using this same strategy. These professional investors aren’t looking at today’s performance stars or at the long-term winners often considered the backbone of an investment portfolio. Rather, they’re trying to find the wallflowers nobody is asking to dance because they’re perceived as unattractive, ungraceful or just plain dull.
Once they’ve been discovered, however, these investments draw a great deal of attention and are wallflowers no more. The potential they offered as bargains disappears, and value investors begin the search again.
Companies that might fall into this category include well-known retailers that have been overshadowed by the competition, respected manufacturers that haven’t substantially updated their products in a generation and even financial services companies that have been buffeted by miscalculating the market.
Picking Through the Bargains
As a value investor, you need a long-term perspective and the conviction to wait out short-term downturns. This doesn’t mean, however, that value investing is always a buy-and-hold strategy. Instead, some value investors establish a target when they buy, and they sell off a portion—perhaps 50 percent — of each holding when its price has increased by a set percentage. This approach not only protects profits that have been realized but also frees up cash for new opportunities.
As with any investment strategy, the key challenge for value investors is to find appropriate investments. The place to start is by assembling a list of undervalued securities. Undervalued stocks, by definition, have price-earnings and price-to-book-value ratios that are lower than average as well as dividend yields that are higher than average as compared with comparable companies in their industry.
These are typically companies most investors aren’t buying and may be actively selling. Investors may be reacting logically to recent negative news about the company. Or they may be behaving inexplicably: Remember that emotions, including irrational ones, often play a significant role in the decisions investors make.
After you identify several candidates, you’ll need to narrow the field. One way to begin is to take a closer look at each company: Do you understand its business, and does the information you have about it tell a clear story? Do the long-term prospects seem promising, perhaps because the company has competitive advantages? Has the company been making money consistently over the long term, or are the financial results erratic?
You must also develop a set of criteria and a methodology that will help you determine a corporation’s intrinsic value, or what it’s really worth regardless of its current stock price. This approach is essential because value investing isn’t about buying cheap. It’s about paying a low cost for something of potentially long-term value.
Sticking With the Fundamentals
The fundamental information you’ll want to focus on in evaluating companies as value investments includes profit margins, the number of consecutive years a company has been profitable, patterns of revenues and earnings, and dividend payouts to see whether they’ve been consistent, steadily increasing or fluctuating considerably. And it’s always important to look at a company’s level of debt, particularly relative to its assets: Are they in balance, or does the level of debt seem burdensome?
Other fundamentals you might want to evaluate include a company’s current assets in relation to its total liabilities, or what’s known as the current ratio, and the company’s discounted cash flow — the estimated present value of cash it expects to receive in the future.
A Word of Caution
When it comes to value investing, there’s also one caveat to keep in mind: The same factors that make a stock a probable candidate for a value investor can also be the signs of imminent meltdown. That’s why it always pays to do your homework. It can protect you from companies whose business is smoke and mirrors while helping you identify firms whose stock is undervalued and worth considering for your portfolio.
Virginia B. Morris is the Editorial Director for Lightbulb Press.