04) Stock Picking Strategies: Value Investing

by · October 16, 2010

Columbia University Professors Benjamin Graham and David Dodd pioneered the strategy of the value investing method during the 1930’s.  The concept of value investing is to find companies trading below their inherent worth.

Value investors look for companies that are mistakenly undervalued by the market.  They look for stocks with strong fundamentals such as earnings, dividends, book value and cash flow.  These companies are sometimes sold at bargain prices despite their quality.  Value investors see potential in these stocks and waits for the market to correct the valuation of these stocks.

Value & Quality

Value investors look for bargain prices but don’t just buy any stock that is cheap.  Value investors have to do a lot of research to make sure that they get a company with quality and potential and not just “junk”.

It is important to understand the difference between a value company and a company that is in decline. For example, Company A sells its stock for $25 per share and then suddenly drops at $10 per share.  This decline does not automatically mean that it is a good bargain.  Remember that there are a lot of factors which could affect a company’s market price.  In order for a company to be a good bargain,  a company must have fundamental worth healthy enough to be worth more than its intrinsic value. Value investing is about intrinsic value and not historic price.

To take a look at value investing, take a look at Warren buffet.  In 1967 his company Berkshire Hathaway was trading at $12 and at 2002 it was at 70,900!  This is real value investing!

Buying A Business Not Stock

For value investors, they are buying a business not stock.  When they trade, they see it as becoming the owner of a quality company.  They like to pay more attention to the worth of an underlying asset.  They don’t see volatility and price fluctuations to be a factor in the value of the business in the long run.

Contradictions

Value investors usually do not pay heed to the volatility of the stock market.  The effective market hypothesis (EMH) states that if all prices are reflecting all relevant information, then they are already showing the intrinsic value of companies.  For value investors, the opposite of EMH is true.  They look for time so inefficiency where the market mistakenly valuates a stock.

They disagree that in a time of high volatility or beta, a drop in stock prices mean that Armageddon is upon us.  Volatility does not mean that a stock is automatically risky.  If a company has an intrinsic value of $20 and trades at $15, this could potentially be a good bargain.  If it drops to $10 per share then the company is experiencing an increase in beta therefore, investors would see this stock as high risk.  But for value investors, they would see the decline as an even better bargain, therefore the lower the risk.  Volatile market conditions do not scare off value investors. In fact, they see this as a good thing.

Screening for Value Stocks

Here are some of the qualities of value stocks:

Qualitative aspects

  • Where are value stocks found? – Value stocks can be found trading in Nasdaq, NYSE, AMEX, etc.  They are everywhere.
  • Which industries are value stocks located? – Just about any industry.
  • In what industry are value stocks most often found? – They can mostly be found in industries that have recently experienced hard times.  They can also be found in industries that are facing market overreaction due to a piece of news.
  • Can a value company be one of those companies that have experienced new lows?  – Yes.  Remember we are looking for cheap.  However, its “cheapness” may not reflect its intrinsic value.

Her are the number values investors use for picking stocks:

  • Share price should be not more than two-thirds of its intrinsic worth.
  • Find companies with P/E ratios at the lowest 10% of all equity securities.
  • The PEG ratio should be less than one.
  • Stock price should be no more than tangible book value.
  • Debt should not be more than equity (i.e. D/E ratio < 1).
  • Current assets should be twice of 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 year and compounded over the last 10 years.

P/E and PEG Ratios

Value investing is not just about P/E and PEG ratios even though undervalued stocks reflect a low P/E ratio.  This is just a way to compare companies in the same industry.  Example, if a technology company has a PE of 20, a company that trades at 15 should start to ring some bells for value investors.

PEG ratio is used to calculate a company’s intrinsic value.  If a company’s peg ratio is less than one, then it is a considered to be undervalued.

Net-Net

The net-net method states that if a company trades at 2/3 of its current assets, then no other methods are necessary.  Why?  Because if a company trades at this level then you are basically getting all its permanent assets including the intangible ones for free! Unfortunately, this sort of company is a rare find.

Margin Of Safety

Everybody needs a margin of safety, including value investors.  Think of it this way, if you were setting up a fireworks display you calculate that staying 100 feet away from the explosion is safe. But just to make sure, you stand 125 feet away from the display.  This is your margin of safety.

In value investing, it is simply leaving room for error in your calculation for the intrinsic value.  If a value investor calculates a company’s intrinsic value to be at $30 per share, he adjusts his computation and pegs the price at $26 per share.  If the intrinsic value of the company turned out to be lower than previously calculated, then the investor would be saved from paying too much from the stock.

Conclusion

Value investing compared to other styles may be boring to most investors because it relies on a tight screening process.

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