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Value Investing

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Equities are often viewed through the prism of being either value or growth stocks.

This is especially true when reviewing different investment styles for equity funds.

Today we will take a look at value investing.

Value Stocks

Stocks in this category are seen as value buys.

That is, the stock is considered undervalued based on quantitative and qualitative analysis.

The objective is to identify companies that trade below their intrinsic (i.e. true) value. Then purchase shares and wait patiently for the rest of the world to see what they have missed.

Companies in this category tend to be: established companies that have fallen out of favour and been beaten down in price due to poor performance, bad news, lawsuits, management changes, etc.; smaller companies that are not extensively followed by analysts and the investing public; mature companies that have minimal upside for internal growth, so they pay out their earnings in dividends rather than reinvest in the company’s operations.

In theory, this is an excellent way to invest. And in any other investment you make (house, art, coins, etc.) you always are trying to find acquisitions being sold at a discount to market value.

Benjamin Graham and David Dodd are considered the fathers of this investment style. Warren Buffett uses this approach in a slightly modified form. Hard to argue with those investors.

I like value investing. But it is not an easy process.

Given the amount of publicly available data, the number of analytical tools one can use to screen stocks, and the sheer volume of investors searching for the next great value stock, it is not simple to find a hidden gem all on your own.

If you lack the time or expertise to do your own in-depth analysis, value equity funds are a good way to invest. Many are professionally managed. And by purchasing a number of companies that meet the value criteria, funds spread out the risk of the individual stocks.

Quantitative Analysis

In analyzing companies under a value approach, analysts look at quantitative data.

This data is known as a company’s “fundamentals”.

The fundamentals of a company are compared against its historic results and expected future performance. A company is also compared against the fundamentals of its peers, the industry and sector in which it operates, and the stock market as a whole.

Common fundamentals include: price/earnings; price/book; dividend yields. We will look at each in separate posts.

It is relatively easy to perform quantitative analysis.

Find the correct data – not always a simple thing to do, especially for small companies -, plug it into the appropriate equation, and you have your result.

But if it were that easy we would all be very wealthy.

Qualitative Analysis

Investors tend to do a decent job on quantitative analysis.

What usually trips them up is the qualitative side.

I believe that qualitative analysis is the key to any investing decisions. Whether they be stocks, buying a home, or lending money to a friend. So pay close attention to this area.

In respect of value investing, the qualitative analysis is what (hopefully) separates the value stocks from the junk.

This is critical, because based on the quantitative data, terrible investments often look like value opportunities. No one wants shares in the bad companies. Weak demand and excess supply drive the share price of a junk company lower. Unfortunately, the fundamentals (being a function of the share price) tend to look very good, when instead they should be a warning to potential investors.

When we cover the common fundamentals later, we will go through some examples.

Qualitative analysis uses non-numeric data to assist in separating the wheat from the chaff. It includes an assessment of: company management; operations; competitors and the industry.

Management

Management is the number one driver when I consider companies.

Management makes the decisions that impact operating performance and ultimately the share price. As an investor, you want to invest in well-run companies. If you do, you will increase your probability of positive returns.

Who is on the management team?

Review their credentials and experience in the industry. What is their track record of success?

With key management, past performance is an indicator of future results. Both good and bad.

How long has the current management team been in place?

If a successful company has recently lost key management, it may be a sign of problems or changes in the approach to running the company.

If management is new, were they successful in their previous ventures?

These are some of the questions you should consider.

Operations

What does the company do? Does the business model make sense in today’s world?

A few years ago, manufacturers of floppy disks were profitable. Today, if they have not evolved into making flash drives, they are no longer in business.

What is your experience with the company’s product?

Consider something as simple as cola products. Let’s pretend that Coke, Pepsi, and RC Cola are all separate companies with only one product, cola.

When you are at the grocery store, in a restaurant, or at an event, what do you see? A lot of Coke and Pepsi for sale, but much less for RC. Intuitively, who do you think sells more cola?

When you plan to invest in a company, think about how its products are seen in the world.

The same is true for your personal likes and dislikes.

For the most part, you are the “average” consumer. Trust your judgement when investing.

Say you plan to buy a smartphone and options include iPhones, Blackberries, and Droids.

Which one is getting the best reviews? Which one did you purchase or would like to buy? What are your friends buying?

If you are a typical consumer, then there is a high probability that other consumers are making the same choices as you and your friends. This results in stronger sales than competitors, which should enhance profitability and the share price.

When assessing if a particular company is a value play, always consider its products. If the product is junk, there is a good chance that the stock is also junk and not a value investment.

Industry and Competitors

Just because your quantitative analysis indicates a stock has potential value does not mean it is a great investment.

If the industry is in a downturn, even good investments may suffer.

Consider the real estate market. In North America, it is currently in a major slump. If you intend to sell your home, you may have to accept less than you believe to be its true value. It is not the fault of the house, rather it is an industry wide issue.

Often you will find a well-managed company that sells quality products. But in their market segment, they cannot compete against even stronger competitors.

If one intends to buy an MP3 player, most people look no farther than the various iPods. That makes it difficult for other manufacturers to make inroads into the industry.

You may love a product, but always review it in light of the industry before investing.

Intrinsic Value

By conducting both quantitative and qualitative analysis, you attempt to determine a stock’s intrinsic value.

But what is this true value?

And that is the problem with value investing.

What exactly is a stock’s intrinsic value?

Based on your analysis, you will arrive at one number. Other investors, using the same publicly available data, will arrive at different valuations. Some will be higher, some lower.

No matter how good the analysis, many investors will be incorrect.

And no matter how poor the analysis, some investors will get lucky.

Further, unforeseen events may render even the perfect analysis irrelevant.

Consider the September 11, 2001 terrorist attacks in the US.

On September 10, certain assumptions were made in respect of investments. Interest rates, government spending, oil prices, consumer demand, company revenues, to list a few variables.

On September 11, many factors changed completely. Share prices across the board fell. The US government launched a long and costly war. And so on.

As you can see, determining the “real” value for a company is difficult, if not impossible.

Should You Value Invest?

While it may be impossible to accurately predict a company’s intrinsic value, does that mean you should ignore value investing?

Not at all.

Studies often show that value investing outperforms growth strategies.

I do not agree with this as a general statement as other data I have reviewed show mixed results. But there are some who believe value investing is the only way to go.

I do believe that investors following any investment strategy (e.g. growth, balanced, Japanese equities) must follow the tenets of a value strategy. After all, when you get to the heart of value investing, it is simply common sense.

Find companies that are undervalued relative to what you believe is their true worth.

Then buy their shares.

At its basis, it is that simple.

And even if you follow a growth strategy you need to adhere to these principles.

Implementing a value investing program requires investing skill. It also takes time and luck to do well picking individual value stocks.

It is difficult, but not impossible. As the success of Warren Buffet and others can attest to.

Many mutual funds follow a value investing pattern. I suggest you consider initially using them if you wish to follow a value strategy in your portfolio.

As you develop experience and confidence, then consider trading individual stocks.