The Value Investor
Buy quality at a good price
Value investing is a popular investing strategy which uses fundamental analysis in order to determine a company's fair value. The basis for this strategy is that the stock price and the business valuation are two different figures.
The basic premise for value investing is to buy a stock when its price is below its valuation (often referred to as intrinsic value). However there are several approaches as to how the intrinsic value is determined. Probably the most popular approach is to use the company's net assets value (also known as book value) and look for stocks where the market is not currently willing to pay for any potential future earnings. This means buying stocks that are trading around their assets value.
A common misconception amongst stock investors who do not consider value investing as a profitable strategy, is that any stock that has had a significant price decline is considered a value stock.
As an example of this misconception, the chart below shows how the stock price for Technical Communications Corp. NASDAQ:TCCO continues to decline despite the current bull market driving stock prices up. Also the stock is now trading below its book value.
Chart 1. TCCO 5-year chart
While Technical Communications Corp. is certainly in a downtrend while the market is working its way higher during the current bull market, the key fundamentals shown in Table 1. below for Technical Communications Corp. show a company that is financially struggling.
Table 1. TCCO - Key Fundamentals
As Table 1. above shows, the key fundamentals for Technical Communications Corp. show that the revenue and book value have both declined over the last five years. Also the earnings losses have generally increased. These are not the sort of fundamental characteristics we look for in a value stock.
Just because a stocks price is in a downtrend does not mean it is a value stock. The stock may be in a long-term downtrend for the simple reason that its net assets are continually declining year after year and the company may well be heading into liquidation. A likelihood of bankruptcy can be determined with a simple calculation known as the Z-score.
Only good quality companies with a history of producing reliable revenue and profits are considered, and one important fundamental measure is that the company's net assets are not declining year on year.
An example of a stock that is currently trading below book value which is displaying the desired key fundamentals is Capital One Financial Corp. NYSE:COF. The key fundamentals are shown below in Table 2.
Table 2. COF - Key Fundamentals
When using the net assets as a company's intrinsic value, stock investors need to be assured that the stock price can rebound higher again in the future, and it can not do that if the company's fundamentals are deteriorating.
Value investing is essentially a bargain hunting strategy that involves buying fundamentally sound companies at a price that is less than what they are worth. Sometimes growth companies that have slowed in their annual growth rates can make good value investing candidates as long as the former growth stock's fundamentals remain solid, which leaves the only reason why it was heavily sold off was that its high growth rate was no longer sustainable.
Generally the stock price of a fundamentally sound company only drops below its net assets value when some event caused investors to sell out, which could be anything from a company reporting less than expected profits, to a generally poor economic environment.
Historically, the stock price of most companies drop below their net assets valuation at some stage and this is where value investors seek to buy their stocks. Value investing is more concerned with the stability of the company than it is with its future growth prospects. The main reasoning for this is that the stock is purchased at such a low price, that even just a small rebound in the stock's price leads to a significant profit.
The stock's price can remain depressed for quite some time and as such considerable patience is required. Sooner or later the stock price rises above the company's net asset valuation and the patient investor is rewarded as they purchased stocks while prices were depressed.
Some value stocks even turn into growth stocks, which can occur with new management changing the direction of the company through aggressive marketing etc. Certainly any value investor holding such a stock will be extremely pleased as they ended up purchasing a now high PE stock at a bargain price. This was a favorite strategy of the famous investor - Peter Lynch who looked to buy future growth stocks at value prices.
Value stocks can turn into growth stocks and
some value stocks are also growth stocks
Some stock investors use a different criterion to determine whether a company is considered a value stock or not. While using the company's net asset value as the benchmark figure is the more popular method used by bargain hunting value investors, some investors use the forecast PE ratio to determine if a stock is overvalued or undervalued.
Using the forecast PE ratio method, a stock is considered undervalued if its PE ratio is less than the forecast EPS growth rate. Conversely, a stock is considered overvalued if its PE ratio is more than its forecast EPS growth rate.
However caution needs to be exercised with the forecast PE ratio approach, as the sole basis for determining whether a stock is undervalued is based upon forecast data, which is merely an analyst's estimate of what might happen in the future.
Indeed most value investors would prefer to use the net assets valuation approach as this method uses actual historical data. Further more, this method provides an absolute valuation.
Value investors are essentially buying stock at a price that does not include any future profit potential as they are only paying for the company's net assets. A company that continues to make a profit into the future will sooner or later reflect this in its stock price, thus raising its stock price back above its net assets valuation price.
Stock investors seek out value stocks by analyzing the fundamental information available to them. The characteristics of good value stock candidates that investors look for include the following.
Characteristics of good value stocks
- Fundamentally sound with a history of reliable revenue and profits. This is extremely important and cannot be emphasized enough. Without this, there is no value stock.
- The stock price is at or below the company's net assets value which has been stable or increasing over the years. This combined with a fundamentally sound company is what makes a good value stock.
- Typically, both the current and forecast PE ratios are low.
- Mature companies that have been in business for quite some time are best. Newer companies that have been in business for only a couple of years have not yet proved their reliability. Companies that are in traditional older industries are more suitable.
- Typically they are smaller companies, even though bear markets can see numerous larger fundamentally sound companies in the S&P 500 sell down to their net assets value.
- Generally they are out of favor with the financial press who tend to focus only on the negative aspects of the company.
- Insiders such as directors and key employees purchasing shares rather than selling shares. These insiders know the company and their own buying provides confidence that the company is fundamentally sound.
- Generally the stock's price has been declining from its previous peak which makes some stock investors nervous. Stock investors tend to be more confident if the stock's price is climbing rather than falling.
Setting up a value investing portfolio can take some time depending on the state of the market, as good quality value stocks become increasingly difficult to find in strong bull markets.
The ongoing portfolio management usually does not take a lot of time. Investing in a fundamentally sound company that was bought below its net assets value usually only needs a review of the annual financial statements.
Quarterly earnings are not that important to the value investor as any negative reporting that would ordinarily drive a stocks price down towards its net assets value has already occurred. That is, the value investor already bought below its net assets value which means that any further price decline would be minor.
The main issue for the value investor is to keep an eye on the company's net assets value. Should the net assets value decline rather than remain stable or increase, then this is a sign that the company may be under financial strain and thus may no longer be a value stock.
Value investing is a relatively low risk strategy for generating long term wealth for the patient investor and can be extremely profitable during periods of slow economic growth, as this allows investors to buy good quality stocks at bargain prices.
Value investing is typically a long-term investment strategy that is generally suited to a buy and hold portfolio. The long-term returns of this strategy are quite impressive and the effects of a bear market are fairly minimal as the stocks have already been sold down.
Traditional Value Investing
The Benjamin Way
Benjamin Graham - the father of value investing
The concept behind value investing was developed by the famous investor Benjamin Graham during the 1930s and he is often referred to as "the father of value investing".
Benjamin Graham was also a finance professor and essentially developed the modern day financial evaluation techniques known as fundamental analysis (which in the early days was more commonly known as security analysis). Benjamin Graham was a through financial analyst who noted that stock prices continuously alternated between being overvalued and undervalued. He attributed this to an excess of optimism and pessimism.
He noted that the stock price the market was willing to pay was not consistent with what the stock was actually worth, which he referred to as Mr. Market's offer to buy and sell. He further noted that a stock is nothing more than a business and as such has a business value, and the market was merely reacting and overreacting to short-term emotions brought about by financial news reports, tips, rumors and speculation that fuels the emotional state of investors.
From his observations and financial analysis of the stock market, he concluded that stocks at some stage will be trading at prices that are below their book value and even below their net current assets value (working capital). This meant that investors were so pessimistic about the stock that they were willing to sell at a price that assumed the company had no future profit potential. He termed this as a company that was worth more dead than alive.
Thus it became clear to Benjamin Graham that a profitable strategy for investing in stocks would be to identify financially sound companies and buy them when their stock prices were down at their absolute minimum price, which is below their tangible book value and even below their net current assets value (working capital).
Further to Benjamin Graham's tangible book value and net current assets value concept, was the notion of "a margin of safety", which he deducted from the net current assets value to arrive at a price he was willing to pay for a stock. Benjamin Graham generally used a 33% margin of safety, which means he seek to buy stocks when they were trading at a price that was 33% below the stock's net current assets value.
While Benjamin Graham had other value investing strategies, his most famous tactic is his net current assets value strategy which is the ultimate in bottom fishing.
This is not to say that Benjamin Graham considered the net current assets value to be the company's valuation, as the company' valuation is the sum of its discounted future cash flows, his net current assets value strategy simply attempted to buy stocks that the market had so pessimistically driving down to unsustainable low levels. Thus, if the opportunity presented itself, the company's net current assets value gave him a guide as to where this rock bottom price level might be.
Is Value investing still valid today
Back in the days of Benjamin Graham, most companies tended to have balance sheets that consisted largely of tangible assets that in the advent of liquidation could be readily sold. This was the basis for Benjamin Graham's principles, that a stock had a price floor, so if the stock price remained below its tangible book value, it could be subject to a takeover and the suitor could merely realize a net gain by liquidating the assets. The tangible assets of these companies include such items as plant and machinery, office equipment, land and buildings, motor vehicles and cash in the bank.
Shown below are some companies that have balance sheets consisting largely of tangible assets.
Companies with balance sheets consisting largely of tangible assets.
Company manufactures and sells steel rolled products.
PetroChina Company Ltd. NYSE:PTR
Company produces and distributes oil and gas.
Korea Electric Power Corp. NYSE:KEP
Company generates, transmits, and distributes electricity.
Table 1. below shows the asset values and the industries that the above companies operate in.
Table 1. Companies with Tangible Assets
In Benjamin Graham's days, industries such as those listed above in Table 1. were typical of the industries that Benjamin analyzed and selected stocks from.
However, industries are evolving with the advent of technology and many of these new technology companies have balance sheets that are light on for tangible assets and can consist largely of intangible assets. These intangible assets such as patents, software, brand names and goodwill are difficult to value and should a company be broken up, may not realize the full value that was included in the balance sheet statement.
The tangible book value actually excludes intangible assets, which means the tangible book value for a technology company may be considerably less than the balance sheet's net assets. As an example, a smaller software development company which provides specialized commercial software programs will have very little tangible assets. This company probably does not have any real estate on their books, choosing instead to rent their premises. Thus their tangible assets are probably limited to office equipment. However, this company will probably have a significant intangible assets value due to patents and software rights.
The question for the stock investor is whether value investing as portrayed by Benjamin Graham book concept is still useful today. The short answer is - it depends on the industry?
Benjamin Graham's analysis revolved around industries with significant tangible assets, such as manufacturing for example. Since these industries are still present today, his investing style can still be used with these stocks since nothing has really changed.
However, for industries that have significant portion of their assets as intangible assets, the tangible book value approach (yet alone using the net current assets with the 33% margin of safety) would rarely ever see such a stock that was financially sound trade at such a low price level, thus making this approach almost useless and pointless.
There are a lot of financially sound stocks that will
never see their stock price below it’s book value
If the stock is an old world type company, Benjamin Graham's tangible book value approach still works well today, but if it's a new age stock with high intangibles, then about the only stocks that will trade down that low, will be company's that are not fundamentally sound or at least have run into significant financial problems.
To help overcome this issue with intangible assets, a variety of modern concepts have been developed which attempt to define the valuation of a stock and provide a means of defining when a stock is undervalued. The simplest and a popular approach is to use the company's net assets value which includes the intangible assets and goodwill (also known as the stockholders' equity) which works quite well for companies that have made a lot of acquisitions (since acquired goodwill is included on the balance sheet), but it does not work well for companies that have grown through internal expansion (as internally generated goodwill is not included on the balance sheet).
To summarize, Benjamin Graham's tangible book value approach is still used today, however investors need to realize that this investing approach cannot be used on every stock and strong bull markets will provide very few candidates.
Finding Good Value Stocks
Find good quality stocks that are financially sound
The value investor needs to thoroughly understand the benefits and risks associated with value investing, and that the aspiring stock investor has the patience required for this style of investing.
Constructing a suitable portfolio is essential to being a successful value investor. Too many aspiring value investors actually end up buying stocks that are nothing more than cheap junk stocks, most of which are heading straight towards financial dome.
The ongoing maintenance for a value portfolio is fairly minimal, with most of the effort needed being in setting up the portfolio. Once setup, the portfolio does not require day to day attention.
Generally, value investors will diversify their portfolio across varies industry groups rather than concentrating on one or two industries. Also, holding a higher number of stocks with smaller share quantities reduces the impact on the portfolio if any one stock performs poorly. Diversification and position sizing are key components of risk management and are extremely important with value investing.
The value investor needs to obtain a good balance between reducing investing risk and the time needed to set up the portfolio. Holding 10 to 20 stocks is generally suitable for most investors. Holding more than 20 stocks marginally reduces the risk further, but this now increases the effort needed to set the portfolio and also starts to require more time to monitor the portfolio.
Finding Good Value Stocks
The whole basis for finding good value stocks is to find good quality stocks that are both fundamentally sound and are trading at a price that is less than the company's book value which is also know as its net assets value. This approach is based on the intelligent investing principles taught by Benjamin Graham who is credited with popularizing this style of investing. While Benjamin Graham actually used tangible book value (which excludes intangible assets and provides a lower figure), modern day value investors often use book value as it is becoming more difficult to find good value stocks trading below book value yet alone below tangible book value. Benjamin Graham also used other methods for obtaining an intrinsic value and his personal investing strategies actually used working capital (net current assets) as the basis for intrinsic value.
Probably the world's most famous value investor is Warren Buffett who made good use of Benjamin Graham's teachings, and some of his tactics are also incorporated here in building a value investing portfolio.
While there are several differing views on just what constitutes value investing and how to exactly determine when a company is considered a value stock, the main principle used here is that a value stock is a stock that is currently trading at or below its net assets value and the company is fundamentally sound. This means that the valuation assumes that the market is currently ignoring the fact that the stock is actually a business that makes a profit.
Online stock brokers generally have some type of fundamental screening application that value investors can use to obtain a list of potential value stock candidates.
- The first step is to run a screen to filter and sort stocks where the stock price is below the company' net assets value. Some investors prefer to screen for stocks where the price is above net assets value (book value) by a maximum amount of say 20%.
- Market capitalization now needs to be carefully considered. Basically, the smaller the company, the higher the risk will be and the greater the profit will be. It is more difficult to find large companies trading near their net assets value (especially in strong bull markets). What range of market-cap values to accept is dependant on each individual investor's personal preferences and current market conditions?
- The next consideration is the industry group. This style of value investing tends to be more reliable with stocks that are in traditional older industries, with companies that have a high proportion of their balance sheet assets as tangible assets. Stocks with high intangible assets relative to tangible assets are generally more risky since their tangible book value is relatively low (which means in the advent of liquidation, their realization value of their assets that can be sold at auction is relatively low).
The next step is to filter this list for stocks that are fundamentally sound. The following basic criteria can be used.
- The net assets value over the last three to five years should be increasing, which shows financial strength. The more years of historical net assets value that's available, the more accurate the long term picture will be. Company's where the net assets value is declining over the years are using up their working capital and/or depleting their assets; these are companies with financial problems. The risk of bankruptcy can be checked with a calculation known as the Z-score.
- The current ratio is 2 or more. That is, the current assets are more than twice the current liabilities. Higher ratios are preferred, which means that the company adequate working capital and does not need to rely heavily on short term financing.
- The annual EPS for the last three to five years that are all positive is preferable. The more years of historical EPS that's available, the more accurate the long-term earnings picture will be. It is preferable that the EPS figures are not declining year after year, however the last annual EPS may well be the lowest.
- The annual revenue for the last three to five years is not declining. The more years of historical sales revenue that's available, the more accurate the long-term picture will be. The last annual sale revenue figure may well be the lowest.
- Should have positive free cash flow, the larger the number the better. This cash flow gives the company the ability to weather difficult operating conditions.
Selecting which Stocks to buy
By now, the list only contains those stocks that are undervalued and are fundamentally sound. These are the most important criteria for a good value stock.
The following are more minor but serve to increase the likelihood of the value stock succeeding.
Selecting the Stocks:
- Stocks with declining profit margins are not desirable as this indicates that the cost to produce the revenue is increasing.
- Stocks with a low current PE ratio are desirable. Negative PEs are meaningless, but if the company did make a loss then preferably it's only a minor loss.
- Any analysts estimate upgrades or any current quarterly earnings that exceeded analysts forecasts are desirable.
- Any insider buying or at least no insider selling is desirable.
- Buy recommendations by analysts are desirable, but sell recommendations are not that important.
Once the final list is completed, then the stock investor needs to determine which stocks to select from this list. To a certain extent this depends on how many stocks are in this list.
For the stocks that meet the above criteria, then the stocks with the lower price to book value ratio would probably be the wiser choice as there is less downside risk and more upside potential for the stock's price to appreciate.
It is a bonus if the stock investor has read through the latest financial report for each candidate. This will provide information of management's objectives and future direction for the company.
Stock investors who are intimately familiar with the industry that a particular candidate belongs too are at an advantage. These investors can more readily determine whether a company's product or service is still in strong demand or whether some new technology from a competitor may be now dominating the industry.
It is generally better for the stock investor to be choosy and only include the best candidates in their portfolio and exclude the marginal candidates. Hastily filling a portfolio with marginal candidates only increases the risk. The portfolio can be built up over time by more carefully selecting only the best stocks.