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Value Investing

Terminology

Bankruptcy

Bankruptcy occurs when a company can no longer pay its debts. The company is usually liquidated which means than all the company's assets are sold and the creditors paid with the proceeds. The creditors normally only receive a portion of the amount they are owned.

Fundamental Analysis

Fundamental Analysis involves analyzing the financial data of companies in order to determine their suitability for a particular investment strategy.

Price Earnings Ratio

Price Earnings ratio (PE). A company's share price divided by the company's Earnings over a 12 month period.

Z-score

The likelihood of a company going into bankruptcy within the next two years can be predicted with a probability calculation known as the Z-score.

The Value Investor

Buy quality at a good price

Value Investing - The Value Investor; picture of investor studying stock charts for earnings and dividends checking for intrinsic value if cheap enough

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

The Value Investor - Chart showing stock price declining over  five year period

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

Value Investing Table 1 TCCO - Key Fundamentals revenue earnings and book value

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

Value Investing Table 2 COF - Key Fundamentals revenue earnings and book value

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 - The Value Investor; picture of man holding clipboard with graph checking revenue data for trends to bottom out for good value to buy now

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.

Value Investing - The Value Investor; picture of financial chart for earnings and revenue data plotted on bars against a light blue background panel

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.

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