What is value investing? One author describes it simply as “looking for cheap stocks.”
The reason behind the idea, he adds, “is that if you don’t pay too much for what you get, there’s less chance of losing money.”
Last time, I suggested that we go back to studying several investing philosophies. The first of which is value investing, which saved a friend’s investment positions from losses during the recent global sell down that was set off by the US Federal Reserve’s announced plan to wind down the bond purchasing package of the economic stimulus program.
The philosophic bent of value investing, as suggested by the said author, is bargain hunting. The principle is to seek stocks that are selling at low prices.
Value investing, however, is more than just picking up low-priced stocks. What the author meant was to seek stocks that have been “undervalued” (or overvalued, as the case may be) compared to how much they earn, together with the value of their assets.
The price earnings multiple or P/E ratio is the most popular quantitative filter used to classify value stocks. The main thesis of this is that the P/E of a stock should be lower than the growth rate of its earnings. Thus, if a stock has an earnings growth rate of 20 percent, its P/E should be below 20 for it to be considered a value stock.
A stock is said to have become a value stock when its current P/E has dropped below the average range of its historical P/E or the relative P/E. This happens when stock prices fall due to intervening market developments.
In the same manner, a stock is deemed to have become a value stock when it traded below industry P/E.
But the main basis in determining whether a stock has become a value stock is its P/E level in relation to its earnings growth rate.
This brings us to the question of which growth rate to use. Will it be the past or the future? The advice is to follow and use both.
But, as one author claims, “we judge the future by how a stock has performed in the past.” He cites the following: “Let’s say two stocks are projected to grow by 25 percent per year. For the past five years, Stock A has grown its earnings by 30 percent and Stock B by 10 percent.”
Now, which stock do you think has the better chance of meeting the 25-percent future growth rate?
The aUthor’s answer to the question is “the one with the superior historical growth rate.”
The same principle applies in looking at the quarter-to-quarter earnings growth of a company. A company with a consistent and/or increasing growth rate in the past has better chances of hitting better results.
Unfortunately, all references claim there is no “perfect number when it comes to earnings growth. It will always be a judgment call.”
The most that author could offer is this: “These stocks could be any one of those whose companies have been overlooked on their journey to success, have fallen on hard times after more successful years, or are in a slump for any number of reasons.”
“They’re on a comeback, with growth potential at the least investment cost to value investor as their shares are hopefully at the bottom of an uphill climb,” one added.
Bottom line spin
The fact about value stocks is that they must have at least a favorable earnings prospect. Without it, the low P/E means nothing.
As one author further explains, “value stocks epitomize the GARP stock (growth at a reasonable price) although a true value stock is more GABP (growth at a bargain price).”
These comments introduce the element of growth to value investing. Like north and south, the two is a continuum that makes the idea of growth a necessary part of value investing.
Warren Buffet clearly captured this when he said, “market commentators and investment managers who glibly refer to ‘growth’ and ‘value’ styles as contrasting approaches to investment are displaying their ignorance not their sophistication.”
On this basis, we will continue our study of “value investing” as applied by past and present stock market masters and as presented by Glen Arnold in his book, “Value Investing,” with additional references from other authors.
The personalities will include the following: Peter Lynch with his “niche investing,” John Neff’s “sophisticated low price-earnings ratio investing,” Benjamin Graham’s “three forms of value investing;” Philip Fisher’s “bonanza investing,” Warren Buffet’s and Charles Munger’s “business perspective investing.” Also, take up the “value growth” method of Glen Arnold.
Follow the series of reviews on the wining investment strategies on value investing as applied by the aforementioned successful investors and stock market traders. These could help improve your game in the market.
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