In part one of this value investing string, I discussed some pitfalls of self investing, primarily buying high /selling low, leaning too heavily on past performances to make stock selections, and most importantly not being prepared to to make value selections.
Part two went into a little more detail of the value of compound investing. I gave a more tangible example of the perks of long term investing by maximizing the benefits of compounding, as well as giving specific examples of how this makes your money work for you.
Finishing up this series, I will review some of the thought processes that I go through when I am researching stock options. Before I go any further, I should explain my thoughts on value investing.
Value, in my opinion, is buying anything that you find useful at a cost below the generally accepted price of that item. Value does not mean cheap, nor does it mean “good to have.” In order to have true value in something, it must be something that you genuinely need, and not simply want. Value does not mean buying something just because it is cheap nor does it mean buying an inferior product simply because it is low cost. Mr. Buffett has been quoted yet again “It’s far better to buy a wonderful company at a fair price, than buy a fair company at a wonderful price.”
For example, lets say I found a terrific deal on widgets. I was able to buy ten of them for 40% of their accepted value. I am able to use one of them leaving me with nine remaining. The first widget was purchased at a great value because I have a use for it. The remaining widgets were not a value because I now have nine very expensive pieces that offer no value to me because I can’t use them. Sure, I can try to resell them at 60% of their value and make a nice profit, but without a plan prior to the purchase, what do you think the odds are of me actually reselling all of these and making money. It certainly sounds like I may have purchased an item or items at a great price, but of no value to me. If I owned a widget shop, this story has a totally different meaning, because this purchase now has value to me.
Value investing is purchasing a stock (mutual fund, ETF, etc.) with a price below the intrinsic worth of that stock. Another term that is often used to identify these types of stock is one that is undervalued. Some may say that a low P/E Ratio is a good indicator of a value stock, and I would agree in some respect, but this is only part of the story. Remember Warren Buffett says “Price is what you pay, value is what you get.”
One of the most popular, and often misunderstood ratios is the P/E ratio, so lets start there. The P/E Ratio values a company by measuring its current share price relative to its earnings. Currently the P/E Ratio for the S & P 500 is roughly 19 – 20. It would therefore make sense that any stock with a P/E Ratio below 20 is a good value. Well, not necessarily. When trying to assess the true value of a P/E Ratio, we must also take into consideration the industry average as well. For a more detailed explanation please review this article on investopedia.com. Generally speaking I love to see a company’s P/E Ratio in the single digits as this typically is equivalent to a bargain basement price, but do remember to make some exceptions for certain securities as long as it is below the industry average and/or below its historical average. In my opinion, a forward P/E is much more valuable than the current P/E, looking retrospectively.
When I research a potential company to invest in, I pay particular attention to the P/E Ratio as it gives a wealth of information, but it is not the only parameter that I review. I will identify what I feel are the some of the more important considerations when evaluating stocks. I will attach a link to the Investopedia site defining each parameter, simply because they do a much better job at defining and explaining these terms than I ever could. Here is a list of other considerations that I use to identify value stocks (in no particular order):
(1) Debt Ratio (D:E): I’m looking for low leveraged companies here. The lower the debt the better. The NYU Stearn School of Business posted the average sector debt ratios for stocks based in the U.S. as of January 2016. As you can see, these ratios vary greatly depending on sector, so it is important to distinguish the sector that your stock is in to guide your evaluation.
(2) Current Ratio: The current ratio is used to measure the ability of a company to pay back its liabilities. Generally speaking a current ratio less than 1 is not good, as this infers that the liabilities outweigh the assets of that company. I look for companies with a current ratio above 1.5.
(3) Earnings (EPS): This is probably the easiest parameter to review but is often the most over looked. At the most basic level, I do not invest in companies that do not make money (show consistent earnings) Companies that do not make money go bankrupt. Graham expands on this further saying he looks for companies that have progressive positive earnings quarter after quarter. I am not so rigid in this category as I like to see upward trends, therefore a hiccup now and then doesn’t bother me as long as I can explain the reason for the drop and that it is a rarity, not the norm.
(4) Book Value (P/B): The book value of a company can help determine if the stock is over or under-priced based on assets that a shareholder would receive if the company were liquidated. I have seen some estimates that call for P/B’s below 1.20, but I feel this is too restraining. I like to look for values under 2.
(5) Dividends: I love dividends. If used correctly, dividends can be your friend, if used incorrectly they can be a nightmare. Essentially, dividends are good for the value investor because you are purchasing these companies at a rock bottom price and they may take some time, often feeling like an eternity, to have their share price start moving up. While you are waiting you can be collecting dividends on a fairly safe investment. I like to see at least 2.5% but anything over 2% has significant value. Be wary of high dividends with elevated payout ratios, as they may be purposely set high to attract investors and mask deeper issues within the company. Companies that pay dividends, in my opinion, are considering the investor’s stake in the game as well.
There are other advantages to dividends, especially consistently performing dividends. Do your own research on dividend aristocrats, I think you will find it interesting. A great read regarding the benefits of dividends is Shareholder Yield, A better Approach to Dividend Investing by M. Faber.
(6) Return on Equity (ROE): ROE is the amount of net income returned as a percentage of shareholder equity. It tells how much money a company has turned by the use of shareholders funding. My favorite podcast Investtalk likes to use 17% as a base measurement, and I would tend to agree.
(7) Price Earnings to Growth Ratio (PEG): Some would actually say that the PEG may be a better indicator of a companies value than the P/E Ratio. I wouldn’t agree, nor would I disagree, it’s the same only different. The PEG evaluates price and earnings but adds growth to the mix as well. I like the PEG to be less than 2 as a value indicator.
(8) Price to Sales Ratio (P/S): A price to sales ratio compares the companies stock price to its revenue. I like to see a P/S less than 2 as a general indicator, but I also like to compare this to the sector average as well. For my evaluations price to P/B and P/S are minor indicators.
(9) Chart Technical Data: A true value investor should not be concerned with the actual price of a stock, but they should understand when is the best time to buy. I look at a few technical aspects of the charts to make a decision when to buy, not if to buy.
I like buying when the chart is sideways or starting an uptrend. There are also some consideration regarding simple moving day averages and when to pull the trigger. If I have decided to wait until an uptrend to purchase, a 10 day sMA is a good place to start, with a decision likely around the 20 day sMA and I would hope to make a decision before it hits the the 50 day sMA otherwise you will see a lot of profit go out the door.
The bottom line though is, don’t buy on the down-slope, otherwise you are catching a falling knife. Don’t be afraid to wait for a pull back or a dip in the market. Technical data should never be used to determine value of a stock, however it does help you decide when to buy. I also like to use MACD, RSI and OBV as indicators of when to buy.
(10) Moat: The moat is the story behind the company you are considering. What makes it special when compared to all of the others, a competitive advantage as Warren (yes we’re on a first name basis now) calls it. The economic moat is literally the body of water (competitive advantage) surrounding the castle (stock) protecting it against invaders (volatility). The wider the moat, the safer you are.
I certainly did not invent or create this concept myself. I did my due diligence in research and looked to the masters of value investing, Warren Buffett and Benjamin Graham. All I do is simply apply their work and adapt it to suit my needs, experience and resources. There are many other fundamental aspects to consider like ROI, ROA, Revenue, Growth, most certainly the balance sheet, etc., but these 10 elements are what I use to get me started, all of the other stuff is fine tuning a decision.
I’ll end this series with another quote from, you guessed it, Warren Buffett “It’s better to hang out with people better than you. Pick out associates whose behavior is better than yours and you’ll drift in that direction.” I like to think that I hang out with Warren and Benjamin on a daily basis, they get absolutely nothing from me, but I have learned a great deal from them.