The way you select investments ultimately determines how successfully you will manage your portfolio and create future profits. The concept of value investing appeals to many people, especially the more conservative, because it bases decisions on analysis of the basic financial strength of a company, combined with the search for bargain prices of shares. This is the equivalent of buying a car by comparing ratings and performance, and then looking for an attractive discount.
The alternative, based on predicting the future and then trying to find companies most likely to grow into the assumed scenario, might succeed but it is much less scientific than applying the principles of value investing. The technique of trying to anticipate the future is flawed in the sense that such assumptions are rarely accurate. It may also ignore or overlook some of the basic facts about a company's financial strength, competitive position, product or service trends, and economic forces that are going to affect future value.
Key PointSeeking investments conforming to assumptions about the future may ignore the basic facts about a company's strength or growth potential.
The more impulsive car buyer goes to the dealership with little or no information other than what they might have heard about the brand. They end up buying for reasons that make no sense to the value investor. For example, they might buy a red car because it looks so nice . . . without considering the ratings, price, or performance issues.
For stock investors, the same principles apply. Value investors focus on individual companies, review the history of growth, read the annual reports, and decide in advance what is a fair price per share of the stock. It is simple and logical, but it requires more work. Once the true value of a company has been determined, the value investor will look for a buying opportunity. This means they will buy stock in the targeted company only if they can execute an order below the fair value price.
Do bargains arise in the market? Some theories claim that the current price of a share of stock is either efficient or random. (See Chapter .) An efficient price is one that has already factored in all known information about the company, meaning the price is always fair and accurate. A random price is one that changes without any prediction and may move up or down for reasons that cannot be known in advance.
Key PointIf the market were either efficient or random, it would be a 50â50 proposition to ever buy stocks. Under those theories, the current price of stock is always 'right' or 'arbitrary.'
Few people accept the idea that the pricing of stocks is random. Many reject the principles followed by value investors, noting that financial information is always out of date by the time it is published. However, current news about products, earnings, and market perceptions all affect the value of stock very specifically. Rather than believing in the random approach to value, it makes more sense to recognize that there are many things affecting price, some canceling one another out and others confirming the current trend.
Always remember the distinction between a technical trend (price movement) and a fundamental trend (changes in profitability, working capital, or financial strength). These are not the same, although they can be used together in analysis of companies and their stocks. However, even a consistent trend does not mean that short-term markets are efficient by any means. In the long term, a value investment is likely to be efficient in the sense that properly selected companies will experience growth. In the short term, however, the market is extremely inefficient and chaotic.
Key PointShort-term market trends are extremely random and chaotic. However, long-term trends rely on the fundamentals.
- Inactivity in a stock's price is not a negative attribute.
- The market rewards patience.
It could take months, and in some cases years, for a stock's value to prove out the theory behind value investing. It is tempting to pay attention to the daily up-and-down changes in a stock's value, but that is not the way to preserve capital, avoid fast losses, or time decisions well. Value investors are patient and are willing to put in the time to research and analyze a company before buying shares.