Value Investment

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—buying a car based solely on its appearance—is a popular but less successful method.

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 Point

Seeking investments conforming to assumptions about the future may ignore the basic facts about a company's strength or growth potential.

Those who try to pick investments based on assumptions about the future may actually outnumber value investors, whose emphasis is on analysis of financial fact rather than an attempt to predict future valuation and stock pricing. Value investing does not require you to predict the future or to be concerned with a variety of unknown influences on future prices. The decision to buy a particular company's stock is based on a study of current value, a history of growth, and application of a few sound fundamental principles (see Chapter ). Returning to the analogy of the car buyer, a value investor goes to the dealership armed with comparative price and performance data, model comparisons and prices, and a very solid idea of the model and price desired. The decision is made ahead of time that if the price is available, they will buy; if that price is not available, they will wait.

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 Point

If the market were either efficient or random, it would be a 50–50 proposition to ever buy stocks. Under those theories, the current price of stock is always 'right' or 'arbitrary.'

Both of these theories are simply wrong. The market is anything but efficient. In fact, the inefficiencies of the market create may bargains. The 'market' as one entity over reacts to all news, both good and bad, meaning prices tend to move too high on good news and fall too low on bad news. These jarring price changes tend to self-correct within a few trading sessions; but once they have fallen, bargains are created in a window of opportunity.

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 Point

Short-term market trends are extremely random and chaotic. However, long-term trends rely on the fundamentals.

The theories concerning the efficiency of the market or its random nature are comforting to those looking at the market academically. But for people investing real money in shares of stock, these theories are either deceptively comforting (efficient at all times) or depressingly fatalistic (hopelessly random). Neither theory is realistic. The good news is that by applying the concepts of value investing, you can find value and a bargain price. It demands research and patience, but it is one way to build a profitable long-term portfolio. Two precepts every value investor has to be able to accept are:
  1. Inactivity in a stock's price is not a negative attribute.
  2. 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.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2020. Content published with author's permission.

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