With an impulsive method for buying stocks, you cannot know when to sell. By establishing a clear set of criteria for how and when to get in, you also can monitor those standards and, if and when they change, know when it is time to sell.
Setting criteria for buying also defines criteria for selling. Without the first step, you cannot know when or why to sell.
Value investors differ from all others in the sense that they set a number of important rules for how and when to buy. If the status of a company changes, the value investor is supposed to sell the stock. So it is a disciplined approach based on defining and seeking value and keeping the position as long as the company keeps meeting the criteria.
The selection criteria begin with an observation about the short-term and long-term market. In the short term, prices change based on company popularity, fads, rumors, and overreaction to all news. This chaos tells you that trading in and out of positions is a difficult game because you need to time decisions on both sides with near-perfect precision. The swings in price are not consistent, and the chaotic nature of the short-term market points to the importance of a long-term perspective.
In the long term, stock prices tend to move in line with the company’s earnings. It’s really that simple. If you want to identify a company that represents value, look to past earnings trends and determine whether those trends will continue into the future. Companies that see falling sales tend to also experience falling stock prices. For examples, check General Motors, Eastman Kodak, and any large U.S.-based airline from the 1990s through to today.
These four rather obvious (but often overlooked) facts point to the first criterion of value investing:
- 1. Track earnings trends to find value companies.
Another interesting fact about the market is that industries and companies experience popularity cycles. At certain times, the market is in love with one kind of company, whether that makes sense or not. At other times, the market ignores an entire industry. Value investors look for the company in an out-of-favor sector that has strong fundamentals but is not on many lists of ‘stocks to buy.’
The reason for buying an out-of-favor company is that it is probably undervalued, but assuming the cyclical nature of most sectors and also assuming that the cycle will come around again, a second criterion for value investing is:
- 2. Look for fundamentally strong companies in sectors that are currently out of favor in the market.
The third rule is that you want to limit your short list to companies that have excellent reputations for quality of management, for product, and for competition. A value company is most likely to dominate its industry and has dominated for many years. By definition, this domination is the result of providing value products or services, and working through exceptionally skilled management.
The third value investing rule is:
- 3. Narrow your list down to companies that offer exceptionally high-quality products or services, are managed expertly, and dominate their industry.
A fourth market reality is that even if prices are set efficiently most of the time, there are times when prices are pushed downward to unreasonably low levels. A company’s earnings might be lower than analysts expected, even if they represent record earnings for the company. It’s irrational, but it is a fact of life. Bargains show up in the market all of the time because of the short-term irrationality of buyers and sellers.
With this in mind, you can look for bargain-priced stock when those prices fall in an exaggerated fashion. This assumes that you first qualify the company based on fundamental strength, exceptional quality, and competitive position within the company’s sector. If you have done that, the fourth rule for value investing is:
- 4. Identify companies you consider exceptionally well managed, that dominate their industries. Then buy on dips that create bargain stock price levels.
These four standards come down to the central definition of value investing: the selection of stocks in exceptionally well-run companies, available at a price below fair value. The definition of fair value (at times also called intrinsic value) varies. In general, it refers to stocks priced below tangible book value or some other assumption of value based on fundamental analysis. This may also be affected by an exceptionally attractive dividend yield available at the time the purchase is made.
Value stocks tend to perform better than average during market downturns, either declining less than average or even rising. In 2007, when the DJIA lost 2,000 points, several value stocks (such as Altria, Coca-Cola, Exxon-Mobil, Merck, and McDonalds) rose in value. Even in 2008, one of the worst years on record, McDonalds rose in value while nearly all other stocks saw their prices decline.
Growth stocks tend to climb rapidly, but also tend to fall just as quickly. Value stocks tend to accumulate value gradually over many years and in many market conditions.
In comparison, growth stocks tend to rise during volatile markets moving quickly to the upside. But there is a danger. Those same stocks tend to lose value rapidly when the uptrend ends, especially if it is driven by a temporary fad in the market dominated by those industries where growth stocks are found. Consider for example the cyclical rise and fall in technology and IT sector stocks.
This does not mean that value stocks insulate your portfolio from price declines. But well-selected value stocks do tend to out perform the market as a whole over the long term. Within that long term it is likely that some years will be low-volume and low-growth years for value stocks. However, as a rule, value investing is more conservative and more profitable than speculation or trying to find the next growth stock.
A second source of returns on a portfolio, beyond price appreciation of stock, is dividend income. Most growth stocks do not pay dividends, so growth stock investors have to rely on price appreciation that outpaces not only the change in value investments, but their dividend yields as well. Value investors can make the most of dividend yield by reinvesting dividends in purchase of additional shares rather than taking payments in cash. The reinvested dividends appreciate at compounded rates. Over many years, dividend income on value investments represents a significant share of overall returns on the portfolio, and may also be thought of as offsets to the cyclical price declines that occur in all markets.
The value investor is probably more conservative and more concerned with volatility than growth investors. However, when your emphasis is on how a portfolio is going to perform over many years and not just over the next few weeks or months, value investing is likely to be a more profitable strategy in the market.
Copyright 2011 by Michael C. Thomsett. All rights reserved. John Wiley & Sons, Inc."
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