In the previous article understand-what-kind-of-stock-investors you are,we mentioned that there are roughly three kind of investors, value investor, growth investor and income investor. Now here is the detail for value investing.
Value investing is one of the best known stock-picking methods. In the 1930s, Benjamin Graham and David Dodd, finance professors at Columbia University, laid out what many consider to be the framework for value investing. The concept is actually very simple: find companies trading below their inherent worth.
The value investor looks for stocks with strong fundamentals - including earnings, dividends, book value, and cash flow - that are selling at a bargain price, given their quality. The value investor seeks companies that seem to be incorrectly valued (undervalued) by the market and therefore have the potential to increase in share price when the market corrects its error in valuation.
Value, Not Junk!
Before we get too far into the discussion of value investing, let's get one thing straight. Value investing doesn't mean just buying any stock that declines and therefore seems "cheap" in price. Value investors have to do their homework and be confident that they are picking a company that is cheap given its high quality.
It's important to distinguish the difference between a value company and a company that simply has a declining price. Say for the past year Company A has been trading at about $25 per share but suddenly drops to $10 per share. This does not automatically mean that the company is selling at a bargain. All we know is that the company is less expensive now than it was last year. The drop in price could be a result of the market responding to a fundamental problem in the company. To be a real bargain, this company must have fundamentals healthy enough to imply it is worth more than $10 - value investing always compares current share price to intrinsic value not to historic share prices.
Value Investing at Work
One of the greatest investors of all time, Warren Buffett, has proven that value investing can work: his value strategy took the stock of Berkshire Hathaway, his holding company, from $12 a share in 1967 to $70,900 in 2002. The company beat the S&P 500's performance by about 13.02% on average annually! Although Buffett does not strictly categorize himself as a value investor, many of his most successful investments were made on the basis of value investing principles.
Buying a Business, not a Stock
We should emphasize that the value investing mentality sees a stock as the vehicle by which a person becomes an owner of a company - to a value investor profits are made by investing in quality companies, not by trading. Because their method is about determining the worth of the underlying asset, value investors pay no mind to the external factors affecting a company, such as market volatility or day-to-day price fluctuations. These factors are not inherent to the company, and therefore are not seen to have any effect on the value of the business in the long run.
Contradictions
While the efficient market hypothesis (EMH) claims that prices are always reflecting all relevant information, and therefore are already showing the intrinsic worth of companies, value investing relies on a premise that opposes that theory. Value investors bank on the EMH being true only in some academic wonderland. They look for times of inefficiency, when the market assigns an incorrect price to a stock.
Value investors also disagree with the principle that high beta (also known as volatility, or standard deviation) necessarily translates into a risky investment. A company with an intrinsic value of $20 per share but is trading at $15 would be, as we know, an attractive investment to value investors. If the share price dropped to $10 per share, the company would experience an increase in beta, which conventionally represents an increase in risk. If, however, the value investor still maintained that the intrinsic value was $20 per share, s/he would see this declining price as an even better bargain. And the better the bargain, the lesser the risk. A high beta does not scare off value investors. As long as they are confident in their intrinsic valuation, an increase in downside volatility may be a good thing.
Screening for Value Stocks
Now that we have a solid understanding of what value investing is and what it is not, let's get into some of the qualities of value stocks.
Qualitative aspects of value stocks:
Where are value stocks found? - Everywhere. Value stocks can be found trading on the NYSE, Nasdaq, AMEX, over the counter, on the FTSE, Nikkei and so on.
a) In what industries are value stocks located? - Value stocks can be located in any industry, including energy, finance and even technology (contrary to popular belief).
b) In what industries are value stocks most often located? - Although value stocks can be located anywhere, they are often located in industries that have recently fallen on hard times, or are currently facing market overreaction to a piece of news affecting the industry in the short term. For example, the auto industry's cyclical nature allows for periods of undervaluation of companies such as Ford or GM.
Can value companies be those that have just reached new lows? - Definitely, although we must re-emphasize that the "cheapness" of a company is relative to intrinsic value. A company that has just hit a new 12-month low or is at half of a 12-month high may warrant further investigation.
Here is a breakdown of some of the numbers value investors use as rough guides for picking stocks. Keep in mind that these are guidelines, not hard-and-fast rules:
*Share price should be no more than two-thirds of intrinsic worth.
*Look at companies with P/E ratios at the lowest 10% of all equity securities.
*PEG should be less than one.
*Stock price should be no more than tangible book value.
*There should be no more debt than equity (i.e. D/E ratio < 1).
*Current assets should be two times current liabilities.
*Dividend yield should be at least two-thirds of the long-term AAA bond yield.
*Earnings growth should be at least 7% per annum compounded over the last 10 years.
The P/E and PEG Ratios
Contrary to popular belief, value investing is not simply about investing in low P/E stocks. It's just that stocks which are undervalued will often reflect this undervaluation through a low P/E ratio, which should simply provide a way to compare companies within the same industry. For example, if the average P/E of the technology consulting industry is 20, a company trading in that industry at 15 times earnings should sound some bells in the heads of value investors.
Another popular metric for valuing a company's intrinsic value is the PEG ratio, calculated as a stock's P/E ratio divided by its projected year-over-year earnings growth rate. In other words, the ratio measures how cheap the stock is while taking into account its earnings growth. If the company's PEG ratio is less than one, it is considered to be undervalued.
Narrowing It Down Even Further
One well-known and accepted method of picking value stocks is the net-net method. This method states that if a company is trading at two-thirds of its current assets, no other gauge of worth is necessary. The reasoning behind this is simple: if a company is trading at this level, the buyer is essentially getting all the permanent assets of the company (including property, equipment, etc) and the company's intangible assets (mainly goodwill, in most cases) for free! Unfortunately, companies trading this low are few and far between.
The Margin of Safety
A discussion of value investing would not be complete without mentioning the use of a margin of safety, a technique which is simple yet very effective. Consider a real-life example of a margin of safety. Say you're planning a pyrotechnics show, which will include flames and explosions. You have concluded with a high degree of certainty that it's perfectly safe to stand 100 feet from the center of the explosions. But to be absolutely sure no one gets hurt, you implement a margin of safety by setting up barriers 125 feet from the explosions.
This use of a margin of safety works similarly in value investing. It's simply the practice of leaving room for error in your calculations of intrinsic value. A value investor may be fairly confident that a company has an intrinsic value of $30 per share. But in case his or her calculations are a little too optimistic, he or she creates a margin of safety/error by using the $26 per share in their scenario analysis. The investor may find that at $15 the company is still an attractive investment, or he or she may find that at $24, the company is not attractive enough. If the stock's intrinsic value is lower than the investor estimated, the margin of safety would help prevent this investor from paying too much for the stock.
Conclusion
Value investing is not as sexy as some other styles of investing; it relies on a strict screening process. But just remember, there's nothing boring about outperforming the S&P by 13% over a 40-year span!
Showing posts with label Value stocks. Show all posts
Showing posts with label Value stocks. Show all posts
2009-03-18
2009-03-08
Basic Stocks (2) ---Different Types Of Stocks
There are many different types of stocks which can be invested in based upon your financial position, your risk comfort level, and your investment goals. In order to determine which type to invest in, you have to first determine what you want the stock to do for you. Do you plan to hold the security long-term, or are you a day trader? Are you looking for capital gains in your investments or is income your main objective? How you answer these questions will give you a good idea of which type of stock you should be considering for your portfolio.
There are two main types of stocks: common stock and preferred stock.
Common Stock
Common stock is, well, common. When people talk about stocks they are usually referring to this type. In fact, the majority of stock is issued is in this form. We basically went over features of common stock in the last section. Common shares represent ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote per share to elect the board members, who oversee the major decisions made by management.
Over the long term, common stock, by means of capital growth, yields higher returns than almost every other investment. This higher return comes at a cost since common stocks entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bondholders and preferred shareholders are paid.
Preferred Stock
Preferred stock represents some degree of ownership in a company but usually doesn't come with the same voting rights. (This may vary depending on the company.) With preferred shares, investors are usually guaranteed a fixed dividend forever. This is different than common stock, which has variable dividends that are never guaranteed. Another advantage is that in the event of liquidation, preferred shareholders are paid off before the common shareholder (but still after debt holders). Preferred stock may also be callable, meaning that the company has the option to purchase the shares from shareholders at anytime for any reason (usually for a premium).
Some people consider preferred stock to be more like debt than equity. A good way to think of these kinds of shares is to see them as being in between bonds and common shares.
Different Classes of Stock
Common and preferred are the two main forms of stock; however, it's also possible for companies to customize different classes of stock in any way they want. The most common reason for this is the company wanting the voting power to remain with a certain group; therefore, different classes of shares are given different voting rights. For example, one class of shares would be held by a select group who are given ten votes per share while a second class would be issued to the majority of investors who are given one vote per share.
When there is more than one class of stock, the classes are traditionally designated as Class A and Class B. Berkshire Hathaway (ticker: BRK), has two classes of stock. The different forms are represented by placing the letter behind the ticker symbol in a form like this: "BRKa, BRKb" or "BRK.A, BRK.B".
In addition, stocks can be classified to other types according to different standard. Listed below are several types of stocks which are commonly traded in the securities market:
· Blue chip stocks are stocks of well-established companies that have stable earnings and no extensive liabilities. They have a track record of paying regular dividends, and are valued by investors seeking relative safety and stability. The name comes from the blue-colored chips in the game of poker, which are typically the most valuable.
· Penny stocks are low-priced, speculative and risky securities which are traded over-the-counter (OTC); i.e. outside of one of the major exchanges.
· Income stocks offer a higher dividend in relation to their market price. They are especially attractive to investors who are looking for current income that will gradually grow over the years as a way to offset inflation.
· Growth stocks are securities which appreciate in value and yield a high return. Their profits are typically re-invested to expand the business. Investors gain because the stock prices increase as the business grows, thus increasing the value of the investment.
· Value stocks are securities which investors consider to be undervalued. They feel that the stock is being traded below market value, and they believe in the long-term growth of the issuing company.
Source from: investopedia.com
There are two main types of stocks: common stock and preferred stock.
Common Stock
Common stock is, well, common. When people talk about stocks they are usually referring to this type. In fact, the majority of stock is issued is in this form. We basically went over features of common stock in the last section. Common shares represent ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote per share to elect the board members, who oversee the major decisions made by management.
Over the long term, common stock, by means of capital growth, yields higher returns than almost every other investment. This higher return comes at a cost since common stocks entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bondholders and preferred shareholders are paid.
Preferred Stock
Preferred stock represents some degree of ownership in a company but usually doesn't come with the same voting rights. (This may vary depending on the company.) With preferred shares, investors are usually guaranteed a fixed dividend forever. This is different than common stock, which has variable dividends that are never guaranteed. Another advantage is that in the event of liquidation, preferred shareholders are paid off before the common shareholder (but still after debt holders). Preferred stock may also be callable, meaning that the company has the option to purchase the shares from shareholders at anytime for any reason (usually for a premium).
Some people consider preferred stock to be more like debt than equity. A good way to think of these kinds of shares is to see them as being in between bonds and common shares.
Different Classes of Stock
Common and preferred are the two main forms of stock; however, it's also possible for companies to customize different classes of stock in any way they want. The most common reason for this is the company wanting the voting power to remain with a certain group; therefore, different classes of shares are given different voting rights. For example, one class of shares would be held by a select group who are given ten votes per share while a second class would be issued to the majority of investors who are given one vote per share.
When there is more than one class of stock, the classes are traditionally designated as Class A and Class B. Berkshire Hathaway (ticker: BRK), has two classes of stock. The different forms are represented by placing the letter behind the ticker symbol in a form like this: "BRKa, BRKb" or "BRK.A, BRK.B".
In addition, stocks can be classified to other types according to different standard. Listed below are several types of stocks which are commonly traded in the securities market:
· Blue chip stocks are stocks of well-established companies that have stable earnings and no extensive liabilities. They have a track record of paying regular dividends, and are valued by investors seeking relative safety and stability. The name comes from the blue-colored chips in the game of poker, which are typically the most valuable.
· Penny stocks are low-priced, speculative and risky securities which are traded over-the-counter (OTC); i.e. outside of one of the major exchanges.
· Income stocks offer a higher dividend in relation to their market price. They are especially attractive to investors who are looking for current income that will gradually grow over the years as a way to offset inflation.
· Growth stocks are securities which appreciate in value and yield a high return. Their profits are typically re-invested to expand the business. Investors gain because the stock prices increase as the business grows, thus increasing the value of the investment.
· Value stocks are securities which investors consider to be undervalued. They feel that the stock is being traded below market value, and they believe in the long-term growth of the issuing company.
Source from: investopedia.com
Subscribe to:
Posts (Atom)
Posts
