You are a long term investor, or are considering diversifying by adding some longer term investments to your portfolio. Where to start? What to do? And the all-important: what to buy?
When considering a long term investment, investors can often get a significant advantage if they ensure that there is a price gap between a projected fair value of a stock and the present share price. You are, of course, looking for a discounted market price that leaves sufficient room for the company’s stock price to appreciate before it reaches the projected fair value. Further, you are assuming that the stock price will move towards the company’s projected fair value in a reasonable length of time. Applying this price gap test before entering a stock is an example of one of the methods used in what is commonly termed Value Investing.
So, what is fair – or intrinsic – value? Accountants define fair value to be the present value of a company’s expected future net cash flows. This can be thought of as the value of a business’ ongoing operations. A widely accepted calculation of fair value uses the idea that at fair value, the P/E ratio of a stock equals its EPS growth rate.
But what else can alter the intrinsic value: Tangibles such as cash holdings, debt, property assets. Plus intangibles, which are inherently more difficult to valuate, such as intellectual property – patents and trade secrets – and brand value. Other items that can lead to varied valuations include a company’s industry positioning and their dividends payment policy/history.
Several methods have been proposed to provide an approximation of fair value in the future. Most are based on projecting share prices into the future using recent business growth rates. It should be noted that the projection into future of growth rates in corporate revenue and earnings per share and other balance sheet figures, however consistent in the past, is not guaranteed to generate an accurate, or “fair”, valuation. But all other things being equal, it does provide value investors with a standard measure to perform comparative analysis for identification of investment candidates.
Looking for Value in all the Right Places
Generally, when markets have experienced a bearish move is a very good time to look for value. Of course, your mission is to pick an entry point that is at the bottom of the downtrend, just as the market index is turning up. That should be easy! All jokes aside, timing an entry at an exact market bottom is very difficult, so you might want to wait until definite signs of a bullish resurgence have been established. Generally, as a Value Investor, you are thinking long-term, so timing of the entry is usually not of paramount importance, but keeping an eye on the overall market direction is always good advice.
Look for sectors that are undervalued. As just noted, when markets are under stress and under-valued, your chances of finding value opportunities are heightened. But there are still lots of value opportunities available even when markets are up. One way to find a candidate sector that might be under-valued in general is to look at the price of a sector proxy relative to its 52 week high. Good sector proxies are ETF’s or indices that aggregate many companies in an industry. For example, the EMT ETF on the NYSE is an emerging markets metals and mining ETF. View a price chart of EMT to gauge whether the metals and mining industry is generally under or over-valued.
Left Chart: Undervalued stock – present stock Price at 30 is significantly below projected Fair Value at 90.
Right Chart: Over-valued stock – present stock Price at 2.75 is significantly above projected Fair value at 1.10.
Once you have identified a depressed sector it is time to look for stocks in that sector that are true value investments. More aggressive value investors will target the most depressed companies in a particular sector; other less aggressive value investors might look for a depressed sector and then invest in those companies that have not fared so poorly as others, rationalizing that these candidates will
• rebound faster in a market upswing
• be characterized by less inherent risk
This is a very clear example of how individual investors rationalize Reward versus Risk differently.