The way most investors approach the market is all wrong. They are stumbling around in the dark, trying to make sense of the markets without having the information they need to make good decisions. Value investing can help light the way.
Time Tested
(I gave a talk on value investing to a group of business owners recently. What follows is an edited version of that speech.)
I’m a strong proponent of value investing. It’s the approach I’ve taken over the last 26 years to grow my own portfolio and it’s served me well. I’ve invested in over 200 companies and in countries around the world. I’ve bought large cap stocks and small, penny stocks. I’ve invested in high growth companies and aging dinosaurs. Distressed companies and stable, dividend paying stocks. I’ve invested across industries and sectors. And I’ve found that value investing and its principles are universal.
There’s a misconception that value investing is a relic of a bygone era. That value investors only invest in the aging, smokestack industries of yesteryear. But the reality is different. Value investing runs the gamut. There are plenty of value investors who focus solely on the higher growth end of the spectrum. You can apply the value investing playbook to whatever corner of the market interests or excites you. The core principle that binds it all together is that you are looking for companies selling well below their intrinsic value. You’re looking for bargains at a giant flea market. If you look long and hard enough, you can find some great deals.
Value investing has fallen deeply out of favour over the last few years as big-name tech stocks and speculative unicorns took over people’s imaginations. Boring, old-school value has become passé, just as it did in the first iteration of tech mania in the late nineties.
But value has a long and illustrious history behind it. Many of the greatest investors of the past 100 years have been value investors of one sort or another. Warren Buffett, Benjamin Graham, Peter Lynch, Seth Klarman, Mohnish Pabrai, Joel Greenblatt, John Neff, Howard Marks and John Templeton just to name a few.
In comparison, I struggle to think of many examples of long-term, successful investors, in the public markets at least, who have not followed some sort of value-oriented approach. For the most part, the value investing style has been the odds-on favourite over many years. And certainly, my own experiences have convinced me that this is the way to go.
Finding Fair Value
The key insight that value investors operate with is this: companies have an intrinsic value independent of their stock price. A value investor approaches buying a stock the same way a private business owner might approach buying an entire company.
First and foremost, they look at how much profit the company is generating. They look at the past history of the company. They see how consistent those profits are and if they have grown over time. They think long and hard about the company’s future prospects. They look at how the business performed during previous downturns. They might look at other things like the value of any assets the company owns or the amount of debt it’s carrying. Once they’ve finished their analysis, if they like what they see, they put themselves in the role of a wealthy business owner and decide what price they would offer to buy the entire company outright.
When you buy a stock, you’re buying a small piece of a company, but it’s always worthwhile pretending that you’re actually buying the whole thing. That you won’t have the luxury of being able to simply sell the stock and move on to the next shiny, new plaything if you change your mind or if conditions deteriorate. That mindset imposes a discipline on you that avoids a lot of costly mistakes. Too many investors rely on selling their stock to a greater fool down the road, but the joke often ends up being on them.
This process of trying to determine a fair price to pay for a business is a somewhat subjective determination. It is not a paint by numbers affair. Every value investor will have a slightly different approach to calculating fair value and will put greater emphasis on different things. Some will favour dividends more highly. Others will be focused on long-term growth. The exact model you use is not important. What’s important is that at the end of your deliberations, you’ve got a number that you’ve calculated, completely independent of the company’s quoted share price and that number represents the fair value you’re placing on that company.
The value investor has a huge leg up on the competition because he has this fixed number in his head that represents what he thinks the company is really worth. Other investors who ignore such antiquated notions as value are flying blind. All they have to go on is the stock price and that is where they get led astray.
A Random Walk Down Wall Street
(This is my value-oriented twist on the investing classic of the same name by Burton Malkiel.)
Imagine a downtown street scape with skyscrapers lining each side of the road. It’s late at night and a drunk man is weaving his way home after a night of bar hopping. The path he takes on his stumble home represents a stock’s price. The center of the road is the fair value of the company in question as calculated by some independent auditor but the actual stock price meanders back and forth on either side of that fair value center line in a completely random fashion as the drunk staggers first one way then the other.
There are, however, limits to how far the drunk can veer off course. If he stumbles too far in one direction, say towards the undervalued side of the street, he will hit a wall. Likewise, if he veers too far to the overvalued side, he is brought up short again. His path down the street is uncertain. He could stagger over to one side of the street and then meander along that side of the road for many blocks before weaving back to the middle and then careening over to the far side. Or he may stagger wildly back and forth. Perhaps he will bob placidly along the middle of the road for a time.
That’s what stock price movements look like to me. I’m always comparing a stock’s price to what I consider to be the fair value of the company based on its profit, track record and growth prospects. Is that stock on the undervalued side of the street or the overvalued side?
What I’m looking for are stocks that have veered far off course and are staggering along the sidewalk on the undervalued side of the street. There is a rational limit to just how far stock prices can deviate from their fair value just as there are limits to how far the drunk can veer off course. I have no way of knowing what the future trajectory of the drunken walk is going to be. The stock could stay undervalued for years at a time or it could veer back to fair value or to the overvalued side of the street just a few months after I buy in. That part of it is out of my hands. But by always buying only the stocks that have veered far off course in the undervalued direction I am setting myself up for success. I have stacked the odds heavily in my favour. If I’m patient enough, it is highly likely that at some point the drunken man will stagger back to the middle of the road at which point I’ll sell my stock and move on to the next undervalued opportunity.
Narrative Investing
Contrast this value approach, where you have a clear fair value target in mind for a stock, completely independent of its share price and you make your investment decisions based on that, to the way most investors approach the market.
Many of the investors that I’ve spoken to over the years practice what I call narrative investing. They buy a stock based on a compelling story, but they don’t pause to consider whether the price they’re paying for that story is a fair price or not.
The playbook often goes something like this: They hear a good story. Their brother-in-law buys the stock. The media are running articles about the amazing prospects for this company and the industry it’s in. The investor buys in based on the hype and they never bother to do any sort of assessment of what a reasonable price might be to pay for the company they just bought. They assume that whatever price they are paying for the stock is the fair market value and that if the company does well, the stock price will go up. The stock price does go up initially, and then it goes down and the investor starts to sweat a bit and then it goes up again and then it goes down. And each time it changes direction, the investor is at a loss.
He has no independent idea of what the company is worth, so he has no way of knowing if the random fluctuations in the stock price have any meaning or not. All he knows is what he paid for the stock in the first place. He assumes that this has some relevancy. After all, in the real world, prices mean something. They have a close relation to the value you get from the underlying good. You can be pretty sure that a $2000 dishwasher is better quality than a $500 one. But not so in the stock market. Here the correlation is tenuous. The price the investor happened to pay for his shares may not be a good representation of the company’s actual value. But the investor doesn’t know that.
Eventually, the tide turns, and the stock price starts heading down more precipitously. It falls below the price the investor paid for it. What to do? In his mind, the price he paid for his shares had some meaning. It said something about the value of the company. So the fact that the current share price is now below that price must mean the company is undervalued and he should buy more. So he does. And the price keeps falling.
He begins to wonder if maybe something has gone wrong. Maybe someone knows something he doesn’t. The media is now reporting on the falling stock price. They too speculate that something might have gone wrong. His brother-in-law claims to have sold his stock at the peak. The investor feels foolish because he never really did know what the company was worth in the first place, but it seemed like a good idea at the time. He decides to hang on until he gets back to break even. He holds on for another 6 months and then finally sells at a large loss. He doesn’t tell his wife about it.
Efficient Market Theory
In this story, the investor is making a flawed assumption: that the price they are paying for their stock is a fair and accurate price. Many investors, including many professional money managers make this same assumption about the markets and it leads to a cascading set of problems. There is even a term for it; it’s called efficient market theory.
This theory states that everything there is to know about a company is already reflected in the stock price. There’s no point in trying to outperform the market because stock prices are perfectly efficient. As soon as some new piece of information comes to light, it is immediately digested and reflected in the market price.
Over the years, I’ve owned hundreds of stocks. I’ve done value analyses on thousands more. I can say with absolute certainty that the market is not efficient; that stock prices often do not accurately reflect the objective net worth of the underlying company. They frequently under and overshoot that fair market value. Any cursory look at some of the many investment fads and manias we’ve had over the past 25 years should convince you of that. Nonetheless, this idea that markets are perfectly efficient is surprisingly pervasive and has more or less become accepted market wisdom.
If the market were perfectly efficient, then the only way to outperform it would be to have some special insight that no one else has. Investing would then become a game of trying to predict the future more accurately than anyone else. This has spawned an entire industry of talking heads, pundits and soothsayers whose job it is to give their sage prognostications on future trends. Experts are outdoing themselves trying to be even more visionary than the last guy. It’s all total BS.
The future is inherently unpredictable. You can’t time the market and believe me, I’ve tried. Economists are terrible at forecasting recessions. Analyst estimates are usually very wide of the mark. It’s not because these people are bad at their jobs. It’s that the future is a black box. There are too many moving parts and too many competing forces at work to be able to see anything more than shadowy outlines.
So all this effort expended on predicting the future and all the faith put in professionals who claim to be able to read the market tea leaves is just wasted energy. And it distracts investors from the real opportunity, identifying the price inefficiencies that exist in the stock market today and taking advantage of those mispricings. That’s what value investing does.
Drop the Anchor
This false assumption that stocks are always priced efficiently also leads to one of the more destructive behaviours I’ve seen from other investors; that of anchoring.
I’ve come across this time and time again in my discussions with other investors and no matter how much I try to persuade them otherwise, they can’t seem to let go of this belief. Anchoring is the phenomenon of attaching a mythical importance to the price you yourself bought a stock at. This price, taken on its own, has no practical meaning. It may be loosely correlated to the value of the underlying business but only loosely. So whatever the price of the stock was on the day you bought it is no more likely to be an accurate representation of true value than the price the month before or the month after. What’s more, the value of a company changes over time as business conditions evolve. The value today could be far different from what it was a year ago. Your buy and sell decisions should be based on the investment merits of the stock in the here and now, not on whatever price you paid for it 6 months earlier.
People may see the logic in this but seem to have a very hard time letting go of that anchor. They are always focused on how much they personally have made or lost on a stock. Because they don’t actually know the true value of the company they own, they have no other guidepost. All they have is the stock price. So they make arbitrary rules for themselves like, “I’ll sell half when the stock price doubles” or “I’ll wait until I get back to break even and then I’ll sell”. They might as well be saying, “I’ll sell when Jupiter aligns with Mars.” It would be about as effective.
One of the best pieces of advice I can give any investor is this: Don’t keep track of the price you bought a stock for. Just don’t do it. Don’t record it anywhere. I don’t. The brokerage can keep track of that for me and I can always look the information up in my brokerage statements if I really want to, but in the spreadsheet I use to track my investments, there’s no entry for my purchase price. While I do track the total value of my portfolio over time and how it is performing relative to its benchmark, I don’t track how much I have made or lost on any given position.
This information has no practical relevance and if you focus on it, it’ll just trip you up. And, if the number is negative, bum you out. What I do keep careful track of is my estimate of the company’s fair value, which changes over time. If the share price ever moves above my fair value estimate, it’s time to sell and move on. Otherwise, I’m in for the ride. What I personally might have bought the stock for never even enters into the equation.
The P:E Ratio
If you go to the store to buy a carton of eggs, you’ll have a decision to make. For $8 you can buy the organic, free-range eggs from chickens that got to run around outside and play in the dirt. For $2 you can buy the grade B eggs from the inhumanely raised chickens. You feel bad for the chickens, so you go for the $8 option.
But what if you didn’t know the number of eggs in each carton? Now you’re at a loss. The $8 carton could have only 1 egg in it. You’d be paying $8 an egg. You feel badly for the chickens but maybe you don’t feel quite that badly. At the same time, the $2 carton could have 24 eggs in it. That’s an awfully good deal. It works out to a little over 8 cents an egg. Maybe those chickens had it coming to them.
Stocks are like those mystery egg cartons with an unknown number of eggs in them. But with stocks, we’re not counting eggs, we’re counting dollars of profit. As an investor, our primary consideration with any investment we make is how much income, otherwise known as earnings or profit, that investment is going to generate for us. So what we really want to know is not the share price per se, it’s how that share price compares to the underlying earnings of the company.
This ratio of share price to profit is known as the price to earnings ratio or p:e ratio. It’s also known as the p:e multiple or just multiple for short. To calculate the p:e ratio, I simply need to divide the current share price by the amount of earnings the company is generating per share. I can get this number from a site like Yahoo! Finance, but I have to be careful. This is a case of garbage in, garbage out. If I want an accurate number, I’ll check the company’s financial statements myself and weed out any temporary items like big insurance gains or legal settlements that might be distorting the picture.
The p:e ratio of a stock is the magical missing price tag. Without it, we’re stumbling around in the dark. It’s like knowing the price of the egg carton without knowing how many eggs are in the carton. A stock’s quoted share price is a bit of misdirection; that is not really what we care about. It’s the p:e ratio that tells us the true price of the company.
Of course, we still have to do our homework. Cheaper isn’t always better and a low p:e ratio doesn’t always make for a better investment than a high one. If we were comparing a $500 dishwasher with a $2000 one, for example, the $500 dishwasher could be a piece of garbage that is destined for a landfill in a year’s time. The $2000 dishwasher could be a high-quality piece of German engineering, with exactly the feature set we’re looking for. In this situation, the $2000 dishwasher might represent the better value despite it being more expensive. In another scenario, the $500 dishwasher could be the heavily discounted floor model of a well-respected brand and so in this scenario, that dishwasher could represent the better value of the two. Context matters.
There are two pieces of the puzzle here: the story behind the company (its growth rate, the competitive landscape and so on) and the company’s p:e ratio. Just as with the egg example, there was the story behind the eggs (organic, free range vs. factory farmed) and the price per egg. Taken on their own, neither piece of information can tell you whether an investment is a good one or a bad one. It’s only when you marry these two pieces of the puzzle together that the magic really happens, and the complete picture finally comes into focus.
My Investing Approach
Generally speaking, the faster a company is growing, the more it is worth. As an investor, I’m essentially buying into the future income stream of a company. If I think that that income stream is going to grow rapidly, then I’m willing to pay more up front. But for any given growth rate, there are some companies that are overpriced and some that are underpriced.
Like most investors, I aim to buy low and sell high. Specifically, I look for those companies with abnormally low p:e ratios relative to their peer group. I’ll match up companies of similar size and similar growth rates and then I’ll look for those outliers that are trading significantly below their peer group average.
If you take a look at rapidly growing companies right now, you’ll find them trading at p:e ratios in the 30’s. Some will be trading above that range, in the 40’s and some will be below that, in the 20’s. Occasionally, you might find one little lamb that has strayed too far from the flock and is trading at a p:e ratio in the high teens. That’s the one I’ll pounce on.
A word of caution: most low p:e stocks are priced low for a perfectly good reason. The market may not be nearly as efficient as the economists would have you believe but it’s no dummy either. You always have to pay careful attention to what the market is telling you. A lot of my job consists of going through a long list of relatively low p:e stocks and figuring out why the price is as low as it is. Maybe there is a large lawsuit pending against the company. Maybe the company has issued way too many options. Maybe they are overly reliant on a single customer or are about to lose a major government contract.
Those are all parts of the story behind a company. The more time you spend learning about the company and learning its story, the more likely you are not to miss any of those hidden land mines. If I go through my whole investigative process and end up finding nothing obvious that would tank the deal, then I start to get excited.
Armed with a full understanding of the company’s history and future prospects, I’ll come up with a target p:e ratio that represents my estimate of the company’s fair value. I’ll base that target p:e on what companies with similar characteristics are trading for, making any modifications I need to, to reflect the company’s specific circumstances.
In many ways, my stock valuation process is similar to the way I might try to determine the fair market value of a used car. I’d start by finding out what other cars of the same make, model and year are selling for and then I’d make adjustments for things like low mileage or a good repair record.
If the company has passed all my tests and still looks undervalued to me, I’ll add this stock to the portfolio and then sit back and wait. Time will pass and the stock price will weave its drunken way down Wall Street, moving higher and lower by degrees. At the end of every quarter, new earnings will get released. I’ll update my p:e ratio with these new earnings and the current share price. I’ll also update my fair value estimate to account for changing market conditions and any changes in the growth profile or outlook of the company in question. As long as the current p:e ratio stays comfortably below my fair value estimate, I’m happy to keep holding on.
I’ll remain on board for as long as it takes. That could mean months, or it could mean years. One day, I hope to run my calculations and find that the p:e ratio has finally caught up with its peer group. I’ll sell my shares, count my winnings, and move on to the next undervalued opportunity.
Putting The Pieces Together
Many individual investors only consider the story behind a company when they buy into its stock. This is an important piece of the puzzle to be sure, but it is only part of the picture. Without knowing the price they are paying to buy into that story, they are setting themselves up for failure. They are operating with incomplete information and are likely to find themselves lost and confused. Value investing gives them that missing price. It helps to complete the picture and lets them make informed and intelligent choices.
It is still not easy. There is a lot of uncertainty in the markets. The future will always be a mystery. But by following the value investing playbook and paying attention to not only the story behind a company but also to the price you’re being asked to pay for that story, you at least have a solid foundation from which to work and some guiderails to help keep you on the right path.
Value investing can be fun. It’s like a treasure hunt. When you finally unearth one of those hidden, undervalued gems, it’s a real rush. If the stock then goes on to double in price because you saw something that no one else saw, it’s even more of a thrill. Keep your eyes and ears open. There is always value to be had out there, and it’s probably not in the places everyone else is looking.