There are two broad strategies that investors typically use in stock investing, namely growth investing, and value investing.
Made famous by Thomas Rowe Price, Jr., growth investing is the art of buying companies that are, well, growing. These companies are usually in its expansionary phrase, and often trade at a premium compared to more mature companies. Despite its higher price tag, growth companies can deliver great long-term returns if the company can fulfill, or exceed its potential.
On the other hand, value investing, which was popularised by investing legend and author of the book “The Intelligent Investor”, Benjamin Graham, deals in the art of investing in undervalued stocks. Undervalued stocks may trade at a discount to their intrinsic value because the company is relatively unknown, have unwarranted pessimism surrounding the stock, or even exhibit short-term solvable problems that have caused market participants to flee the stock. Investors who spot these gems can profit when the market realises the discrepancies between the stock price and the value the stock offers.
Today, I will be focusing on value investing.
We will take a look at why some stocks may be underpriced, and what are some criteria that value investors should look out for.
Stocks that have unwarranted pessimism
Every single company is bound to face problems as part of its business life.
The headwinds can range from challenging market conditions (think trade wars), slower economic growth, or even company specific problems such as stiffer competition, poor brand reputation, or new industry regulations.
All of the above can create volatility in the markets when stock market participants react hastily to unwelcome news. As sellers exit the stock market, it can create a price-value mismatch whereby value investors can find exciting opportunities for abandoned stocks.
At the same time, that does not mean that every price correction provides bargain hunters with good entry points. Sometimes, the problems that a company may face may be too difficult to overcome, or have long-term implications on the company. It is important we, as investors, suss out whether the market pessimism surrounding a company is warranted (or not).
Look for less-known stocks
Legendary investor, Peter Lynch famously said, “When even the analysts are bored, it’s time to start buying.”
Lynch believes that we should look out for companies that are neglected by the general public. These neglected stocks often have little coverage, low percentage of institutional funds, or trade at discounted prices compared to the “hot” trends of the day.
If we look hard enough, we may find underpriced gems in the stock market.
Use simple valuation metrics as a guideline
Valuation metrics provide value hunters with a guideline on finding stocks that are deemed to be undervalued.
For instance, when looking at REITs or property stocks, it is important to compare the price of the stock versus the book value of the stock. This ratio is known as price-to-book. In theory, buying a stock with a price-to-book ratio below one is akin to buying a dollar coin for less its worth. Investors stand to make a nice profit, simply by waiting for the company or REIT to cash in on its assets, or return its profits to shareholders through dividends or buybacks.
Investors may also use the price-to-earnings (PE) multiple as a guideline to finding undervalued stocks. Typically, investors should look for companies that trade below its historical price-earnings average, or are trading below the PE ratio of their peers.
Beware the fundamentals
Stocks that trade at a discount often have underlying problems.
The trick is to figure out whether the problems are solvable, or unsolvable. The former would make it a value stock, but the latter would make the stock be a value trap.
Investors should look the company’s balance sheet for clues. To avoid value traps, we should avoid companies with unsustainable debt, and poor cash-flows from their operations.
Value hunters can also check if the company’s a current ratio is above 1.5. The ratio is the company’s current assets compared to its current liabilities. A low current ratio may suggest that the company could face a liquidity crunch in the near term.
Finally, we also have examine if the company’s business prospects remain good. For instance, technological disruption has had a real and damaging impact on the profitability of Singapore Press Holdings Limited (SGX: T39). Over the past five years, newspaper readership and the associated ad revenue have declined dramatically as more people turned to online news. Even as the company’s share price trades at close to a five year low, the company is unlikely to make a turn-around anytime soon.
Value stock example
A prime example of value stocks, which arose due to short-term solvable problems, appeared in 2016, when shares of Singapore’s three major banks fell. Back then, bank stocks had plummeted as investors feared that the banks’ exposure to the oil and gas sector would cause losses, and result in large write-offs from bad debt.
By now, we know that the concerns turned out to be a short-term problem, and the banks, in fact, had sufficient liquidity to negate the effects of the non-performing loans from the oil and gas sector. Since then, bank stocks have rebounded on the back of growing interest and non-interest income. Value stock hunters who had bought in during the turbulence would be sitting on good returns.
The Foolish bottom line
“Price is what you pay. Value is what you get”
– Warren Buffett
Value investing is a great way to profit in the stock market. Investors who are able to find these under-valued gems can make a killing once the market realises the discrepancy between price and value. However, it is also crucial that we do not simply dive into any stock that has depressed prices.
Investors should do their own due diligence to sieve out the real value stocks from the value traps.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Jeremy Chia doesn’t own shares in any companies mentioned.