Value trading is based on the ideas that Ben Graham and David Dodd started teaching at Columbia Business School in 1928. There are many interpretations of what value trading is, but the basic concept is as follows:
Essentially a value trader wants to buy stocks at a discount to their intrinsic value. Intrinsic value is calculated by taking a discount to future cash flows. Therefore, if the stock price of a company is lower than the intrinsic value by a “margin of safety” (normally around 30% of intrinsic value), then the company is undervalued and worth investing in. Generally, value stocks are companies that are in decline, but the market has overreacted to their situation and the stock is trading lower than their intrinsic value.
Therefore, a value trader is seeking assistance from financial analysts, statisticians, actuaries, macro-economists, industry economists, market professionals, accountants, engineers, scientists, computer programmers, librarians, and research assistants.
Not many traders become value traders, because there is a great deal of effort required to make these trades work. The goal of a value trader is to make money on cheap stocks - which is harder than it sounds and can take years to play out.
Consequently, the long-term rewards don't go to people who think value investing is easy. Superior returns can be earned only by those who know that it is hard - and stay put.
The value trader, perhaps more than any other type of trader, is more concerned with the business and its fundamentals than with other influences on the stock’s price.
Fundamentals, such as earnings growth, dividends, cash flow and book value are more important than market factors on the stock’s price. Value traders can also be classed as buy and hold investors as they are with a company for the long term.
If the fundamentals are sound, but the stock’s price is below its obvious value, the value trader knows this is a likely investment candidate. The market has incorrectly valued the stock. When the market corrects that mistake, the stock’s price should experience a nice rise.
Value trading guidelines
Here are some guidelines that value traders look for in a potential investment. Investors should settle on a formula that works for them, but it will probably include as a minimum these elements:
- A Price Earnings Ratio (P/E) in the bottom 10% of its sector
- A PEG of less than one. A PEG (P/E growth of earnings) of less than one may indicate the stock is undervalued.
- A Debt to Equity Ratio of less than one.
- Strong earnings growth over an extended period. A realistic number might be in the 6-8% range over seven to 10 years.
- A Price to Book Ratio of one or less.
- Not paying more than 60-70% of the stock’s intrinsic per share price.
Finding value trades
To find truly undervalued stocks, value investors follow a three-step process:
- They sort stocks by price/earnings (P/E) or other metrics and concentrate on the lowest P/E stocks. This step enables value investors to reduce the number of stocks they will examine more closely and at the same time identify potentially undervalued stocks by focusing on the lowest P/E stocks.
- Next, value investors individually value each of the low P/E stocks to find which of the stocks are truly undervalued. A stock may have a low P/E because it is a bad stock. The only way to differentiate the good from the bad is to value all stocks in the low P/E group.
- The final step in the value-investing process compares the intrinsic value of each stock to the market price. If the stock price is lower than the intrinsic value by more than the so-called “margin of safety” (normally around 30% of the intrinsic value) the stock is considered truly undervalued and may be worth investing in.
An example of value trading gone wrong!
The classic case is Research in Motion, now Blackberry Limited (Nasdaq: BBRY).
- In January 2007, RIM was trading at a high 55 times P/E multiple. A computer company called Apple had reinvented itself as an MP3 player company and was unveiling a new phone set to launch in the summer.
- By the end of December 2009, market share for Apple’s iPhone iOS as a percentage of US smartphone OS was 25% while RIM had increased from 28% to 41% in that same period. Though RIM had grown its market share, fears of iOS growth had toppled the P/E multiple to around 17 times.
Many traditional value traders viewed the situation in the following way:
- RIM is holding up pretty well compared to the iPhone, yet their P/E multiple is getting destroyed. It’s trading at near the historical average S&P 500 P/E multiple of 15 times.
- Apple hasn’t historically been strong in the enterprise, so maybe iPhone will just be a consumer phenomenon that doesn’t break through to business users.
- Android is irrelevant with 5% market share.
- The smartphone market is growing rapidly and RIM is the clear leader. RIM is still growing north of 35% and generating nearly $2.5B in net income.
These value traders still saw RIM as cheap and sound. However, two years later, RIM was trading at a 3.5 times P/E multiple and topline growth had screeched to a halt. Market share for RIM had contracted to 16% while iOS and Android combined for 77% market share. In fact, in 2012, RIM posted a net income loss of $847M. Investors lost a great deal of money and were left scratching their heads.
1. Technology adoption accelerating - New technologies are being adopted much faster than ever before. While technologies from the early part of the century like electricity, automobiles and the telephone took well over 50 years to reach 50% adoption, newer technologies like Internet, PCs, smartphones and tablets are being adopted much faster.
2. Internet way of life - An individual’s interaction with the world generally takes on three forms: consuming, communicating or creating. Historically these three mediums required a very different set of products and services to help them get the task done. Today all of this happens digitally.
3. Software changing the world - Technology is upending markets and is becoming a threat to value traders. In the case of RIM, the company thought that their scale was defensible and stopped innovating on the operating system, favoring battery life instead. Apple’s iPhone operating system and associated software was an order of magnitude better than RIM and attracted consumers. Interestingly enough, as of July 2013, Apple was dangerously close to losing their own software battle to Google with mobile versions of Google Maps, Gmail and Google Voice being far better than their iOS counterparts.
While there may still be opportunities for value investing, a value trader needs to be cautious of businesses that appear to be on a slow decline. With the rate of technology adoption accelerating, the internet being a way of life and software consuming the world, businesses that refuse to embrace or adapt don’t just slowly decline; they fall off a cliff and take their cash flows with them.
However, many value traders have made fortunes using a value-based approach to trading, which suggests a philosophy that works over time if they buy carefully and hold for the long term.
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