Investing for value
In continuing our examination of different investment styles, this article looks at value investing and outlines some of the opportunities available to Australian investors
Value investing has been in favour for much of this decade after growth was abandoned in the wake of the tech boom and bust and the excessive valuations of the late 1990s. A word of caution, no one investment style - growth, value or variants of these - should be used to the exclusion of one or the other because the investment environment can change making discounting one style in favour of another risky. That said let’s see what’s so intrinsically appealing about value investing beyond its description.
Value investing conjures up the idea of buying assets that truly represent value. In some cases that means searching for bargains – beaten up stocks that are out of favour. In other cases its stocks in areas that don’t attract much attention. Did you know Warren Buffet’s first investment was in a furniture retailer because he understood the business and its value? And on the subject of furniture IKEA founder Ingvar Kamprad has just recently overtaken Microsoft's Bill Gates as the world's richest man. So what’s involved in becoming a value investor?
Value investors invest in undervalued companies believed to possess something that could improve their ability and/or unlock value. They also attempt to take advantage of opportunities created by investor overreaction and short-term focus without being put off by these factors themselves eg Oct 1987, Sept 11 2001.
Value Investing Requires Patience
If your investment style is to trade in and out of stocks in the short term then becoming a value investor requires a new approach. Where growth investors might typically hold a stock for six months, value investors hold for three to five years. Value investors don’t try to predict which way interest rates are heading, or the direction of the market or of the economy. They don’t look at stock charts nor pay attention to analysts’ buy/sell ratings or earnings forecasts. Value investors don’t try to determine if all the bad news is already built into the stock’s price, or if further disappointments will drive the share price down further. In short they ignore general market “noise” and instead focus on the company and its ability to execute.
Value investors view all industry sectors as cyclical, meaning that each sector, and hence the stocks making up that sector, will go through periods of out performance. Then inevitably the companies over-expand and growth falters, margins contract in the face of oversupply, and stock prices plunge. Eventually the excess capacity is absorbed, demand picks up, and the cycle repeats. Sound familiar? The TELCO sector is currently working through excess capacity and investors can only wonder when demand and pricing will pick up.
Rather than trying to predict the timing of these cycles, value investors compare a stock’s current valuation ratios (e.g. price/earnings) to their historical ranges, and from that information determine whether it’s time to buy or sell.
Value investing can be defined as investing in companies with high cash flow, low P/E, low p/e/g, low p/b ratios, among other things. In particular value investors have long considered the price earnings ratio (p/e ratio for short) a useful measure of the relative attractiveness of a company's stock price. The price /earning ratio is the price an investor is paying for the company's earnings. In other words, if a company is reporting earnings per share of $2 and it’s selling for $20 per share, the p/e ratio is 10 ($20 per share divided by $2 earnings per share = 10 p/e.) Made popular by the late Benjamin Graham, Warren Buffett etc, Graham preached the virtues of this financial ratio as one of the quickest and easiest ways to determine if a stock is trading on an investment or speculative basis.
For example if a particular stock’s price/earnings ratio has ranged between a low of 15 and a high of 40. Value investors would consider the stock a buy candidate if its current P/E is around 20 or less. Once purchased, they would hold the stock until its P/E moved into the high 30 to 40 range. Ask your broker, go to their website or a free site such as Yahoo and look up the p/e ratio for the last 3 years. It’s a valuable check before you consider buying a stock that you’ve read about. Once you’ve got the figure use the p/e ratio to compare your stock with other companies in the same industry, then check out the valuation of the whole sector. If the average p/e ratio of all of the companies in the sector is far above the historical average this could spell trouble. Investors would do well to avoid sectors where the market capitalisations are unrealistic. CSL at one stage traded above $50 giving it a market cap in excess of $10 billion only to fall back at one stage to $11, now $28.
Finding value in unlikely places
Distressed assets such as debt securities or the stock in companies that are out of favour and have been in a slump often allow investors to buy in at very attractive valuations. With the benefit of hindsight ALL- Aristocrat Leisure was a “screaming buy” 12 moths ago. It was not only out of favour with investors for not being upfront about its US operations (there is class action before the courts by disgruntled investors on this very point) but was embroiled in a legal dispute with since ousted CEO Des Randall. Today the stock is back trading around $7.50, a far cry from 90c at its low point.
BPC - Burns Philp Limited is another example of a stock and its debt securities that have benefited from the turn around orchestrated by its biggest shareholder and deputy director Graeme Hart. BPC has had a volatile history, recovering from near-collapse in the late 1990s when its U.S. herbs and spices businesses were pummelled by a pricing war. A word of caution - value investors don’t buy stocks just because they’re cheap, they have to be assured that the problems are temporary, or solvable. Value investors hold these stocks until their prospects once again look bright, and then they sell them back to growth investors.
Not all situations of course rely on “bottom fishing” for stocks on the precipice. Bank stocks were universally discarded in the hype of the tech boom despite posting solid earnings throughout the 1990s and represented exceptional value at the time. Most bank stocks have since doubled as the flood of money moved back in favour of value stocks.
Finding Value in Far Away Places
As the world continues to evolve into a global economy and the Australian market is at or near record levels, more investors are seeking opportunities abroad. With more diverse options, the international stock markets may be able to provide those opportunities. International markets may provide greater value and add a measure of diversification to a domestic-heavy portfolio. Closed end country funds can often trade for less than their NAV- net asset value when the country or region is out of fashion. At the end of 2002, both India Investment Fund (NYSE: IIF) and The India Fund (NYSE: IFN) traded at discounts of around 15% to NAV. They have since benefited both from the rise in the Indian stock market and the elimination of this discount, more than doubling in price during the last 15 months. These and other opportunities are available to Australian investors via their Australian brokers as part of ASX World Link.
Long term view necessary for value to come to the surface
If you aren't willing to buy shares in a company and forget about them for the next ten years, you really have no business owning those shares at all. The simple truth is professional money managers attempt to beat a benchmark such as S&P/ASX 200 yet the majority do not. Rather the way to create long term value has historically been to select a great company, pay as little as possible for the initial stake, begin a dollar cost averaging program, reinvest the dividends and leave the position alone for several decades.
For more information on the role of different ASX products in building a portfolio based on value investing visit the ASX website.
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