No rational investor claims to be seeking to buy the most expensive stocks. Of course, everyone wants to buy a stock low and sell it high, but what is it that sets ‘true value investors’ – who are actually quite rare – apart from other investors? And what sets ‘Deep Value’ investors (even more rare, indeed) apart from ‘regular’ value investors? Consider the different types of investors:
1) TECHNICAL (PRICE-BASED) INVESTORS
First, let’s consider the technical analysts. This group of investors almost abhor fundamental analysis. They typically study past price patterns and volume levels seeking to extrapolate and infer future price movements from those historical patterns of supply and demand. Technicians care nothing about a stock’s fundamental aspects, never considering a company’s balance sheet or earnings power in the analysis. Instead, they plot charts of price patterns in the past and seek to infer future patterns from the past patterns. Technical analysis lends itself to very short-term (frequently day- or even hourly trading), which is something most investors neither have the time nor inclination for doing.
Does technical analysis work as an investment approach? Sure, it works for some. We even use it ourselves as an enhancement to (not a driver of) our approach, but we know of no investors who claim to have become millionaires or billionaires from a purely technical approach, do you? On the other hand, many investors can bring to mind a half-dozen or more names of billionaires from the world of value investing. But first let’s examine some other more common alternative investment investing approaches…
Macrofundamentalists are concerned with broad economic factors that affect stocks as a whole. These investors are interested in things such as interest rates, unemployment rates, gross domestic product (GDP), and business cycles. This top-down approach starts with the overall economy and works its way down to specific sectors and then to specific companies. Like any other investor, macrofundamentalists seek to buy low and sell high, and they hope that their superior analysis of the overall economy will allow them the privilege of doing that. Again, I don’t know many macrofundamentalist billionaires, although there may be one.
The type of investors who analyze specific companies, taking apart the financial aspects of each, are called micro-fundamentalists. Even among microfundamentalists, value investors in the tradition of Graham and Dodd are very rare. The common approach of microfundamentalists begins with the current price of the stock as the point of departure in analyzing a company.
These investors research how the price of the stock has reacted historically to changes in earnings, changes in the company’s industry, changes in the product channel (i.e., channel checks), improvements in product technology and new product development (think Apple). Others focus on management of the company, and management shakeups (think Hewlett-Packard or Yahoo) as the starting point of their investment. These microfundamentalists try to anticipate how changes to these various factors are going to affect the future price of the stock. Again, because of their self-perceived expertise, they believe they can estimate future prices better than the next analyst, thereby buying low and selling later at a higher price.
Another style of microfundamentalist investor places all of their attention on company earnings. We all know how much brouhaha surrounds ‘earnings season’ every quarter, and how the TV-business news channels like to make a big, dramatic announcements when a popular company’s earnings ‘surprise the street.’
Many microfundamentalists focus their efforts on analyzing and predicting (using what they hope is a greater degree of effectiveness than other approaches) a company’s future earnings. When they find a stock that they believe is underpriced compared to their estimate of future earnings growth, they buy. They believe they are buying low- and based upon their superior knowledge of the future – they intend on selling high. At least that is the foundation of their hope.
Those are the primary types of investors in the world: 1) Technical Analysts, 2) Macrofundamentalists with a top-down analysis, 3)Microfundamentalists focusing on company-specific events that might impact the stock, or 4) Microfundamentalists who think they have a sharper insight into a company’s earnings prospect. These categories account for 90% or more of all investment approaches.
Two Consistent Themes
There are two consistent themes among each of these common investment approaches. One is a focus on anticipated changes in prices, and the second consistent theme is a focus on estimations of future events.
If you listen to any of the television business-news channels with these two themes in mind, you will hear them over and over and over. Each of the guests is promoting his own style of expertise, and almost to a man they are making a prediction about the change of prices based on an estimated outcome in the future. One will say they ‘expect Apple to have strong price performance going into the third and fourth quarter as a result of the introduction of a new iPhone.’ Another will say they expect the prices of materials and industrial stocks to surge higher as the economy picks up steam going into next year. If you listen to the TV news channels, or read any of the printed investment newspapers, you will hear these approaches to investing over and again.
4) VALUE – THE RARE APPROACH
True value investing in the Graham and Dodd tradition makes no estimation whatsoever of the future. True value investing starts with a careful analysis of the present value of the company - assigning a per-share worth, and then looks at the current level of a stock’s price compared to the current underlying value of the company. Once the value of a company is determined by careful micro-fundamental analysis, and a ‘margin of safety’ (usually 30% or more) is subtracted from that value, the true value investor can determine whether a specific stock is an attractive or unattractive prospect.
Under no circumstance is an estimation of future outcomes factored into the analysis. The value investor does not start with the stock’s price – the true value investor starts with the underlying company’s intrinsic value, then compares the stock price to the intrinsic price, seeking a bargain. The bargain is the key aspect of the value approach. This is also why true value investing is the LEAST RISKY approach to investing: you are buying at less than fair market/liquidation value!
The best estimation of a true bargain is buying a stock below the value of the company’s liquid assets. It doesn’t happen often, but when it does, it’s a beautiful thing! This is really the goal of ‘DEEP VALUE’ investing. We seek to purchase the beaten-down stock of weakened companies, companies where it is unclear if they will survive.
This is why true value investing is a very rare approach. Many thousands of people will tell you that they are ‘value investors,’ but they aren’t – at least in the classic, Graham and Dodd sense. Most are simply micro-fundamentalists that are pinning their hopes on an estimation of the future and a guess that the stock’s price will be higher tomorrow than it is today. Estimating the future and guessing outcomes based on those estimates is a very poor way to invest for the future, but that’s how its usually done.
Each of the investment approaches we discussed earlier is a valid approach if pursued carefully and diligently, but the key is that there is an estimation of the future involved in each of those approaches, and as far as we know, no one has the proverbial crystal ball to consistently and flawlessly to forecast the future.
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