Why a Cash Recommendation is Just as Valuable as a Stock Recommendation

We are holding a high amount of cash (60%) in our three portfolios at this time; we are not adding any new stocks again this week, and we have tight stops on each of our existing positions.  This is at a time when the overall market (represented by the S&P 500) is hitting fresh all-time highs.  So what’s the problem? Why aren’t we taking advantage of this bull market?

In the past, many IntelligentValue subscribers would choose to leave us about now, ostensibly because they felt that their subscription was payment for the regular disclosure of good stock picks.  If we didn’t have those undervalued stock picks listed each week consistently, apparently some felt they were shortchanged and subsequently cancelled their subscription.

This pattern of behavior is unfortunate, because the advice to hold cash in a portfolio (either partially or completely) is just as valuable as a recommendation to purchase particular individual stocks.  Because of the high cash condition of our portfolios again this week, I’m going to elaborate briefly on why this is true.  To some, this discussion may be blatantly obvious, but to others it’s not so clear why cash is an advantage.   If you’re in the former group, please consider this a brief refresher article.  If you’re in the latter group, please pull up a chair.

“There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.”
– Mark Twain


THE  TEMPTATION OF THE QUICK BUCK

The majority of market participants follow approaches that provide no real hope of long-term gain.  In fact, most pursue avenues that hold the chance of considerable financial loss and resemble outright gambling more than they do investments.  It’s easy for the undisciplined individual to fall prey to investment schemes that promise quick and easy gains.

The temptation of making a quick buck is high, and the majority of investors are unable to fight the influence of the crowd.  This activity is invariably focussed on stock prices and speculation of where those prices might go next, rather than a clear and thorough analysis of a business’s fundamentals.

After all, fundamental analysis is difficult, and surely anyone can easily see that the latest hot technology stock will quickly grow into its 175 PE ratio!  “There’s no analysis needed to anticipate that gain,” they reason.  Plus, “Everyone on TV is talking about that stock and how could everyone be wrong?”  This kind of flawed logic is rife in the investment world, both with individual investors and professionals.

THE SOURCE OF THE INTELLECTUAL CORRUPTION

In many ways, Wall Street functions as a giant casino where the collection of commissions and fees easily trumps any fiduciary responsibility a firm may have to their clients.  Wall Street is clearly more concerned with the volume of trading than it is with their client’s financial success.  This can be attributed to up-front fees being charged on every transaction, which provides the entire structure of the Wall Street machine with an incentive to promote the volume of trading over successful investing.

In this atmosphere, Wall Street’s drive for commissions coerces the entire system into a short-term trading mentality.  The concept of investing in America has developed into a speculative gambling enterprise, with the ‘house’ consistently winning.  Stocks become less a document of partial ownership in a business and more a digital ‘chip’ that is traded endlessly back and forth.

The speculative churning of stocks seeps into every nook and cranny of the investment world.  Institutional money managers face pressures that force them to join a short-term relative performance derby.  In this race, the risk of portfolio losses on their job security is great.  In an effort to avoid losses, many engage in indexing, which is a sure-fire recipe for mediocrity.  This base of holdings is then supplemented by short-term investment fads and the latest, most popular stocks as a way to stay ahead of the ever-present S&P 500 benchmark.

These money managers can rest assured that their quarterly reports to their clients are greeted with gusto when the most popular names comprise the investment list.  However, historically only 3% of money managers beat the S&P and the majority actually lose money over any given 10-year period, so this approach is most assuredly not working out well for the clients.

For individual investors, the frenzied atmosphere of the market, which includes breaking headlines continuously fed to their inbox and TV channels with one ‘expert’ after another, supplemented by regular features about ‘fast money,’ leads many to become enmeshed in the short-term chase for returns.  In this environment, stocks are more like commodities than certificates of ownership in a business.

THE GUESSING GAME POSING AS INFORMED ADVICE

As the daily parade of experts on TV give their opinions about what to expect next, you constantly hear phrases such as “I think,” “I believe,” and “we expect.”  In essence, these gurus and experts are just giving their opinions, which are merely guesses.  As soon as the opinion is projected out in airwaves across the world, it is quickly forgotten by the speaker because we find them back on the show a week later giving an entirely different forecast, oblivious to the fact that their previous guess turned out to be 100% incorrect.

The stock-market community is obsessed with something that is diametrically opposed to a rational approach to investing, i.e., forecasting the future.  Value-investing great Seth Klarman said it well:

“Speculators are obsessed with predicting—guessing—the direction of stock prices. Every morning on cable television, every afternoon on the stock market report, every weekend in Barron’s, every week in dozens of market newsletters, and whenever businesspeople get together, there is rampant conjecture on where the market is heading.  In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.”
– Seth Klarman

 

This speculation of what will happen in the future is a fool’s game.  However, it’s the same game that has been played over centuries using crystal balls, tarot cards, and tea leaves.  It’s disappointing that with so much fundamental business information now available at their fingertips, the majority still depend on the predictions of investment soothsayers to tell them what will happen tomorrow or next week.

Most so-called ‘investment professionals’ that appear in the media are really ‘speculation professionals,’ because they are advocating short-term bets based on predictions of market fluctuations rather than making intelligent long-term investment decisions based on business fundamentals.

The majority of market participants are caught up in the comfortable atmosphere of speculative consensus, a world where the emotional responses of greed and fear dictate short-term decision-making.  However,  as addictive as it is, the excitement of hitting the ‘buy’ and ‘sell’ buttons with an online broker and taking a ‘flyer’ on the latest hot stock is truly asinine behavior.  It is the definition of ‘speculation,’ which is another word for gambling.

There’s one critical difference between investors and speculators that should be important to you: investors have a good chance of achieving long-term gains, while speculators are likely to lose money over time.

WHY QUANTITATIVE VALUE INVESTING WORKS

Quantitative value investing is the antithesis of the speculative activities that dominate the stock market today. There are several crucial ways in which value investing differs from all other styles of investing.

First of all, it is based upon the quantitative analysis of a company’s fundamentals, i.e., its book value, its cash flow, its capital expenditures, its return on equity, etc. Based on these fundamental aspects of the business, we can assign a reasonable value. Purchasing at a substantial discount to this value is the key to unlocking the world of investment gains (more on this in a moment).

Secondly, there is little or no forecasting of the future involved in quantitative value investing (at least the way IntelligentValue practices the art).  Any discipline that depends upon forecasts of the future is risky, vulnerable to error every step of the way.   We base our value analysis strictly on conditions as they exist today, not extrapolations or predictions of the future.

The typical speculative approach to stocks includes the daunting task of predicting the unpredictable, whether it is oil production next year, next quarter’s GDP figure or a particular company’s net earnings next year. You also have to accomplish this mission faster and more efficiently than thousands of other very smart individuals.  Is an impossible game you would be wise to avoid.

Thirdly, quantitative value investing is a risk-averse approach.  We are looking to purchase at a discount to the company’s intrinsic value. In the words of Warren Buffett, it’s the concept of purchasing a dollar bill for forty cents.  We seek to find a margin of safety in our investments to protect us from loss of capital.  On the other hand, speculative investing is a greater-fools game. You’re hoping someone else will pay a higher price for an asset when the price may be entirely unrelated to the asset’s value.

Consider Amazon, currently with a shockingly high PE of 871. Will someone pay a higher price than that?  Perhaps. Perhaps not. But Amazon investors are hoping someone will buy their shares at a higher price based wholly on speculation that it will someday make a reasonable profit.

In value investing, we have a good idea of what an asset is worth and are paying for the stock at a safe margin below that value.  Amazon’s stock could shoot higher, or the bottom could fall out based upon the next company-related headline, either positive or negative.

And a fourth difference is that value investors maintain cash balances at times.  We maintain a cash balance when we are unable to find attractive, undervalued opportunities, and put that cash to work when those opportunities become available.  We’re not afraid at all to hold a significant amount or even 100% cash in our portfolio if we are unable to find stock ideas that meet our margin of safety requirements.

The result of our quantitative value-investing approach is apparent: returns greater than 100% annually and never a losing year (even in the 2008 market collapse we made a solid return).  On the other hand, the speculative approach that dominates the market, while potentially exciting, is a losing game.

WAIT FOR THE OPPORTUNITY

Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands.  The rampant speculation that rules the market is an edge that value investors can exploit to their financial advantage.  Currently, we are finding few stocks that meet our quantitative standards for selection.  The most likely reason for this is that stocks are somewhat overvalued.

At times like these, it pays a value investor to maintain their discipline and hold cash even if the overall market is setting new highs.  Turn off CNBC, Bloomberg, and Fox Business, cancel your subscription to the Wall Street Journal, and put aside Forbes.  Those are all media that thrive on the Wall Street volume-at-any-cost machine and cause unnecessary distractions for value investors.

For years, investors have been given the message by the ‘machine’ that they need to stay totally informed about conditions of the market in order to anticipate changes, get ideas, and speculate on the future.

You will be better-served by ignoring the media and instead following our value-based stock selections, which means holding cash at times until our quantitative systems reveal fresh undervalued opportunities. There’s a substantial reason our portfolios are mostly in cash at this time, and we believe our systematic approach will be proven correct again.

Stick with the program! Our 100%+ annual returns have proven the case for this admonition year after profitable year since our launch in 2004.

True Value Investors are a Rare Breed

‘TEMPORARY LOSERS’ ARE THE MOST PROFITABLE INVESTMENTS

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…

2) MACRO-FUNDAMENTALISTS

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.

3) MICRO-FUNDAMENTALISTS

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.

You are apparently a member of the small group of individuals who recognize this fact and see true, Graham and Dodd-oriented, Deep-Value investing as the clear choice for you. We’ll help you with insights and stock suggestions that meet this choice.

To join IntelligentValue.com now and get instant access to our VALUE portfolios which have truly phenomenal returns, go to this link: http://www.intelligentvalue.com/subscribe.htm.  Get a special 2-week trial forFREE with a full Money-Back Guarantee if you continue!

Stock Strategies: Basics of The Value Investing Stock Strategy

Value investing is a very popular stock strategy where investors seek out companies that they believe have the ability to create profits at an acceptable level during a sustained holding period. An acceptable level of profits would probably mean doing better than the market average, but it would be different for every investor. What is the same for all value investors is the desire to buy a well performing stock at a bargain price.

For value investors, simple market factors that can cause fluctuations in stock prices are not of great concern. Common market factors which tend to affect stock prices are: inflation reports, Fed rate hikes, oil prices, and wars. While it is true that market factors will affect stock prices, value investors tend to look further down the road and, therefore, believe temporary fluctuations will not affect long-term profitability – when owning ‘value stock.” In fact, the “buy and hold” stock strategy is employed by most value investors because they tend to hold onto value stocks for many years at a time. Where the two strategies differ is in their selection of stock.

Value investors are not concerned with market factors as much as the actual companies in which they are investing. In fact, a value investor likes to know the “fundamentals’ of a company – or all factors relevant to the business and its relative strength in the market. Some very useful fundamentals for value investors to know include: cash flow, earnings growth, dividends, and company debt.

However, just because a company is sound in all of the categories listed above, that does not mean it would be considered a value stock investment opportunity. A company with great cash flow, solid, consistent earnings growth, reasonable dividends and relatively little to no company debt – may actually be a growth stock investment and therefore not desired by a value investor.

The value investor is looking for the best deal: a company with sound fundamentals but, trading below its “true value” for some reason. The market should eventually correct its inaccurate valuation and, send stock prices sharply upward when that correction occurs. This is why value investors comb the markets for great companies that have been missed by analysts and the investment community.

But, finding a good investment that appears undervalued by the market (and therefore trading at a price below its true worth) is not the same as buying cheap stocks or those that have already peaked and won’t recover. There is usually a fundamental reason behind the decrease in the market value of a company and the consequent plummet in stock prices: essential business principles or operations may have changed (such as decreased earnings, loss of market share, etc.). Fundamental market changes will also cause fluctuations in value, such as government imposed new emissions regulations on the auto industry that would severely increase the costs of production for all automakers.

Analysis in Value Investing Stock Strategy

As the value investor is trying to find good companies with strong growth and earnings potential that have been overlooked by the market somehow, a lot of homework and analysis will be necessary. The trick for anyone using the value investing stock strategy is to find the true value of the company as opposed to its “market value.” A number of factors are used to determine the true value of a company and each investor will have their own “winning formula.” Some common valuation metrics for value investors are:

Price/Earnings Ratio (P/E Ratio) - The P/E ratio can be used to determine how the earnings of a business compare with the current share price. It is obtained by dividing the current stock price by the annual earnings per share. The higher a company’s P/E ratio, the greater the expectations placed upon it by investors in the near future. These higher expectations also drive up stock prices, which is why investors using the value stock strategy do not like high P/E ratios as they may indicate that the company is over valued by the market. This is precisely the opposite of what a value investor is looking for – instead, the value stocks tend to be those that have a P/E ratio in the bottom 10-20% of their business sector.

PEG - The PEG is a valuation metric concerned with future earnings growth. The PEG factors in future growth rates with the P/E ratio. It is calculated by dividing the P/E ratio by the projected growth in earnings for the coming year.

PEG = P/E Ratio / Projected Growth in Earnings

For instance, assume that Business A has a P/E ratio of 15 with projected earnings of 12%, or 15/12. Most value investors like companies with a PEG of 1 or less because it is a good indicator of being under valued by the market. Business A has a PEG of 1.25 which means that investors are willing to pay more for future earnings growth than a company with a PEG of 1 or less. Essentially, the market already recognizes the value in company A and, the stock prices have risen accordingly. Thus, company A would not be considered a value investment but, may still be a solid growth stock worthy of investment. The higher the PEG number, the more expensive the investment and the less likely a value investor will be interested in owning stock in that company.

Solid Earnings Growth over an Extended Time

It is not uncommon for a company to have great earnings over a period of 6-8 years and, then decide its time to take the business public. After a great IPO, the business may stagger and fail to meet earnings or revenue expectations. As a result, the stock may nose dive and fall out of favor with the investment community. Value investors, however, see this as a potential opportunity: solid and sustained earnings growth is no accident – the company knew what it was doing before and, one or two bad quarterly reports don’t necessarily spell disaster. In fact, they may be due to massive investments in the company that may result in increased profits, higher dividends, and higher stock prices in the not-so-distant future. If a company can maintain 7-10% earnings growth over a period of 5-6 years or more, then one or two misses can probably be explained by some temporary factors. So long as the fundamentals remain solid and any poor performance is explained sufficiently, a value investor would consider this a value stock with the prospect of solid future earnings growth as well.

Intrinsic Value

Determining the value of a business used to be fairly straightforward: add up all the assets, subtract any outstanding debt and financial obligations – whatever remains is the value of the company. Value investors need to look beyond the obvious assets and market position of businesses – especially in the Information Age.

It is difficult, if not impossible, to put an accurate value on intellectual property, developing technology, and any knowledge based asset. How do you know what a patent is truly worth when you don’t know what future sales will actually be? How many sales are made because of a trademark or logo – what if you had to put a dollar amount on how much that trademark is worth? Sometimes, these corporate “intangibles” do not even show up on the financial statements. Value investors seek out and purchase stocks when they believe that current share prices do not accurately reflect the value of intangibles and their potential to affect future growth. When the market corrects based off of higher-than-expected earnings and revenue, the stock prices will rise nicely and handsomely increase investor profits.

To find the intrinsic value of a company, investors need to determine the market cap – or establish how much it would cost to buy every single share of company stock at current market prices. This is the total value of the company according to the market – including intangibles, fundamentals, and market conditions. A value stock generally has a market cap which is close to or maybe even lower than the book value.

The book value of a company is found by totaling assets and, subtracting all obligations and liabilities. If the assets had to be liquidated and all the debts paid off, how much would be left? That is the book value of the company. The market cap will exceed the book value by a fair margin in growing companies because of their ability to generate earnings growth – often due to intangibles such as patents, trademarks, or other intellectual property that gives them an advantage over the competition.

Value investors use a number of valuation metrics and analysis to help find stocks that are under valued today, but are destined to rise once the market corrects its mistake in the future. P/E ratio, PEG, earnings growth, and intrinsic value are just some of the variables that value investors look at when trying to find the best bargain stocks on the market.

via Stock Strategies: Basics of The Value Investing Stock Strategy.

How To Use Price-To-Sales Ratios To Value Stocks

How To Use Price-To-Sales Ratios To Value Stocks

Investors are always seeking ways to compare the value of stocks. The price-to-sales ratio (Price/Sales or P/S) provides a simple approach: take the company’s market capitalization (the number of shares multiplied by the share price) and divide it by the company’s total sales over the past 12 months. The lower the ratio, the more attractive the investment. As easy as it sounds, price-to-sales provides a useful measure for sizing up stocks. But investors need to be mindful of the ratio’s potential pitfalls and possible unreliability.

How P/S Is Useful

In a nutshell, this ratio shows how much Wall Street values every dollar of the company’s sales. Coupled with high relative strength in the previous 12 months, a low price-to-sales ratio is one of the most potent combinations of investment criteria. A low P/S can also be effective in valuing growth stocks that have suffered a temporary setback.

In a highly cyclical industry such as semiconductors, there are years when only a few companies produce any earnings. This does not mean semiconductor stocks are worthless. In this case, investors can use price-to-sales instead of the price-earnings ratio (P/E Ratio or PE) to determine how much they are paying for a dollar of the company’s sales rather than a dollar of its earnings. P/S is used for spotting recovery situations or for double checking that a company’s growth has not become overvalued. It comes in handy when a company begins to suffer losses and, as a result, has no earnings (and no PE) with which investors can assess the shares.

Let’s consider how we evaluate a firm that has not made any money in the past year. Unless the firm is going out of business, the P/S will show whether the firm’s shares are valued at a discount against others in its sector. Say the company has a P/S of 0.7 while its peers have higher ratios of, say, 2. If the company can turn things around, its shares will enjoy substantial upside as the P/S becomes more closely matched with those of its peers. Meanwhile, a company that goes into a loss (negative earnings) may lose also its dividend yield. In this case, P/S represents one of the last remaining measures for valuing the business. All things being equal, a low P/S is good news for investors, while a very high P/S can be a warning sign.

Where P/S Fall Short

That being said, turnover is valuable only if, at some point, it can be translated into earnings. Consider construction companies. They report very high sales turnover, but, with the exception of building booms, they rarely make much in the way of profit. By contrast, a software company can easily generate $4 in net profit for every $10 in sales revenue. What this discrepancy means is that sales dollars cannot always be treated the same way for every company.

Many people look at sales revenue as a more reliable indicator of a company’s growth. Granted, earnings are a complicated bottom-line number, whose reliability is not always assured. But, thanks to somewhat hazy accounting rules, the quality of sales revenue figures can be unreliable too.

Comparing companies’ sales on an apples-to-apples basis hardly ever works. Examination of sales must be coupled with a careful look at profit margins and their trends, as well as with sector-specific margin idiosyncrasies.

Debt Is a Critical Factor

A firm with no debt and a low P/S metric is a more attractive investment than a firm with high debt and the same P/S. At some point, the debt will need to be paid off, so there is always the possibility that the company will issue additional equity. These new shares expand market capitalization and drive up the P/S.

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Companies heavy with corporate debt and on the verge of bankruptcy, however, can emerge with low P/S. This is because their sales have not suffered a drop while their share price and capitalization collapses.

So how can investors tell the difference? There is an approach that helps to distinguish between “cheap” sales and less healthy, debt-burdened ones: use enterprise value/sales rather than market capitalization/sales. By adding the company’s long-term debt to the company’s market capitalization and subtracting any cash, one arrives at the company’s enterprise value (EV).

Think of EV as the total cost of buying the company, including its debt and leftover cash, which would offset the cost. EV shows how much more investors pay for the debt. This approach also helps eliminate the problem of comparing two very different types of companies:

The kind that relies on debt to enhance sales and

The kind that has lower sales but does not shoulder debt.

The Bottom Line

As with all valuation techniques, sales-based metrics are just the beginning. The worst thing that an investor can do is buy stocks without looking at underlying fundamentals. Low P/S can indicate unrecognized value potential – so long as other criteria like high profit margins, low debt levels and growth prospects are in place. In other cases, P/S can be a classic value trap.

via How To Use Price-To-Sales Ratios To Value Stocks.

Value Investing for Outstanding Returns

In 1934, Benjamin Graham, a Cambridge business professor considered by many to be the ‘Father of Value Investing,’ teamed up with fellow professor David Dodd and wrote the ‘bible of equity investing,’ Security Analysis.  A few years later, Graham wrote the classic investing tome, The Intelligent Investor, which Warren Buffett describes as “the best book about investing ever written.”

Seeing his family suffer through economic troubles when he was young, and later in life hardened by the terrible investment losses of the Great Depression, Graham was influenced to sysytematically select stocks that he could purchase with what he called a significant margin of safety. In times of economic meltdown (such as the Great Depression or the 2008 crash), that may be a discount to a company’s liquidation value or a discount to its cash- minus-all-debts. In today’s investing environment, which is becoming more to akin to a ‘managed economy’ than a free-market economy, it’s less about buying a stock at a discount to its book value or its cash, but instead buying the stock at a significant discount to its acquisition value – as if it were a private company.

VALUE INVESTING IS THE MOST PROFITABLE APPROACH

Value investing has proven to be the most profitable way to achieve steady, market-beating returns over the long run.  In the short term, some trading methods can make spectacular returns, but no approach can match the returns you can achieve over time through conservative, disciplined approach that is founded in value investing.

Always a great example of the power of seeking value over growth, Warren Buffett has become America’s richest man simply by following the teachings of his college professor, Ben Graham.  When he graduated from Cambridge University, Buffett started out with just $500 that he had saved and formed a small investing partnership with friends. That $500 grew into a net worth of more than $50 billion today, through the application of the teachings of his professor Ben Graham.

A few years ago, respected reseach firm Ibbotson Associates conducted an extensive study which shows that over 80 years, value stocks beat both growth stocks and the S&P 500 by a wide margin.  In fact, over that 80-year time period, a $1,000 investment would have turned into $5,000,000 (five million dollars).

Most investors don’t have 80 years, so another way to calculate Ibbotson study’s return from value investing in todays terms is to start with $10,000 over just 25 years, which would produce $1.3 million.  But the point is that there are many approaches to investing, and investing fads come and go – most of them dismal failures – but value investing consistently produces sound, market-beating returns year after year.

That fact doesn’t stop the average investor from chasing spectacular shooting corporate stars.  Decades ago, it was the ‘Nifty Fifty’ that captured many investor’s imagination.  In the late 90′s, internet stocks were supposed to be fueling a ‘new economy’ before they flamed out.  Growth stocks with a good ‘story’ of wonderful future expectations as well as momentum stocks of the moment are always an attaction to inexperienced investors.

In 2004, about the time IntelligentValue was launched, Krispy Kreme Donuts (KKD) was crashing to the dust following the reversal of a meteoric 350% gain. But to come to the rescue of all the momentum chasers, Taser (TASR) became the new popular rage as its price shot from $1 per share at its IPO to $30 before returning to the single digits within a year.  Shooting stars attact a lot of attention, but neither momentum, high growth, nor fads can hold a candle to the consistent, logic-based effectiveness of true value investing.

What Is the Difference between Investing and Speculation?

Philip Carret, who wrote The Art of Speculation 1930, believed “motive” was the test for determining the difference between investment and speculation. “The man who bought United States Steel at 60 in 1915 in anticipation of selling at a profit is a speculator. . . . On the other hand, the gentleman who bought American Telephone at 95 in 1921 to enjoy the dividend return of better than 8% is an investor.” Carret connected the investor to the economics of the business and the speculator to price. “Speculation,” wrote Carret, “may be defined as the purchase or sale of securities or commodities in expectation of profiting by fluctuations in their prices.”

via What Is the Difference between Investing and Speculation? | Inside Investing.