Investing in Undervalued Stocks for Maximum Gain
Article by C. Thomas Howard PhD, Emeritus Professor of Finance Daniels College of Business, Chief Investment Officer AthenaInvest. Author of The New Value Investing: How to Apply Behavioral Finance to Stock Valuation Techniques and Build a Winning Portfolio
The goal of Value Investing is to identify undervalued stocks, thus those that are expected to produce above average returns. The idea has been around for a long time. Very early on in happenings such as the Tulip Bulb craze of the 1500's and the South Sea Bubble of the 1700's and more recently in the stock market crash of 2008, investors have noticed that markets, being a human institution, make valuation mistakes.
Over the last 20 years the evidence has turned decidedly against the concept of an efficient stock market in which stocks are correctly priced. Instead we now realize stock prices are largely determined by the actions of the many emotional crowds that rampage about the market. This strengthens the case for implementing a Value Investing strategy. My success in managing the Athena Pure portfolio, using a Value strategy over the last 12 years, provides further support for this contention.
Successful equity investing is a combination of mastering your emotions along with building and consistently pursuing an objective investment strategy. My book, referenced at the end of this article, focuses on the latter by exploring various analytic techniques that can be used to identify attractive stocks in which to invest. But even a carefully constructed strategy will not allow you to outperform unless you ruthlessly drive emotions out of your decision process.
Value Investing is within everyone's reach. So why doesn't everyone use it? The key is patience. Value Investing does not work all of the time nor does it work with every stock. So you have to stick with it through thick and thin. Many investors are unwilling to wait out the dry spells. But it does work if you are willing to stay the course.
The Important Value Range
Value Investing is comprised of techniques for objectively measuring whether or not a stock is properly priced. These techniques range from understanding financial statements to ratio analysis to growth analysis to a number of valuation approaches. The emphasis is on anchoring your strategy in objectively measured fundamentals in order to drive emotions from the analysis.
One of the important components of Value Investing is defining the value range for a stock. This is the range of prices that is consistent with the fundamentals of the company. If the stock price is below the value range, then the stock is undervalued and is a buy candidate. On the other hand,if the stock price is above this value range, then it is overvalued and a sell candidate. A stock with a price falling within the value range is said to be properly valued.
The width of the value range reflects the difficulty of estimating a precise value due to the noisiness of company information. In essence by estimating a value range you are trying to filter out the signal from the noise. The basic idea is that if the stock price deviates far enough from its fundamental value, then there is a good chance that market forces will bring the price back towards a correct valuation.
Small deviations from fundamental value, the noisy price movements captured within the value range, are not large enough to trigger market forces. Thus the width of the value range represents the noise bounds for the stock. Graham and Dodd referred to the lower part of the value range as the margin of safety. They argued that determining this value makes it less likely that the investor will overpay for the stock.
A stylized representation of a value range is summarized in Figure 1. The central line represents the best estimate of the fundamental value of the company and is bracketed by a value range of ± 20%. The actual price of the stock wonders through this range, at times rising above the range and at times falling below this range. These are the times of greatest interest in the stock, either to buy it or to sell it. Both a buy and a sell signal are shown.
Figure 1: Value Range vs. Price for a Stock
Value Investing Fig 1: Value Price Range vs Stock Price
The value range in Figure 1 is ± 20%. This is about as narrow a range as you will be able to estimate. The information about a particular stock is very noisy in its own right. Fundamental series such as revenues, earnings, cash flows and, to a lesser extent, dividends contain quarterly and annual variations that may have little to do with the fundamentals of the company. Examples of this include bad weather that temporarily reduces revenues, a single product success that increases earnings and a change in accounting treatment that alters cash flow.
There are literally hundreds of such events each year that impact the financial information of a company. This makes it very difficult to determine if something is a fundamental change or simply noise. The width of the value range you use will be dictated by the noisiness of the company's information tempered by your own judgment.
Using information for a real company, Figure 2 reports value ranges based on dividend, earnings, cash flow, revenues and book value. These value ranges lead to the conclusion that the stock is correctly valued at its current price of $28 and does not represent an attractive investment at this time. If you currently own this stock, should you sell it? A reasonable case can be made for selling the stock, particularly in light of the dividend valuation. But I also think it would be reasonable to hold onto the stock as there is not an overwhelming sell signal at this point.
Figure 2: Value Ranges
Value Investing Fig 2: Value Ranges
Mastering Your Emotions
Besides building an objective based valuation approach, it is important to master your emotions. I make this suggestion because I believe it is the surest route to superior returns.
A large body of behavioral research shows that individuals make decisions based on emotions and anecdotal information and that the resulting choices they make are poor. While you may use an emotional, anecdotal approach when making day-to-day decisions, applying this same approach to investing leads to underperformance.
Here are some ways you can master your emotions when making investment decisions.
The purpose of investing in a stock is to make money, period. In picking stocks, you?re not assembling a group of friends or family, but instead are identifying the best possible combination of stocks for generating the highest possible return. Do not fall in love with your stocks and when they cease to meet your criteria, sell them without regret.
Some might be thinking that investing should be about more than just earning the highest return. Shouldn?t money be put to work to encourage companies to pursue socially desirable goals? I have a different take on this. I want to generate as much wealth as possible with my stock portfolio and then use that money to support my favorite causes. In short, first be wealthy and then do good. Don?t mix good intentions with investing decisions.
I encourage you to relentlessly drive emotions from the investment process. Don?t use phrases such as ?I think?, ?I feel?, or ?my intuition tells me? when making these decisions. Build an objective process, involving as little subjectivity as possible. Base decisions on a careful hardnosed quantitative analysis. This is the surest way to drive out emotions.
When making investment decisions be sure to stay in the now. Don?t dwell on past decisions. Make the best decision you can based on the information available at the time. Some stocks will generate superior returns and some will not. Accept the fact that at the time the investment decision is made, it is not possible to know if a stock will be a winner or a loser. The best you can do is tilt the odds in your favor (aim for 60% or more winners) and so investing in losers comes with the territory.
To help in this regard, I do not remember the names of the stocks in which I invest nor the price I paid for the stock. Neither the name nor the price is an important part of my strategy and so not remembering them helps me avoid a number of emotional decision errors. If it is not part of your strategy then ignore the information even if it is being widely reported by the press. Consequently, investment decisions that do not work out are not mistakes, but instead are an expected part of the investment process.
Do not waste time and energy on regret nor on second-guessing past decisions. Relentlessly stay in the now.
There is substantial risk when investing in stocks. But a careful examination reveals that what many think of as risk is really an emotional reaction to volatility. We know from behavioral research that we are hardwired to feel twice as bad about a loss as we feel good about an equivalent gain. We also have a hard time focusing on the long-term and instead evaluate performance over short time periods. This leads to myopic loss aversion and a subsequent reduction in long horizon wealth.
But volatility has very little impact on long horizon wealth. So one of the results of driving emotions out of the investment process should be to largely ignore emotionally charged volatility. Volatility and risk are not synonymous and so when talking about risk in stocks you should not be talking about volatility. Instead you should focus on business and economic sources of risk and should largely ignore short-term volatility in such discussions.
Ruthlessly driving emotions out of the investment process means short-term volatility plays virtually no role when making stock picking decisions.
A Smorgasbord of Analytic Techniques
My book covers the full range of techniques that you will need in order to transform your stock decisions into a winning portfolio. Everything from initial portfolio construction to economic and market analysis to individual stock valuation and selection will be described. Along the way I make it easy for you to understand and then use the techniques.
Helping you identify valuation mistakes is the goal of my book. I draw from my own experience as well as from the extensive research that surrounds this area. It probably doesn't surprise you that the stock market is the most studied institution in history. Out of all this intellectual horsepower comes a very clear and simple message: if you consistently pursue Value Investing and learn to master your emotions, you will earn an above average return on your portfolio. This may mean hundreds of thousands if not millions of extra dollars in your portfolio at the end of your investment horizon.