Along with the prior post on growth investing, it seemed appropriate to talk about its counterpart: investing in value stocks. While growth investors are looking to future sales, the value investor looks backward to justify the price of shares. The method has some strong followers, including investing legend Warren Buffett, and may be the most suitable for long-term investors.
The Oracle of Omaha and other Investing Legends
The basic theme in value investing is intuitive, never pay too much for a stock. While growth investors are willing to pay high prices for future earnings, value investors only buy when shares are cheap. They reason that no one can predict future sales so looking at past earnings and valuations are a better metric.
The most famous value investor is arguable Warren Buffet, nicknamed the Oracle of Omaha for his almost prescient ability to pick long-term winners. Far from having a crystal ball, Buffett success at building his $288 billion Berkshire Hathaway (BRK-B) has come from taking advantage of temporary low-prices for great companies.
Buffett’s mentor, Benjamin Graham, literally wrote the book on value investing. “The Intelligent Investor”, was first published in 1949 and is a must-read for any investor. More than just about value investing, the book is a well-rounded education in economics and the financial markets.
Price-to-Earnings and other tools
The price-to-earnings ratio is the star of value investing. Discussed in a previous post, this is the stock price divided by the company’s earnings over the previous four quarters. Value investors look at this number in two different ways, relative to the company’s history and relative to competitors.
Value investing starts with comparing the price-to-earnings of companies within an industry. It does not good to compare companies across different industries or sectors because the P/E ratio can vary pretty significantly. Investors are much more willing to pay higher prices for the same amount of earnings in faster growing industries like social media than for mature industries like semiconductors.
Case in point, shares of Facebook (FB) trade for 75 times its earnings and LinkedIn (LNKD) trades for an astounding 140 times earnings. This compares to semiconductor companies like Intel (INTC) which trades for 14 times earnings. Earnings for social media companies have doubled over the last year while semiconductors have seen their earnings fall for several years.
The first question an investor needs to ask is whether the higher P/E ratio for one company is warranted by other measures. If management is able to drive stronger growth through margins and innovation, then the cheaper stock may not be the best value. The value investor uses fundamental analysis along with the price-to-earnings ratio to select the best stocks within a sector or industry.
Even the most attractive value stocks may not be a good buy when the entire stock market is expensive. Remember that comparing a company’s P/E to others in the sector is a relative measure of value. A cheap stock compared to peers may still be too expensive. This is why investors also compare a company’s price-earnings ratio to its own history.
At the time of this writing, Facebook looks extremely cheap compared to business-networking site LinkedIn at almost half the P/E ratio. The problem is that Facebook has traded at a much lower 42 times earnings less than six months ago. Has something changed to make the shares worth their higher valuation compared to earnings? Shares of Intel may seem like a screaming buy at 14 times earnings but they also traded below 10 times earnings just recently.
Successful value investors learn how to manage these differences. Setting formal limits for how much you will pay for earnings within a sector and compared to historical averages will go a long way to avoiding paying too much. When looking at value stocks, I generally look to stocks with P/E ratios at least 10% below their sector’s average.
Even if a stock is cheap among peers, I will usually not buy it unless it is close to its own recent P/E average as well. The overall market can remain expensive for a long time so you need patience to wait for good prices.
There is another reason for comparing stocks only within their industry or sector. If you simply looked for the stocks with the lowest P/E ratios in the market, you would end up investing most of your portfolio is just a few sectors. Companies within the utilities, energy and financial sectors typically have lower price-earnings ratios because sales growth is usually slower. A portfolio invested in just these groups would face a huge risk if the economy turned against the sectors. A portfolio of value stocks diversified across many sectors will face less risk of problems in any particular sector.
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