Finding real value in beaten-down markets

Finding real value in beaten-down markets

Indeed, it is during bearish times like these that investors who believe in the value proposition come out hunting for bargains.

-ST Tue, Feb 10, 2009The Straits Times

By Lorna Tan

With stocks hitting new lows, the share market is like another Singapore sale but minus the crowds, given that only a few brave souls are putting their cash down.

While investors may have misgivings about the uncertain and volatile markets, the assets are just too cheap to ignore.

Valuations of many stocks are at attractive levels, so it is no wonder that financial experts are pointing to 'value' as a key theme for this year.

Indeed, it is during bearish times like these that investors who believe in the value proposition come out hunting for bargains.

What value investing is

Essentially, value investing means buying at good value and holding for the long term to reap capital appreciation and dividend yields. It is the investing style that made Mr Warren Buffett and his mentor, value-investing pioneer Benjamin Graham, kings of the share markets.

It contrasts with the strategy known as growth investing. This involves investing in companies deemed to have good growth potential, even if the share price appears expensive.

A growth stock is typically defined as a company whose earnings are expected to grow at an above-average rate compared with that of its industry peers or the overall market.

In value investing, buying something for less than its worth is a fundamental principle.

This was an important concept used by Mr Graham, who believed that investors should buy only firms that are selling lower than the value of their net current assets. That is, their value after deducting their liabilities.

Doing this ensures that even if one is wrong, there is a margin of safety. Your downside is protected to a certain extent if the stock price falls further.

For example, if your perceived value of stock A is $3, you may want to buy in only at around $2.70. This gives a margin of safety of 10 per cent to protect you from any fall.

Many investors have trouble deciding if a stock is cheap or expensive. There are several factors to consider to accurately determine a share's worth.

How to pick value stocks

First, never look at the stock price in isolation. To see how it is faring, it must be compared with other stocks in the same industry. You also need to know how the industry and overall market are performing.

For instance, if you are considering buying a property stock, do not sink your money in just because it seems cheap on the surface.

Compare it with other property stocks in the same region, say, the Asia-Pacific, or in the same business segment, such as residential mass-market developers.

If you are value investing, do not rely just on prices to determine how cheap or expensive a firm is. In the long term, price and intrinsic value are likely to be similar but this is not so in the short term, when prices usually reflect investor emotion.

So low prices do not necessarily mean low values. Instead, use an appropriate valuation measure to help determine the value.

A common measure for comparative purposes is the firm's earnings. In this case, buy stocks selling at a low multiple of their earnings - what the company has left after expenses are paid. It follows that a firm selling at a low earnings multiple is usually a better value pick than one with a high earnings multiple.

You should also compare the price-earnings multiple to that of its competitors in the same industry and also the broader indexes to determine if the company is a value buy.

Another common measure is a firm's price-to-book ratio, which is derived by dividing its share price by the book value of the firm. The book value provides an estimate of how much the firm would be worth if it had to be liquidated.

Investors should also check if a firm passes the following criteria: Does it have sound businesses with good earnings and revenue growth? Is it run by competent managers?

Be wary of 'value traps'

Some stocks and markets could turn out to be 'value traps'. This means that despite being attractively valued, they could still prove disappointing and remain cheap for a prolonged period.

This could happen when a particular market is suffering from political uncertainty, for example, or the company is facing depressed earnings without any prospects of a near-term turnaround.

This is the first of a three-part series on value investing brought to you by DWS Investments.
This article was first published in The Straits Times on February 08, 2009.