Last week, in parts one and two of my investing strategies series, I discussed the growth strategy and GARP stocks. Both strategies focus primarily on the market potential and the businesses rapid capturing of market share. The main difference is that Growth At a Reasonable Price (GARP) has a greater focus on the price you pay.
The third instalment of my investing strategies series, value stocks, focusses even more on paying fair value or less for a company.
What is value investing?
As the world’s most famous investor Warren Buffett put it “Price is what you pay; value is what you get.” In his early career, Mr. Buffett was known as a “cigarette butt” investor. He was someone who could identify the potential in underperforming and/or undervalued businesses, buy them on the cheap and then re-build, sell or liquidate the company for a profit.
Value stocks will often trade on a discount to the price-to-earnings ratio of industry peers or the company’s historical valuation; or a discount to book value per share. At the heart of this approach is valuing a company, making it your job to work out if the market is correct in applying a discount to the company’s share price. If you’re wrong and the market is right, then you may be buying a value trap.
A value trap is a company that appears to be undervalued, but which over time turns out to be overvalued. It is, unfortunately, possible for a company that has lost 90% of its value to half again!
A company can be a value trap for a number of reasons: the market was simply overvaluing the company; a change in the market turns out to be structural rather than a moment in time, or the company is run poorly. This isn’t an exhaustive list, but here is some further detail on management and structural change.
A great example of a structural change is the move to omni-channel and online retail. Although it is growing rapidly, e-commerce represents only a fraction of total commerce worldwide. Companies that are not nimble enough or simply can’t afford to invest in diversifying their bricks and mortar business models are being left behind.
A value investor needs to assess if a change is structural and then whether management has the tools to react accordingly.
Quantitatively management’s job is to allocate capital to maximise shareholder value. Qualitatively, in the 21st century, their mandate is much broader. Management can burden a company with debt; payout cash (as buy-backs or dividends) that the company needs; invest in the wrong industries or acquisitions, or simply not see the forest from the trees.
I’ve tried to illustrate that management is vital to a company’s success or failure. Trusting the management you are backing to realise the intrinsic value of the business is incredibly important as a value investor.
Stay tuned for my next instalment in the series, income investing, coming out in the next few days. In the meantime, take a look at these great dividend stocks.
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Motley Fool contributor Proutlb95 has no position in any of the stocks mentioned. The Motley Fool Australia has recommended Nine Entertainment Co. Holdings Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.