Buy low, sell high. As simple as it sounds, most investors have a tough time actually doing it.
The lure of following a hot tip or chasing a high flier often proves more appealing than the somewhat mind-numbing task of trying to figure out what a company is really worth, an investment style known as value investing.
“America is very fascinated by speculation and striking it rich,” says Mike Wolcott, a value style portfolio manager for institutional investors and well-off individuals at Chicago Asset Management Co.
Even though many famous investors like Warren Buffett are value investors, people haven’t caught on to it, Wolcott says.
Nonetheless, value investing has gained converts in the wake of the technology stock blowout. Investors who were burned by supposedly sure-thing investments in companies such as Cisco Systems and JDS Uniphase now are returning to fundamental investment analysis for their stock ideas.
Even a “new economy” magazine like the Red Herring has hopped on the value bandwagon, touting traditional value-oriented books in a recent issue as it trashes some new Internet-focused investment guides.
Omar McLaughlin is among the new value disciples. The business and law student at the University of Kansas in Lawrence was active in momentum-style investing until his conversion last year. Falling prices in his stock portfolio and the arguments of a finance professor convinced him that value investing made more sense than trying to chase the hottest stocks, McLaughlin says.
“It’s very time-consuming and nerve-racking,” McLaughlin says of momentum investing. “The biggest advantage is you don’t have to sit on the edge of your seat.”
And don’t fall into the trap of thinking you can’t buy growth companies as a value investor.
“Value and growth are not two opposite things,” Wolcott says.
Value investors buy growth companies all the time, but only when they believe that a current market price is less than what the true value of the company is. Unlike momentum investors, who seek out rising stocks that they think will continue to rise no matter how high the price is now, value investors seek out neglected or overlooked companies that others will eventually discover and bid up the price.
“If you’re not buying a financial asset for less than what you think it’s worth, I’m not sure what you’re doing,” Wolcott says.
Not so fast, say efficient market proponents. There’s no better gauge of a company’s worth than where the market is currently valuing it. The only way a price changes is when market participants change their view on what a company is worth. So trying to find “undervalued” companies is a futile task, under the efficient market view.
Noted value investor Robert Sanborn agrees, to a point. Sanborn, who recently started a value-oriented hedge fund for Sanborn Kilcollin Partners LLC in Chicago, says that in the long run markets are efficient. Eventually, the market price and the true value of a company will converge.
But in the shorter term, prices can become depressed or inflated for a variety of non-financial reasons. Back in the 1990s when Hillary Clinton was pushing her health care plan, health-care stock prices became overly depressed, creating value investment opportunities, Sanborn says.
These opportunities are logically compelling. “The thing I like about value investing is it’s consistent with human nature,” Sanborn says. Investors like the thought of finding a bargain, and often go into investing with that frame of mind.
But the needed patience to wait for an undiscovered gem to be discovered by others often leads investors into the high growth arena. “You get sucked into it,” Sanborn says.
Value investing does requires some number crunching. “While it sounds simple, it’s not always practiced,” Sanborn says.
In a nutshell, value investors try to estimate what a company should be worth based on the future value of the company’s earnings or cash flows, generally called intrinsic value. Part of the equation for calculating it must take into account the fact that a dollar today generally is worth more than a dollar in the future. So value investing is much more than buying stocks after a big dip. Sometimes stocks fall fast and hard for good reasons, and may never recover.
There’s a catch, though. Calculating intrinsic value is as much art as science, with investors offering a wide range of formulas based on corporate profits, a financial concept called cash flow, interest rates and other financial data.
Benjamin Graham, one of the icons of the value investing community, claims you can estimate intrinsic value using a simple pocket calculator, says Janet Lowe, in her book “Value Investing Made Easy.”
Lowe said that estimating intrinsic value is daunting at first, but it makes the rest of the investment process much easier. “You become an investor, not a speculator. You put all of your work into the initial investment decision,” Lowe says.
Lowe offers her own version of calculating intrinsic value in her book. If you’re interested in giving it a go right away, check out the intrinsic value calculator found on Quicken’s Web site (www.quicken.com). Find it by plugging in the stock ticker symbol of a company you follow and clicking “Go” for a quote. Once that’s done, click on “Evaluator” on the left side of the page. Click again on Intrinsic Value, and Quicken will estimate it for you, and tell you whether that intrinsic value is greater or less than the company’s stock market value.
Included on the page are the assumptions Quicken used, as well as detailed explanations of how and why Quicken’s calculator did what it did. It’s an excellent tool for getting started with value investing.
But don’t use it as a substitute for your own analysis or calculations. Harold Anderson, who owns a farm and a bed and breakfast in Boscobel, Wis., has been researching value investing for about a year to better manage about $100,000 he has in IRA money.
He says that the Quicken tool is great for offering validation of his own intrinsic value calculations but adds that calculating intrinsic value can be more complicated than how Quicken presents it.
For example, Anderson might use a different number than the one suggested in the earnings column of the Quicken calculator. Anderson favors what’s called “owner earnings,” a concept attributed to Warren Buffett in the book “The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor,” by Robert G. Hagstrom Jr.
Similarly, professional investors like Wolcott and Sanborn base their intrinsic value calculations on sophisticated techniques not easily performed by regular investors. To develop your own approach, try to study the different ways to calculate it, and use the one you think makes the most sense.
Hagstrom’s book and Lowe’s book are good choices for beginners. More advanced investors can go directly to Graham’s “The Intelligent Investor.”
What stocks represent a good value today? Sanborn says Brunswick Corp., the Lake Forest boating and bowling company, fits the mold. Brunswick has a variety of businesses, all of which are number one or two in their industry, Sanborn says.
The stock has done nothing for years, and the overall value of the company is less than one year’s worth of its sales, whereas a company like Cisco Systems, which hit a 12-month high of $65.93 last September but closed Monday at $14.47, still trades at five times sales, he said.
Sanborn says companies like Cisco still have additional room to fall at current price levels.
Wolcott says Inforte Corp., a small Chicago tech consultancy, offers value amid the tech wreckage. Inforte helps companies install leading-edge computer software. “It’s an excellent business” at a good price, he says.
