The Eliot Rose Blog
What are Value Stocks?
Added 02/18/2016 by Gary Siperstein
Over time it has been shown that value stocks have greatly outperformed growth stocks. This has been the investing philosophy passed down from Benjamin Graham to Christopher Dodd to Warren Buffet. As Warren Buffet says:
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
The technical definition would state that value stocks are stocks that are trading at a price lower than their intrinsic value or true worth. We define value stocks as stocks trading at a low multiple of earnings, sales, and book value. We look for positive earnings dynamics, insider buying, strong cash positions, little to no debt, and a catalyst not yet understood by Wall Street.
Spotting value stocks is as much an art as it is a science. Some stocks may meet all the financial screens discussed above, but still don’t qualify as true value stocks. This is called a value trap and what we try to stay away from. For example, let’s say a stock declines by 50% and starts to hit our screens. Suddenly investors may be lured in and buy the stock only to find the stock continues going down. This can be due to many non-technical factors – poor management, contracting market demand, pending regulatory changes, new entrants to market, etc… The key is to identify the difference and buy value stocks and stay away from value traps.
Many times the reason a stock trades at a discount is because many investors are short-term focused. For example, investors may be looking for large increases in earnings from one quarter to the next. Often times, if the stock does not post the earnings increase expected by short-term investors they will exit the stock, inevitably driving down the price. And this is where opportunity presents itself. There are many reasons a company may not post higher earnings. One of them could be because they decided to invest back into the business eliminating short-term earnings improvement, but greatly increasing future earnings prospects. The long-term investor is the greatest beneficiary if he spots this type of opportunity.
One of the greatest benefits that value stocks possess relative to growth stocks is their margin of safety. A good way to think of margin of safety is thinking about what happens when things go wrong. Warren Buffet says:
“If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety...”
Taking this concept back to the stock market, let’s compare what happens to a growth or value stock when we are wrong. Take a growth stock (by definition trading at high multiples) trading at 5x sales. Let’s say they miss earnings estimates. The stock can fall to 1x sales. You’ve just lost 80%. On the other hand take a value stock trading a 1x sales. Now, let’s say they missed estimates. Chances are it will go down, but maybe to .7x sales. In this case, you have only lost 30% of your investment. In the end, you always want to protect yourself when things don’t go like planned, which is why it is essential to always have a margin of safety.