Value Investing

Published: Wednesday October 1, 2008

Would you invest in times such as these when the US and other international stock markets are reaching multi-year lows and reference is being made to "a global financial crisis" and "market meltdowns"? Should you? Share prices have been trending downward (both locally and internationally) and even the novice investor knows at least this - "buy the share when the price is lower and sell it when the price is higher to make a profit". While buying low and selling high "makes sense" it also seems intuitively odd to purchase something when its price (often mistaken for its value) is falling. Therein lies the challenge. How do you distinguish a good opportunity from a dive into the deep end or "catching a falling knife"? The answer - invest for value.

When one gets into equity investing, it is tempting to run after the "winners" whose share prices are increasing while the "losers" with falling prices are not given much thought. However, knowledge of the intrinsic value of a stock (using fundamental analysis) is an important consideration. The output of fundamental analysis is a value (price) which the investor can compare to market prices to determine if a stock is under-valued or over-valued. The aim would be to buy under-valued stocks, that is, stocks which are currently going for a price lower than their calculated worth. The assumption is that eventually, the market will pay for the stock what it is actually worth. So, if you get carried away by market euphoria you may buy too high and have a difficult time selling at a gain. On the other hand, if the price is falling, you can decide on an entry price that would get you a return when the price of the share rebounds to reflect the share's intrinsic value.

There are various methods available for valuing a stock, for example the dividend discount model which is a type of discounted cash flow analysis. Discounted cash flow analysis is used to determine a stock's value based on estimated future cash flows. Valuation ratios are also used such as the price-to-earnings (P/E) ratio and the price-to-book (P/B) ratio which compare the market price of the stock to earnings per share and book value respectively. Use of these ratios is most effective when a comparison is made to the company's past performance and the performance of industry peers. It should be noted as well that the reliability of these ratios is dependent on the reliability of information presented in a company's financial statements.

A challenge that presents itself is that no one method is "correct". This means that two individuals analysing the same information could come up with different valuations. One way to maximise the possibility of arriving at an accurate valuation is to use different methods and determine an average intrinsic value / fair price. In addition, you can purchase shares with a "margin of safety", that is buy at an even lower price to limit the impact of an incorrect estimation.

There are external factors that could impact on a company's performance and by extension its share price that must be considered as well. The overall health of the economy must be taken into account, for example a downturn may negatively impact a company that sells discretionary consumer goods such as jewelry, electronics or trendy clothing. Attention should be paid to the industry in which the company is operating - are there new regulations that might impact costs? Or are there new competitors that may take away market share? In addition to the quantitative analysis of the company (using the valuation methods mentioned above), one must also consider qualitative factors such as the skill and expertise of the management and whether the company has a special competitive advantage.

While this sort of analysis may seem a bit daunting, the good news is that information is bountiful, for example, from your investment broker and even via the internet. With regard to companies trading on the Trinidad and Tobago Stock Exchange, there are a few examples of shares that are currently trading below their fair value (as at 26 September 2008) and which therefore present buying opportunities. Based on CMMB's analysis, these include Sagicor Financial Corporation (SFC) with a one-year valuation of TT$25.56, Neal and Massy Holdings Limited (NML) with a one-year valuation of TT$68.89, and Guardian Holdings Limited (GHL) with a one-year valuation of TT$37.40.

What should be remembered is that while in the short-term share prices experience swings in both directions, in the long-term share prices generally trend upward. Once you choose to invest in companies that have strong prospects for future growth and profitability and exercise patience, you should be able to generate sufficient returns to compensate you for both the time and risk you have taken. So as long as you have the nerve to tolerate some volatility then value investing over the long term may be the way to go.


Source: Trinidad Express Newspapers
http://www.trinidadexpress.com/index.pl/article_business_mag?id=161382167