Value investing is about buying stocks that are trading at prices below what they are worth. As Warren Buffett has said, “price is what you pay, value is what you get.” Most investors assume that price and value are the same. They are not.
Price is what the stock is trading for at the moment. This price varies based on changes in an uncountable number of factors, including daily broad market sentiment, Fed policy, political events and economic conditions. Even news about one company can drive the stock price of a totally unrelated company: on August 25, Nvidia (NVDA) reported results that cheered chip stock investors, driving the entire Nasdaq Composite higher and lifting the S&P 500, as well. Shares of Paramount Global jumped 4% on the day, but it would be a stretch to connect the fortunes of a media company to those of a semiconductor maker.
Most investors focus on price. Common questions include: “is the stock price going up?” and “how volatile is the stock price?” If a stock price is going up, that is seen as a judgment by the market that the underlying company is probably good, and that the price will continue to rise. If a price shows some volatility, that might suggest that the shares are risky and should be avoided. If you ask these kinds of questions, you are like most other investors. This in no way suggests a lack of intelligence, skill or savvy. Most hedge funds and Wall Street research firms are focused on price, too, even though they fancy-up their investing processes by adding sophisticated-sounding terms like “alpha,” “directional exposure” and “value-at-risk” to justify their high fees. Price-based investing is embedded in human nature, and human nature drives the stock market.
Value investors, however, focus on value. Common questions include: “what is the underlying company actually worth, on a per-share basis?” and “how strong is the balance sheet?” Other questions would include, “does the company’s management provide competent leadership and maintain a shareholder-friendly mindset?” and “will this company even be around in five years, or is it just capturing a momentary trend among its targeted customer base?” This approach emphasizes developing an understanding of the company itself while initially ignoring the stock price. Only after the value of the company is determined is it then compared to the stock price. If the stock is trading at a price that is below its per-share value, it will be a worthy value candidate. If not, the stock is set aside until some future date when it becomes undervalued.
No valuation analysis is perfect. The sensible value investor will look for a margin of safety, emphasizing stocks that trade at perhaps a 20% or greater discount to the estimated per-share value. And, since valuation gaps don’t correct overnight, the sensible value investor will patiently hold a value stock through the interim price volatility until the shares reach the target price that indicates they are no longer bargains.
Value Investing for the Rest of 2022
Today, in September 2022, price-based investors lament seeing the stock market resume its downturn, especially after an encouraging mid-year rebound. Value investors, however, take the opposite view: after a discouraging mid-year rebound that artificially pushed share prices higher, a market downturn is great news as it means stocks are on sale at lower prices. As long as the value of the underlying asset (the company) remains intact, lower prices are good, and the lower the better. Those waiting to buy a new car, or house, or piece of clothing or outdoor gear know exactly how this works. This is the value investors’ mindset.
This is also why value investors are often called contrarian investors – they tend to go against the market’s prevailing sentiment.
With so many popular stocks collapsing in the post-pandemic market, so many meme-driven stocks whose prices may double or lose half their value in a day, so many theme-based stocks that may be so overvalued that any bad news may send their prices plummeting, this can be a great time to focus on undervalued stocks of real companies. It’s a great time for value investing.
At the Cabot Undervalued Stocks Advisoryand theCabot Turnaround Letter, we help investors navigate the equity markets using a common-sense value-oriented approach that emphasizes out-of-favor stocks of companies with real value. Let us help you sort through the market to find them.