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Value Investing: a new look
new ways to analyze value stocks

In past columns I’ve described a variety of growth-stock selection strategies, but I haven’t written much about the value stock investing. That’s probably because, until recently, growth has been where the action is, and many investors, myself included, anxiously await the day when growth investing once again rules. 

However, during the past few weeks I’ve had the occasion to talk to a number of value-style financial managers about their stock selection strategies, and, as a result, I now have a much greater appreciation for the subject. In fact, based on what I’ve learned, value investing seems to me to be much more of a disciplined and methodical approach to investing than chasing growth stocks. 

By way of definition, value-stock investors believe that the market always overreacts to news, either good or bad. When the news is good, the stock price zooms up, out of proportion to the long-term affect that news is likely to have on the company’s future performance. By contrast, when unexpected bad news happens, the offender’s share price typically takes a worse drubbing than the fundamentals dictate.

Value investors scan the market for stocks that growth investors once loved, but are now dumping. Value investors don’t buy stocks just because they’re cheap; they have to be assured that the problems are temporary, or solvable. Value investors hold these stocks until their prospects once again look bright, and then they sell them back to growth investors.

Value Stock Investing Requires Patience
Value investing requires a much longer-term outlook than growth investing. Where growth investors might typically hold a stock for six months to a year, value investors plan on holding their picks for three to five years.

Value investors don’t try to predict which way interest rates are heading, or the direction of the market or of the economy. They don’t look at stock charts and they don’t pay attention to analysts’ buy/sell ratings or earnings forecasts. Value investors don’t try to determine if all the bad news is already built into the stock’s price, or if further disappointments will drive the share price down further.

For Every Stock, There’s a Time
Value investors view all industry sectors as cyclical, meaning that each sector, and hence the stocks making up that sector, will go through periods of out performance when market mavens predict strong sales and earnings growth for all participants for the foreseeable future. Then, as sure as night follows day, the sector companies over-expand their manufacturing capacity, growth falters, profit margins contract in the face of product oversupply, and stock prices plunge. Eventually the excess capacity is absorbed, demand picks up, and the cycle repeats.

Rather than trying to predict the timing of these cycles, value investors compare a stock’s current valuation ratios (e.g. price/earnings or price/book) to their historical ranges, and from that information determine whether it’s time to buy or sell the stock.

For instance, suppose that you’ve determined that over the past five years, a particular stock’s price/earnings ratio has ranged between a low of 15 and a high of 50. Value investors would consider the stock a buy candidate if its current P/E is around 20 or less. Once purchased, they would hold the stock until its P/E moved into the 40 to 50 range when they’d consider selling. The only reason they’d sell sooner is if the company’s long-term fundamental outlook significantly worsened. 

Big Charts for Historical P/Es 
You can see a chart of historical P/E ratios going back to 1986 on Big Charts (www.bigcharts.com). Enter a ticker symbol or company name into the data box near the top of the screen, and then click the middle button labeled “Interactive Charting.”

When you see the charting screen, select “All Data” in the timeframe dropdown window, and select P/E Ratio in one of the “Lower Indicator” dropdown windows. I’ve found that it’s easier to read the numbers on the P/E ratio chart if you select “Big,” the largest size available, in the Chart Size dropdown menu at the bottom of the parameter selection menu. You should see the historical P/E chart below the main price chart after you click Draw Chart.

When I looked up Microsoft, I saw that it had traded as low as 15 in the late 1980s, and as high as 75 in recent years. Its current P/E, around 40, is more or less in the middle of the range. By the way, if I’m looking at a tech stock, I usually ignore the 1998/1999 high readings, because the market probably won’t sustain those valuation levels again for quite some time.

Morningstar Shows More Info
Morningstar (www.morningstar.com) offers a great way to view the historical ranges of four different stock valuation ratios: price/earnings, price/book, price/sales, and price/cash flow. The only downside is that the data only goes back five years.

Get there by entering the stock ticker symbol on Morningstar’s homepage, and then selecting Stock Valuation (left menu). Once there, you can see a definition of each ratio by clicking “Show Data Definitions” at the bottom of the page.

What’s great about Morningstar’s display is you can see, in bar graph form, each of the stock’s four valuation ratios for each year compared with the corresponding ratio for the stocks making up the S&P 500 index. Even more helpful is Morningstar’s calculation of the ratio of your stock’s valuation to the S&P’s valuation for each year.

For example, Microsoft’s current P/E, according to Morningstar, is 2.1 times greater than the S&P 500’s P/E. Looking back, you can see that only once before, in 1999, did Microsoft’s P/E trade that high compared to the S&P. In the other years, the ratio ranged between 1.4 and 1.5. That’s important information, because Microsoft doesn’t trade in a vacuum. You would expect a stock to trade at higher valuation ratios when the entire market is richly valued, and vice versa. By comparing Microsoft’s P/E to the S&P 500’s P/E, you can easily see that Microsoft is trading at a historically high relative valuation. That would be enough reason for a value investor to look elsewhere.

You can see the same information for each of the other three valuation ratios, and it’s better to check out all four than to rely on only one ratio.

I’ve only had room to cover a very small portion of the analysis that value investors perform before seriously considering a stock. I’ll continue in my next column.
published 12/2/01 

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