a new look
new ways to
analyze value stocks
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.
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.
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
Value Stock Investing
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.
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
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.
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.
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
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
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
Morningstar Shows More Info
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
Get there by
entering the stock ticker symbol on Morningstar’s homepage, and then
Valuation (left menu). Once there, you can see a definition of each
ratio by clicking “Show
Data Definitions” at the bottom of the page.
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.
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.
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.