ASK most seasoned investors what they would consider to be the biggest challenge to successful investing and more often than not, the answer would be a person's ability to deal with the psychological pitfalls of investing.
The most well-known of these mind traps are the feelings of greed and fear. An investor who allows himself to be swayed by these powerful emotions will find it tough to reach intelligent and rational decisions about his investments.
Indeed, this is the major test for those who aspire to be value investors. By definition, value investing is about buying stocks that are incorrectly priced by the market. The focus is more on the company's business and fundamentals rather than on market influences on the stock price.
As a result, there is a tendency to gravitate towards stocks that have temporarily fallen out of favour and those that have yet to be spotted by other investors. Thus, value investing can be considered a contrarian approach. Going against the crowd is not easy. It will test both your patience and fortitude, especially when things are not going your way.
In our article last week, we discussed the key elements of the value investing philosophy. We explored three basic concepts introduced by the father of value investing, Benjamin Graham: Viewing investments as the purchase of a business, 'Mr Market' and 'Margin of Safety'.
Value investors believe that these concepts, if followed faithfully, should lead to investing success in the long term. But with hundreds of stocks listed on the SGX alone, finding that fistful of gems for your portfolio is akin to looking for the proverbial needle in a haystack, unless a systematic approach is adopted.
There are a number of schools of thought on the methodology that a value investor should use to narrow down potential investments. One common system is to employ a filtering process based on quantitative screening of a company's financial statements.
Below are some 'screens' that are commonly used to sieve out potential value stocks:
Low price-to-earnings (PE) ratio
The PE ratio acts as a good indicator of the level of interest in a stock. Generally, value investors look for stocks that are out of favour with other investors, that is, those with low PE ratios. Typically, the preference is for stocks with a PE ratio below 10 times and within the bottom 10 per cent of comparable stocks.
Low price-to-book ratio
Stocks that trade at a discount to their book or net asset value are also prime candidates. From a value perspective, you would be buying the business at a bargain as it would be worth more if broken up and sold piecemeal.
Such companies could be even more attractive if they have intangible assets, such as a strong brand name, as this is not reflected in financial statements as part of book value. Hidden assets such as real estate or potential spin-offs could also mean that a company's book value may be understated.
Debt-to-equity ratio below one
The debt-to-equity ratio shows how a company has structured its capital to finance its business. In general, value investors prefer earnings growth to be generated by shareholders' equity rather than borrowings. This is because companies that have a large proportion of debt incur high interest expenses, which could result in a more volatile earnings performance.
Low price-to-cashflow multiple
Although a company may be showing strong profit growth, value investors usually also measure its financial health by its ability to generate positive cash flow. A general rule of thumb is a price-to-cashflow multiple of less than five times.
Price-to-earnings growth (PEG) must be less than one
The PEG ratio relates a company's future earnings to its estimated growth rate. It is calculated by dividing the prospective PE ratio by the estimated future earnings growth rate of the company. Although PEG is more often associated with growth investing, it can also be a useful tool in value investing.
Consistent and high return on equity (ROE)
This is computed by dividing net profit by shareholders' equity and reveals how much profit a company generates from the money its shareholders have invested. Value investors use ROE as a way of comparing whether a company is able to consistently generate better returns than its industry peers.
High and sustainable profit margins
Comparing a company's gross profit margins against that of its rivals is a good way of assessing the competitiveness of its products or services. Value investors also look for companies that are able to consistently improve net profit margin as this is a sign that management is getting more efficient at controlling expenses as the business grows.
These are just a few of the quantitative screens commonly used by value investors. Some have other criteria in their selection process. In addition, most value investors also evaluate potential investments on qualitative factors such as the quality of the management team, level of corporate governance and transparency, how well the company differentiates its products or services, its geographical reach, and so on.
The main point is to gather as much information as you can in order to assess if management has established a business with a sustainable competitive advantage. The most difficult step in the identification of a value stock is determining if it is trading at a sufficient margin of safety to intrinsic value.
As mentioned previously, investors usually have differing opinions on a stock's intrinsic value. This depends on the methodology used to calculate this value, which is why many value investors recommend a margin of safety of at least 25 per cent. However, the most difficult part in the whole process is the discipline that an investor must continually exercise to remain steadfast to the value investing philosophy.
In the end, achieving success will depend on patience.
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