Here are 11 crucial issues for all investors to consider in “value stocks” and “value investing” when the stock market is hitting all-time highs.
1. Cheap Stocks Are Cheap for a Reason (or Many Reasons).
When screening for cheap companies, beware what “cheap” really means. If a stock is valued at 10 times earnings when the S&P 500 is valued at 18 times earnings, there may be issues around low growth, asset sales, competition, regulation or myriad other issues. The “efficient market theory” may falter from time to time, but it suggests that the market is never really that wrong and that the market values companies and assets properly based on the known and unknown information at that time.
Regardless of what rationale investors and analysts are using to determine how “cheap” a stock or asset is, they have to know going in that there is probably a big reason or a series of reasons that made it look cheap.
2. Never (Ever) Pile Into a Value Stock All at Once!
Quite often, value stocks look cheap, and it already has been stated that there can be many reasons why they look cheap versus peers or the market. It seems in at least some ways that the reason a stock looks cheap is less important than a poker adage of “going all in.” Never go all-in on a single value stock. Some companies never recover from past woes. Some top management teams falter (or they may even die) before turning a ship around. If a stock is valued far less than peers, generally speaking the only impetus that suddenly will reverse its bad fortune is if a competitor or private equity firm believes it can run the company better.
The biggest lesson is not just for individual investors to keep too much of their assets in one company, but to not just buy all at once and not all at the same price. Averaging in, or “nibbling” or “legging,” is the only way to go on a value stock. Investors almost never find a true bottom in value stocks, and there often are many times when cheap stocks get even cheaper. Again, they look cheap for a reason, and it can take years for a value scenario to unfold. This is where investors need to concede that the market may remain irrational for longer than the rest of us can remain solvent.
The same “never all-in” lesson should be considered when it comes to earnings or other upcoming events. If a value stock is cheap because of poor history, what are the odds that the next earnings or corporate news reaction will be overwhelmingly positive?
3. More to a Story Than P/E Ratio (and the PEG Ratio Trap).
At the start of 2017, the S&P 500 was valued at close to 19 times trailing earnings per share and more than 17 times expected earnings per share for fiscal year 2017. These valuations may be high by historic standards of 15 times expected earnings, but the reality is that earnings growth was expected to be close to 10% and interest rates remained quite low. Stock sectors are valued quite differently from each other, and these premiums and discounts change over time. Established banks, telecoms and utilities might have lower P/E ratios than industrials and technology, but that does not make them cheap. When individual companies trade at 10 times expected earnings and the S&P 500 (or their sector) is valued at 15 to 20 times expected earnings, the market is not willing to pay much for the future value on the current earnings. There can be many reasons for the disparity, but the market really never improperly discounts a company or a sector for very long.
The PEG (price to earnings to growth) ratio is where investors look at a price-to-earnings multiple versus earnings growth rates. The problem here is that most investors focus on historic growth rates rather than future growth rates. So this PEG ratio often makes many companies look cheap after a hiccup or business change, causing them to be just value traps. Companies can grow earnings for 25% for 10 years, but if their growth is about to slow to 15% or 10% then their PEG ratio simply does not matter using 25% growth in the calculations. Even using a new lower growth number doesn’t work if the earnings are set to be under pressure or face sporadic trends. Falling for a cheap PEG ratio can make many companies look cheap in screens, but it is the growth rates ahead and the quality of future earnings that matter more than the growth rates of the past.
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