Whenever somebody talks about ‘Growth Stocks’, he or she also talks about ‘ Value Stocks’ in the same breath as both these types of stocks are considered two primary types of investment worthy stocks. In my last post, I talked about ‘Growth Stocks’. It’s but natural that this post is about Value Stocks and the philosophy behind picking a value stock i.e. Value Investing.
My whole blog is primarily about value investing because this is perhaps the most robust and least risky way of investing in stock marekt. Legendary investment guru Benjamin Graham and his equally legendary disciple Warren Buffett have made ‘Value Investing’ very popular amongst investors. Practising value investing requires some amount of effort and patience from an investor. Which is why though value investing is a much talked about term, it’s not really widely practiced despite its obvious advantages.
The concept of value investing revolves around investing in stocks that are trading at a price levels lower than their ‘intrinsic value’ or their real worth. The fundamental thing to remember in value investing is that when you are buying a stock of a company, you are essentially investing in the business of the company. You should buy a stock only if you believe that the business behind the stock will be able to give you good returns on your investment. Before investing in its stock, you should assess the business fundamentals, earning stability and growth, financial structure, dividend record and the management quality of the company. A value investors pays special attention to the principle of margin of safety before investing in a stock. A company can be running a great business, but if its stock is priced at a higher level than its intrinsic value, it’s not worth investing in it. Similarly, a company might be in under distress and may have lost the confidence of investors for a temporary period; but it could be a great buy if the intrinsic value of the stock is much higher compared to the current stock price after taking into account the risk factors.
For a full understanding of how you should go about selecting a value stock, you can read the series of posts on ‘How to Select a Stock for Investing’ on my blog as given below:
How to Select a Stock - Part I- Understanding a Business
How to Select a Stock - Part II- Success Levers
How to Select a Stock- Part III- Earning Record
How to Select a Stock- Part IV- Financial Stability
How to select a stock- Part V- Retained Earnings and Dividend Income
How to Select a Stock- Part VI- Management Quality
How to select a stock- Part VII- Finding the right price of a stock
A value investor doesn’t pay attention to trends in the stock market. There are various reasons why a stock price moves in the stock market in the short term. However, in the long run, it is the fundamentals of the company that drive the stock price. If you have done your analysis thoroughly following the value investing philosophy and you are a long-term investor, the chances of your investment going awry are almost zero.
Showing posts with label Margin of Safety. Show all posts
Showing posts with label Margin of Safety. Show all posts
Friday, April 10, 2009
Saturday, March 21, 2009
What is the right time to buy a stock?
How should an investor decide the right time to buy a stock? Many investors are interested in entering the stock market, but are not very sure about their timing.
Let’s try to work around this problem.
In the short term, nobody knows which direction a stock price is going to move in. It can go up or down depending on various factors including stock market sentiments, liquidity in the market, etc. However, if you have done a good amount of research on a stock and are convinced that the stock is undervalued presently and offers good margin of safety, you should go ahead and buy the stock. Here, I am assuming that you are not a short-term investor (that’s an oxymoron though- an investor can only be for long term. For short term, you have speculators) and you have sufficient patience to be able to reap the rewards of your efforts in future. If you keep holding the stock and your research on the stock was sound, the market will discover the true value of the stock and reward you with good return on your investment. The key here is to buy cheap and have patience.
If you are looking to make money in short term, there is no sure fire strategy. You can as well try your luck in a casino.
Many retail investors start thinking about entering the stock market when the market is in a bull phase. This is a general tendency of beginners as they see many people making profits (some realized and much unrealized!) on their stock market investments. During the peak of a bull phase, stock markets see entry of all kind of investors and speculators. At this stage, you will see that anybody and everybody, who doesn’t know anything about stocks, is talking about purchasing shares and giving tips on which stocks to buy. At such times, stock prices get very heated as there is huge demand for stocks and many stocks see unrealistically high prices that do not justify their underlying business valuation. You will still see promising companies but you will rarely see any stock that can be bought at a cheap price with a good margin of safety. In such times, you should not buy a stock or think about entering the stock market. In fact, this is the time to get out of the stock market, as a fall may not be far away.
A corollary of the above discussion is that a bear market is a good time to buy stocks for a long-term investor. You will find that many good businesses that are generating good returns consistently have come under the spell of bears. Fortunately or unfortunately, investors act in hordes. Even great businesses can be found trading at huge discounts in a bear market. As an investor, you should hunt for bargain stocks in a bear market. You will not be disappointed. The key again is to ensure that you are confident about the value of the stock and the business behind it.
Let’s try to work around this problem.
In the short term, nobody knows which direction a stock price is going to move in. It can go up or down depending on various factors including stock market sentiments, liquidity in the market, etc. However, if you have done a good amount of research on a stock and are convinced that the stock is undervalued presently and offers good margin of safety, you should go ahead and buy the stock. Here, I am assuming that you are not a short-term investor (that’s an oxymoron though- an investor can only be for long term. For short term, you have speculators) and you have sufficient patience to be able to reap the rewards of your efforts in future. If you keep holding the stock and your research on the stock was sound, the market will discover the true value of the stock and reward you with good return on your investment. The key here is to buy cheap and have patience.
If you are looking to make money in short term, there is no sure fire strategy. You can as well try your luck in a casino.
Many retail investors start thinking about entering the stock market when the market is in a bull phase. This is a general tendency of beginners as they see many people making profits (some realized and much unrealized!) on their stock market investments. During the peak of a bull phase, stock markets see entry of all kind of investors and speculators. At this stage, you will see that anybody and everybody, who doesn’t know anything about stocks, is talking about purchasing shares and giving tips on which stocks to buy. At such times, stock prices get very heated as there is huge demand for stocks and many stocks see unrealistically high prices that do not justify their underlying business valuation. You will still see promising companies but you will rarely see any stock that can be bought at a cheap price with a good margin of safety. In such times, you should not buy a stock or think about entering the stock market. In fact, this is the time to get out of the stock market, as a fall may not be far away.
A corollary of the above discussion is that a bear market is a good time to buy stocks for a long-term investor. You will find that many good businesses that are generating good returns consistently have come under the spell of bears. Fortunately or unfortunately, investors act in hordes. Even great businesses can be found trading at huge discounts in a bear market. As an investor, you should hunt for bargain stocks in a bear market. You will not be disappointed. The key again is to ensure that you are confident about the value of the stock and the business behind it.
Saturday, March 14, 2009
How to select a stock- Part VII- Finding the right price of a stock
In this post, we will learn about how to find the right price for a stock. Many people confuse good companies with a good stock. If they like a company’s business model, they purchase its stock without any consideration of the price it is trading at. What matters more in investment is that you have bought a stock at the right price. If you have bought stocks of a great company at a very high price level, it may not turn out to be a great investment. On the contrary, if you have bought stocks of a good company at a good price level (cheap), you may get good return on your investment. It’s important to buy cheap.
A stock price is supposedly an indicator of net present value of future earnings for the stock on per share basis. This is also called the intrinsic value of a stock. However, the problem with this concept is that one needs to predict the future to be able to arrive at the right stock price. Millions of people have tried predicting future in the past, but rarely have we seen anybody doing so accurately. This very concept leads to a lot of investing mistakes by millions of people. A lot of analysts get into the game of predicting future earnings through various esoteric mathematical formulae. Nobody gets it right!
A good approach for stock selection could be following what legendary Investment Guru Benjamin Graham advised- follow the principles of ‘margin of safety’ and ‘diversification’.
The margin of safety concept says what you are buying should be worth more than what you are paying by a wide margin. Such a simple thing, but it’s really difficult to act on it considering the problem in assessing the value of a stock. Graham says you shouldn’t get into the business of predicting the future; instead, use the past performance to assess the ability of the company to keep producing decent earnings in future. Hence, if the company has a current earning of about 12% of the stock price (i.e. a PE ratio of 8), and meets all our criteria of selection as mentioned in my previous posts, and risk free return (of a 10-year government bond) is 6%, you have a good margin of safety in the stock. There is no general formula for all industries. However, in most of the cases, the PE ratio should not go beyond 15. The higher the PE ratio, the more future growth dependent your return on the stock becomes. Never buy a stock if you believe it is fully priced even if it is of the best performing company.
Diversification is linked with the concept of margin of safety. Let me explain. If you are playing dart, and you are good at it; what are your chances of hitting bulls eye once if you have only once dart? What if you have ten darts? Of course, you will have much better chances of hitting Bull’s Eye at least once if you have ten darts. Do you understand the difference? If you have margin of safety in your favor, your chances of making good returns or at least not incurring loss in a portfolio of diversified stocks becomes pretty high. However, there is a caution here. Diversification will work to your favor if you have diversified in stocks with good margin of safety. It will hurt you badly if you have bought all losers. Diversification in overpriced stocks will ensure that you most likely incur loss on your investment. So, be careful. Don’t buy costly stocks. Always maintain a diversified portfolio of good stocks bought with a margin of safety.
With this, the series on ‘how to select stocks for investing’ ends. I hope I have been able to give you a few basic guidelines on how to go about picking stocks for investment. I must add that these are indicative guidelines and by no means exhaustive. You will do well if you use these guidelines along with your own research and experience backed by some sound reasoning.
A stock price is supposedly an indicator of net present value of future earnings for the stock on per share basis. This is also called the intrinsic value of a stock. However, the problem with this concept is that one needs to predict the future to be able to arrive at the right stock price. Millions of people have tried predicting future in the past, but rarely have we seen anybody doing so accurately. This very concept leads to a lot of investing mistakes by millions of people. A lot of analysts get into the game of predicting future earnings through various esoteric mathematical formulae. Nobody gets it right!
A good approach for stock selection could be following what legendary Investment Guru Benjamin Graham advised- follow the principles of ‘margin of safety’ and ‘diversification’.
The margin of safety concept says what you are buying should be worth more than what you are paying by a wide margin. Such a simple thing, but it’s really difficult to act on it considering the problem in assessing the value of a stock. Graham says you shouldn’t get into the business of predicting the future; instead, use the past performance to assess the ability of the company to keep producing decent earnings in future. Hence, if the company has a current earning of about 12% of the stock price (i.e. a PE ratio of 8), and meets all our criteria of selection as mentioned in my previous posts, and risk free return (of a 10-year government bond) is 6%, you have a good margin of safety in the stock. There is no general formula for all industries. However, in most of the cases, the PE ratio should not go beyond 15. The higher the PE ratio, the more future growth dependent your return on the stock becomes. Never buy a stock if you believe it is fully priced even if it is of the best performing company.
Diversification is linked with the concept of margin of safety. Let me explain. If you are playing dart, and you are good at it; what are your chances of hitting bulls eye once if you have only once dart? What if you have ten darts? Of course, you will have much better chances of hitting Bull’s Eye at least once if you have ten darts. Do you understand the difference? If you have margin of safety in your favor, your chances of making good returns or at least not incurring loss in a portfolio of diversified stocks becomes pretty high. However, there is a caution here. Diversification will work to your favor if you have diversified in stocks with good margin of safety. It will hurt you badly if you have bought all losers. Diversification in overpriced stocks will ensure that you most likely incur loss on your investment. So, be careful. Don’t buy costly stocks. Always maintain a diversified portfolio of good stocks bought with a margin of safety.
With this, the series on ‘how to select stocks for investing’ ends. I hope I have been able to give you a few basic guidelines on how to go about picking stocks for investment. I must add that these are indicative guidelines and by no means exhaustive. You will do well if you use these guidelines along with your own research and experience backed by some sound reasoning.
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