by John Persinos, InvestingDaily.com
Article of the Week from Investing Daily
The father of value investing, Benjamin Graham, famously said:
“Price is what you pay; value is what you get.”
Below, I’ll show you how to take advantage of the market’s overall rotation to value, but in ways that prevent you from getting burned by cheap stocks that deserve to be cheap.
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This week, stocks have resumed their winning ways. On Tuesday, the Dow Jones Industrial Average rose 68.61 points (+0.20%) and the S&P 500 climbed 21.65 points (+0.51%). The tech-heavy NASDAQ jumped 111.79 points (+0.79%), to set a fresh record high.
In early trading Wednesday, the three indices were in the green as their comeback from last week’s swoon continued. Investors are starting to believe the Federal Reserve’s assurances that inflationary spikes are transitory. Supply imbalances are getting ironed out and prices for certain commodities, such as lumber, have plummeted.
As the rally resumes momentum, standard earnings multiples suggest stocks are the priciest they’ve been since the dot.com run-up. Headline risk is persistent and, as we witnessed last week, just the hint of bad news can trigger sharp selloffs.
During these selloffs, should you buy on the dips? Yes, but you must be highly selective. There’s a Wall Street saying: never try to catch a falling knife. A falling investment could rebound. Or it could lose more value. Trying to predict the bottom is like grabbing a knife on its way down. Pain usually ensues.
The hunt for value…
We’ve been witnessing a market rotation from growth to value. The iShares S&P 500 Value ETF (IVE) year-to-date has generated a total return of 15.25%, compared to a YTD return of 11.31% for the iShares S&P 500 Growth ETF (IVW) and 13.22% for the SPDR S&P 500 ETF Trust (SPY), as of market close June 22 (see chart).
By investing in value stocks, investors essentially buy a built-in gain and/or a safety net. The smallest bit of good news can propel their stock up to a fair price. Even significant bad news doesn’t necessarily bring the price down. In many cases, the stock is undervalued because such bad news was already anticipated.
Overvalued stocks, or even some fairly valued stocks, on the other hand, are highly susceptible to bad news and don’t always respond as expected to good news. Surely, you’ve held a stock that released quarterly earnings that “met expectations” and proceeded to get hammered.
In an efficient market, short-term irrational thinking is eventually corrected. Stock prices rise and fall but the market is in constant pursuit of finding fair value. This is what leads to mean reversion.
There’s an extra benefit of buying stock in intrinsically sound companies when they’re undervalued. Not only do you get exposure to strengthening fundamentals that propel prices higher over time, but in the short to medium term, you’ll probably enjoy an added bump from mean reversion.
Easy money and market distortions…
My first rule of investing success is to be a value investor. But therein lays the rub. How can you separate the value plays from the value traps?
Ultra-low interest rates and trillions of dollars’ worth of quantitative easing in the U.S. and Europe have been distorting valuations for the past decade. These loose monetary policies have made bond yields extremely unattractive, compelling traders to shoulder greater risk by bidding up many stocks well beyond prices that are justified by projected earnings and economic growth.
Global macroeconomic trends are important, but I prefer to emphasize company fundamentals. I like to see a strong competitive advantage in an essential business, a good balance sheet, high level of free cash flow, and healthy returns on capital. Also, I look for resilience in terms of profitability, even during depressed years.
Undiscovered small-cap stocks with little analyst coverage are particularly appealing. High-quality stocks that have fallen out of favor with the market for temporary reasons are prime value candidates, but be wary of speculative names or dubious “turnaround” stories.
Stick to companies selling at a steep discount that have a clear strategy for stabilizing or improving their fundamentals. That’s because cheap stocks can turn into value traps, if earnings or margins keep deteriorating.
Caption graphic photo credit: Benjamin Graham, Wikipedia.
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