Focus on Value — Not Price — in Your Stock Investments
In Message #1039, I passed along some advice from Lynn Carpenter, a member
of the Oxford Club Investment Advisory Panel, who said that some investors
make a mistake when they focus too much on the price of a stock and not
enough on the underlying value. This, Lynn said, can lead to losses if
you buy a low-priced stock with little inherent value rather than a higher-priced
but more valuable issue.
Dan, a longtime ETR reader, and a stock analyst and newsletter editor,
took us to task for passing on advice that he claims does not hold water.
In fact, Dan said we “overstated the case against cheapness”
and that “‘big’ stocks are the worst stock-market investments over
the long term.”
“Without focusing on the smallest, cheapest, most beaten-down stocks,”
he said, “buying public equity is largely a waste of time.”
He then went on to say that “if you divide the market up into 10
slices by price-to-book-value, buy only the cheapest slice, and rebalance
your portfolio every year, you’ll be a millionaire in 20 years, even if
you invest only $2,000 a year. That’s many times richer than if you buy
those big stable companies.”
Dan is right. He won’t get an argument from ETR, or, for that matter,
from investors like Warren Buffett and Peter Lynch, who have made fortunes
by buying shares of good businesses when they’ve been beaten down to “bargain”
(oversold) levels, often because of bad news.
“Buying the cheapest slice of the market based on price-to-book
value and rebalancing every two years is worth about 21% a year on the
average,” said Dan, adding that buying big, stable companies is worth
about 8% a year.
Then he said, “If you mechanically bought all the stocks under 10
times earnings each year and held them for 10 years, you’d make in excess
of 16% a year. If you do that for stocks over 20 times earnings, you’ll
probably make about 4% a year . . . the same rate you get for buying Treasuries,
which are risk-free.”
So what should you do? Focus on “beaten-down, bargain” stocks?
Or on the relatively expensive shares of big, healthy companies?
Well, I’m going to stick by the advice I passed on to you before from
Lynn Carpenter — namely, that it’s a mistake to focus ONLY on low price
when investing in stocks.
I still believe it is important not to rush out and plunk down your money
on a stock — any stock — just because it’s “cheap.” To be
sure, as Dan points out, buying the cheapest stocks based on price-to-book
value is a good way to make big profits. However, buying cheap stocks
JUST because they’re cheap (meaning low-priced rather than “cheap”
relative to value) is a good way to go broke.
But, as Dan says, and we agree, you shouldn’t avoid low-priced stocks
simply because they’re low-priced, any more than you would buy a stock
just because it’s high-priced.
Here, then, is what we suggest — and this is the path that’s followed
by true-value investors:
1. Before you consider buying a stock, estimate what the company is worth
per share by figuring its book value or PE ratio relative to similar companies
in the same industry.
2. Don’t pay the full value. Buy a stock only when you can get a discount
to your estimated value of the company.
3. When you buy a stock, always put a trailing stop-loss on it — and
stick to it.
(Ed. Note: To learn more about “real” value investing . . .
and to discover specific recommendations made by Lynn Carpenter and the
other experts at the Oxford Club . . . visit http://www.agora-inc.com/reports/OXF/WOXFDC10/.)