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/.)