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Why value investing on its own can be a risky strategy

Why value investing on its own can be a risky strategy


In this article, Lincoln Indicators discusses:

  • Why relying solely on a stock’s valuation will leave you potentially wearing a loss.
  • Why paying a premium price for a premium business can be justified.
  • How company’s financial quality is always the best measure of potential long term value.

Value Investing: Why is it cheap in the first place?

Many of us are told when we start investing that the trick is to ‘buy low and sell high.’ Though no one ever asks, ‘Why is it cheap in the first place?’

In order to identify whether a stock is cheap, market analysts will endeavour to calculate a valuation for a company. This valuation is a measure of what a company is worth today based on its current business and prospects moving forward. To arrive at this belief an analyst will need to perform detailed research into a business’ current operations and they need to predict the likely performance of the company moving forward.

And that is the difficult bit. They say, “A week is a long time in football.” When it comes to share investing this reality is amplified. All it takes is one update by the company to the market and all of a sudden its prospects and aspirations are turned on their head. This will often lead to a re-rating and a subsequent valuation upgrade or downgrade.

When it comes to investing, a stock is often cheap because of some issue relating to the business. And though there are sometimes where deep value available, you need to tread that path carefully and ensure you are find a bargain, and not last season’s trend.

Companies on the Australian share market from time to time can trade below their real worth or intrinsic value. But unless you know what you’re really buying into when investing in shares, you really are taking an unnecessary gamble.

If it sounds too good to be true it probably is

Do bargain buys really exist? The short answer to that is ‘yes’, because sometimes companies do trade below their “fair” value. Conversely, sometimes companies are deemed to be trading above their fair value – perhaps having risen too high, and too quickly, because of a range of market factors. As such, they are considered by certain company analysts to be overpriced.

But value investing can be a very risky strategy, especially without the right stock research. Time and again, so-called value experts make a call that a stock is in value because it is trading below their calculation of its real market worth. In doing so, they will put a “buy” recommendation on the stock. Using their same market value calculation model, they may also deem a stock to be overvalued. Their “sell” flag is promptly raised.

Disturbingly, however, the so-called value experts get it wrong more often than not. Companies they have identified as being priced below value continue to fall, and others recommended as “sells” (above value) continue to rise. Investors who made their decisions on a value at-all-cost recommendation alone will invariably have missed better market opportunities.

Many investors over the years have become very sceptical of valuations, and in many cases this scepticism is justified, because in an attempt to not look out of step, they will often jack-up earnings expectations to unachievable levels making a mockery of the concept of ‘value’ as they chase share price up. This creates the risk of a company becoming priced for perfection as the constant valuation upgrades fuels more of the speculative buying.

Paying a premium price for a premium business

There are often occasions where companies deserve to trade at a discount to their valuation. Particularly where the company is struggling fundamentally. It is also not unusual to see a company become even cheaper if it is unable to turnaround its fundamental underperformance.

Just like when you go to a clothing store, often the items which are on sale and are selling at a discount are last season’s fashion that the retailer is keen to offload. It’s the same with shares where investors take a discounted price to offload a poor business and realign their portfolios.

An investor may have to be prepared to pay a premium price for a premium business. If the company is of the highest quality then the old adage of “you get what you pay for” applies.

Investors who are comfortable paying a premium price for a company that is expected to be bigger tomorrow that what it is today are known as Growth investors. They appreciate the fact that if you want to buy into a quality business with strong prospects moving forward then you need to often pay a fair, if not a premium price to partake in the business’ long term growth.

Quality always comes first

Value investing is popular amongst many investors. However many inexperienced investors are left disappointed when their cheap stock becomes cheaper, or worse still, they sell an overvalued stock and it keeps going up and up.

So while the stocks in value game is played out on the Australian Securities Exchange (ASX) almost every day, the reality is that the one single thing factor in identifying long term value is the quality of the companies you are invested in. While analysts use value to determine a buy or sell recommendation, this method is flawed.

Value investors can help mitigate the risk of trying to catch a falling dagger by identifying great fundamental businesses to select from. Companies such as our Star Stocks can provide investors comfort that the bargain buys they are seeking to identify will not fall out fashion anytime soon.

Within Stock Doctor you can apply a rigid value strategy focussed on quality by:

  • Receiving Lincoln’s intrinsic valuations on all Star Stocks.
  • Identify Star Stocks, the most fundamentally superior businesses on the ASX from a gowth and/or income perspective
  • Have a access to our in-house research analysts to help form an opinion whether you are really looking at a bargain

 

Our team is always here to help. If you would like to discuss this article in more detail or would like more information on Stock Doctor or our Managed Investment Solutions, please contact us on 1300 676 333.

Tim Lincoln
Managing Director

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