Unless the stock market stages an unexpected late rally, the month of February 2018 will be the first February since the 2008 market crash where stocks have gone down instead of up. Inflation is gaining momentum and interest rates are about to go up from years of historic lows. The unique financial conditions of the last several years have been ideal for high tech growth stocks, the FANG group especially. But, now that conditions are changing, growth stocks are overpriced and at risk for a major correction. The better choice for many investors is to move into value stocks and other investments. But, what is a value stock?
Investing in value stocks tends to be the most profitable approach over time.
Investing in value stocks is not just investing in cheap stocks. Good value stocks pay dividends and/or have high growth potential. These stocks commonly have a very sound business plan and return profits year after year. When there is a market rally value stocks often get left behind as investors follow rapidly growing stocks. However, when the rally corrects or the market reverses value stocks do, in fact, retain their value. Value stocks tend to outperform the overall market over the long term.
Long term investors look for intrinsic stock value. This is a value calculation based on projected returns on an investment over the next several years.
In the aftermath of the stock market crash of 1929 in the early days of the Great Depression Benjamin Graham introduced the concept of value investing.
Mr. Graham presented investors with a formula for calculating intrinsic stock value in 1962 and modified it in 1974. The 1974 version considers the following:
- Earnings per share, EPS, for the preceding twelve months
- A constant of 8.5 representing an expected price to earnings ratio, P/E ratio, for a company that is not growing
- An estimate of long term growth, five years = g
- A constant of 4.4 which was the average yield of high grade corporate bonds in the early 1960 decade
- The current yield of AAA corporate bonds = Y
- Where V = intrinsic value
The formula is as follows:
V = (EPS x (8.5 + 2g) x 4.4)/Y
The way the investors were encouraged to use intrinsic value was to derive what is referred to as a Relative Graham Value, RGV. This is to divide the calculated intrinsic value of the stock by its current price. If the result, the RGV, is less than one the stock is overvalued and a bad investment and if the ratio is above one it is undervalued and may be a good investment.
Value stocks are often not ones favored by current market sentiment. Investing novices too often look at what has appreciated recently and assume that the same stock or other investment will continue on its upward course. The history of market bubbles and collapses over the decades is clear proof that this approach does not work. If you are a student of the markets and want to both make a profit and sleep soundly at night, switch your investment focus from growth to value before the market teaches you a painful lesson.