Should You Really Sell Your Investments in May?
“Sell in May and go away” is an old investment adage that seems to be true more often than not. Should you really sell your investments in May or simply stop trading stocks? CNBC notes that the recent rally might be a concern because after the previous early year rally stocks plummeted over the summer.
Stocks have surged through April in their best start to a year in 32 years.
But, markets don’t have a good track record of following up on a rally of that size.
“There are four other years since World War II that the S&P was up at least 15% to kick off the year like we’re going to be this year. Three of those years are virtually flat during these worst six months of the year, the other was 1987 when we lost about 13%, ” said Ryan Detrick, senior market strategist at LPL Financial, on CNBC’s “Trading Nation ” on Tuesday.
Since the Second World War the stock market has had four similar rallies starting the year. The 1987 19% rally in the first four months was followed by a 13% loss culminating in Black Monday. In 1967, 1975, and 1983 the market started the year very strong but then went flat for the summer months and into the fall.
Here at Profitable Investing Tips we routinely suggest that investors pick strong stocks using fundamental analysis techniques such as finding intrinsic stock value for buying and selling stocks. But, if what you need to choose and hold onto an investment is based on such solid analysis, how is it that the old adage, “sell in May and go away” has any value?
Is Sell in May and Go Away a Good Idea?
Why Sell in May and Go Away?
Investopedia looks at the adage sell in May and go away.
If a trader or investor follows the sell-in-May-and-go-away strategy, he would divest his equity holdings in May (or at least, the late spring) and invest again in November (or the mid-autumn).
Some investors find this strategy more rewarding than staying in the equity markets throughout the year. They subscribe to the belief that, as warm weather sets in, low volumes and the lack of market participants (presumably on vacations) can make for a somewhat riskier, or at a minimum lackluster, market period.
They cite the fact that between 1950 and 2013 the market has had an average gain of 0.3% during the May to October time frame and 7.5% during the November to April time frame. No one is absolutely sure why this happens but it seems to be tied to trading volume and presence of more investors.
Sell in May and Long Term Stock Investing
Some of the most successful investors are those whose preferred time period to hold a stock is forever. How does the “sell in May and go away” rule apply to them? It should be noted that while the stock market on the average does not do as well in the summer months as during the winter, over the years the market is still up on the average, by a little, in the summer. If you are thinking of selling your well-chosen stocks in May, consider the costs of fees and commissions as well as the work involved in repeated analysis of investments that have otherwise served you well. One of the basic reasons that long term buy and hold investors are successful is that they avoid the excessive overhead of investing found in paying repeated fees and commissions. Rather they use dividend reinvestment plans to keep purchasing stock without paying commissions and they typically use a dollar cost averaging approach that evens out the peaks and valleys.
Stock Market Timing and the Sell in May and Go Away Adage
The place where “sell in May and go away” would seem to work is in market timing. Trying to find bargains in May is a difficult task when so many investors and traders take the summer off. Rather, a better choice may be to use the summer months to evaluate investment opportunities and start buying, as a rule, in October. Of course, you will want to avoid the next Black Monday!
Buying Stocks That Let You Sleep at Night
A solid approach to investing is to buy stocks that have a long history of paying dividends, steady growth, and minimal volatility. These are investments that let you sleep at night. To the extent that these stocks experience their growth during the winter months may be a good reason to time your buying to take advantage of the winter months. It is not a good reason to sell the stocks that will provide you with a secure retirement.
Investments That Let You Sleep at Night
Investing in Canadian Banks
Bank stocks in the USA have been suspect ever since they led us into the financial crisis with their predatory lending practices. However, right next door in Canada, the banks have followed more conservative practices and several are ideal long term investment opportunities. A common practice, among Canadians, is investing in Canadian banks when their stock price falls, dividend percentage rises, and P/E ratio drops. The three Canadian banks we have in mind are these.
Toronto Dominion (TD)
Royal Bank of Canada (RY)
Scotiabank (BNS)
These are the three largest Canadian banks.
New banks are rare in Canada because the regulatory hurdles are so difficult to go over. This also makes Canadian banks, as a group, safer than U.S. banks. In the last century, while tens of thousands of U.S. banks have failed, only three Canadian banks have gone under! Of all the Canadian banks, Toronto Dominion is considered the safest.
Canadian Bank Stocks
The three Canadian bank stocks we have in mind are all dividend stocks. While you may think that these stocks are not great growth opportunities, that is not correct. This graph from Seeking Alpha shows investment portfolio returns for these three banks going back twenty-three years.
Top Three Canadian Bank Stocks
Not only are these bank stocks safe investments due to strict Canadian banking regulations but investing in Canadian banks can be very profitable as well.
Investing in Toronto Dominion Bank (TD)
Toronto Dominion was formed by the merger of Dominion Bank and Toronto Bank in 1955. Those banks dated back to 1869 land 1855 respectively. Today TD is the largest Canadian bank by total assets, one of the top ten North American banks, and the 26th largest bank in the world. Over the last two decades, the bank stock has gone from the $2.50 range to the $75 range and its current dividend yield is 3.89%.
Toronto Dominion Bank Stock
Investing in Royal Bank of Canada (RY)
Royal Bank of Canada is the largest in the country by market capitalization and is always around the fiftieth largest bank in the world in yearly ratings. RBC was founded in 1864. Two decades ago this bank stock traded in the $6.60 range and today trades at $105. Its stock has a dividend yield of 3.84%.
Royal Bank of Canada
Investing in Scotia Bank
The Bank of Nova Scotia was founded in 1832 and operates under the name of Scotia Bank. It is the third largest bank by deposits and market capitalization. Two decades ago this stock traded at about $10 a share and today it trades at around $55. Its dividend yield is 4.77%.
Scotia Bank Stock
How Canadians Invest in Canadian Bank Stocks
Many savvy Canadian investors have the same preferred length of ownership as Warren Buffett, which is forever. They simply wait until the bank stock price slips a little and then buy a little more. The approach has served many Canadian investors very well for many years.
Seeking Alpha touches on this subject in an article about Canadian dividend stocks.
It’s a strategy that many Canadians employ with the big Canadian banks – buy the worst performer. Wash and repeat.
I took that approach at times with my Canadian banks and my other holdings.
We might see an immediate and more generous income boost and the potential for a greater long term total return boost.
When we have a group of quality holdings we might use that value hunting approach as a consistent strategy.
The author goes on to explain his approach of using P/E ratio, stock price, and dividend yield as guides for when to buy more of these bank stocks.
Timing Canadian Bank Stock Purchases
We have written about the perils of buying cheap stocks recently in our article about choosing undervalued investments. The risk of buying a stock when it is down is when the stock price is down for a good reason and will likely fall even more. Investing in Canadian banks helps reduce this risk as the banks are highly regulated and in the last century only 3 have failed, compared to tens of thousands in the USA. Thus, these stocks can be seen as slow and steady growth stocks with a cyclical component. The trick for maximizing profits with these stocks is to buy when their stock prices are down and when their intrinsic stock value is still strong.
Dollar Cost Averaging Canadian Bank Stock Purchases
If you are not interested in constantly checking stock prices on even a few Canadian bank stocks, consider using dollar cost averaging for these investments. Investopedia defines dollar cost averaging as follows:
Dollar-Cost Averaging is a strategy that allows an investor to buy the same dollar amount of an investment on regular intervals. The purchases occur regardless of the asset’s price.
Because you will purchase fewer shares of these stocks when the price is high and more shares when the price is low, dollar cost averaging gives some of the same benefit as timing your Canadian bank stock purchases based on price, dividend yield, and P/E ratio.
Intrinsic Stock Value Calculation of Canadian Bank Stocks
Our belief is that every time before you buy a stock you should calculate its intrinsic stock value. That holds true for the three large Canadian banks we reference in this article. However, these are really stable investments that really do let you sleep soundly at night. As such, a yearly review of your portfolio of these investments is a good idea. Every five years is probably too long to wait. And, if you keep evaluating Toronto Dominion, Royal Bank of Canada, and Scotia Bank every month, you are wasting your time.
Investing in Canadian Banks with Dividend Reinvestment Plans
All three of the Canadian banks we looked at have dividend reinvestment plans. Using these plans during your working years is a great way to simulate the dollar cost averaging approach. Taking the dividend checks during retirement is a great way to reward yourself for investing in these safe, solid, and secure Canadian banks over the years.
Can You Diversity Your Investments too Much?
It is a good idea to diversify your portfolio of investments. Doing so reduces the risk of loss by spreading out your investments over several vehicles and several sectors of the stock market. But, can you diversify too much? The answer is, yes. There comes a point where adding more stocks, for example, does not improve your risk profile but makes it harder to keep track of your individual investments. And it takes you away from investments that you understand. If you are a dedicated long term investor, you will routinely review your portfolio and assess intrinsic stock value. While doing this for four or five stocks is reasonable, carrying out this sort of fundamental analysis for more than twenty-five stocks is not. How do you approach this issue? What are the best places to invest your money in order to get a good return and minimize risk? Should you learn how to invest in Mutual Funds or how to invest in index funds and simply let someone else diversify for you?
Diversify Your Investments and Sleep Better
How Can You Diversify Your Investments?
There are some basics to sound investing that set the stage for diversification. After paying off credit card debts and putting enough money in a bank account to cover expenses for three months, it is time to consider investments. For the vast majority of people, owning their own home is the best investment of their whole life. It is cheaper over the long run to pay off a mortgage than to pay rent and for many people, their largest asset becomes the home they live in. So the first investment is in your home.
Investing and having your taxes deferred until retirement is a huge benefit that you can get from a 401 (K) at work or from an IRA. You may be able to invest these by yourself or may need to pick one of several options offered by work with the 401 (K). Whichever is offered, you should take advantage of the tax-deferred aspect of these opportunities and they should be your second routine investment.
A common and time-tested approach to investing is to treat part of your investments very conservatively so that you do not lose money. Last year we wrote about how to invest without losing any money and focused on bank CDs, US Treasuries, and AAA corporate bonds. As you invest over the years, part of your investment portfolio should go into such safe investments.
The U.S. stock market is generally considered to be the best way to make money over the long term for the vast majority of people. The S&P 500 has appreciated by 10% on the average since its beginning in the 1920s and that includes making up for the 1929 Stock Market Crash and Great Depression. U.S. stocks should be part of your investment diversification routine. And, those stocks should be diversified as well.
Diversifying a Stock Portfolio
Some people simply bypass this issue by investing funds with Fidelity or Vanguard in one of their mutual funds or in an ETF. The difference between an ETF and a mutual fund is that the ETF passively tracks a stock sector or even the entire S&P 500 while a mutual fund is managed and charges you for that service. Investing in stocks this way is easy, passive, and takes very little of your time. But, as we mention in our article about picking the best stocks to invest in, smart investors only invest in companies when they know what the company does to make money and how that business plan will continue to work for the long term future. This approach requires that you limit the number of stocks that you hold to those that you understand and have time to follow. But, even if you have all of the time in the world, can you diversify your investments too much? Yes, you can and here are a couple of opinions on the subject.
How Many Stocks in a Portfolio Are Too Many?
In the book, A Random Walk Down Wall Street, the author makes the point that with an efficient stock market, an investor could randomly purchase enough stocks (ten large-cap stocks or 40 small-cap stocks) to reduce risk and outperform many active investors.
By “diversifying in this way, the investor lets the market take over and generate profits. But, there is a point of diminishing portfolio risk reduction compared to market risk.
Risk versus Benefit of Diversification
If one simply picks large-cap stocks and small-cap stocks at random, one’s portfolio risk is the same as market risk by 25 stocks. Holding more stocks does not provide more diversification benefit but it does increase the work needed to manage the portfolio.
A Market Watch article writes about the exact number of stocks one should own. The point they make is that in order to “beat the market” you need to be invested in stocks that you understand and have time to follow and that does not work very well when you have too many stocks to keep track of.
Is there such a thing as too much diversification? Yes, in fact, there absolutely is, according to Phil Fisher, an influential stock picker whom Warren Buffett BRK.A, -0.54% credits as a major source of inspiration.
“Investors have been so oversold on diversification,” Fisher said many decades ago, “that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others which they know nothing about.”
Sean Stannard-Stockton, president and chief investment officer of Ensemble Capital, agrees, saying that while diversification is critical in mitigating risk, active market participants should be mindful of just how much diversity is ideal.
“Too much of anything can be bad for you and diversification can be taken too far,” he wrote in a post on the Intrinsic Investing blog. “But the level at which ‘too far’ kicks in is surprising to most people.”
In the article, they show the graph from The Random Walk Down Wall Street. Their advice for active investors is to stick with stocks that they know and not “randomly” add new investments in the name of diversification.
Investopedia also warns about the dangers of over-diversifying your portfolio. They start by noting why it is that an investor should diversify.
Most investment professionals agree that although diversification is no guarantee against loss, it is a prudent strategy to adopt toward your long-range financial objectives. There are many studies demonstrating why diversification works – to put it simply by spreading your investments across various sectors or industries with low correlation to each other, you reduce price volatility.
This is because different industries and sectors don’t move up and down at the same time or at the same rate. If you mix things up in your portfolio, you’re less likely to experience major drops, because as some sectors encounter tough times, others may be thriving. This provides for a more consistent overall portfolio performance.
But, they make the point that just buying twenty stocks is not true diversification unless the stocks are chosen to be in different sectors. And, they emphasize that you can diversify your investments too much and crowd out your most promising stocks. They end by quoting Warren Buffett. “Wide diversification is only required when investors do not understand what they are doing.”
How to Buy Stock Directly
Long term investing works out well when you choose secure investments whose value appreciates over time. Investments like dividend stocks are a good choice because the dividends can be reinvested during the early years and taken as income during retirement. Many dividend stock investors take advantage of dividend reinvestment plans but these plans are also how to buy stock directly without ever going through a broker.
How to Buy Stock Directly with Dividend Reinvestment Plans
If you already own stock in a company that has a dividend reinvestment plan, all you need to do is sign up and the company will reinvest your dividends for you in fractional shares without any fees or commissions. Such plans commonly let you send them a check to buy more shares as well, free of fees and commission. Some now even allow you to use a credit card or bank debit card to make commission-free stock purchases. What has happened in the last decade or two is that 1) many more companies have dividend reinvestment plans and 2) many of these allow you to make all of your purchases of the company’s stock directly through the plan.
Finding Stocks That Allow You to Buy and Reinvest Directly
An excellent source of information for those who want to know how to buy stock directly and which companies offer this opportunity is DRIP Investor.
In 1992, there were less than 10 companies that permitted investors to buy their first share and every share of stock directly.
Today, the number of companies permitting initial purchases has grown to over 400 firms. There are a similar number of foreign stocks whose shares trade on U.S. exchanges that also allow U.S. investors to buy shares directly, the first share and every share.
Today’s DRIP plans certainly are quite robust from a service level. There are:
- IRA options
- Discounts
- Borrowing features
- Automatic investment programs via electronic debit of a bank account
- Market orders
- Online buys and sells
The DRIP Investor site makes the case for using this method to buy stock directly and continually reinvest dividends.
The combination of long-term (one might even call it the much-maligned “buy-and-hold”) investing, dividend reinvestment, dollar-cost averaging, and no-cost/low-cost investing is a powerful strategy for wealth creation. It worked for me, and it has worked for many of the investors who started with our Charter issue 26 years ago and are still with us today!
But, if you are reading this, you do not need a pep talk about how to buy stock directly but rather the tools find the best stocks to invest in which also have this feature.
You will need to subscribe (for free for 30 days) see if their advice on how to buy stock directly might work for you. The most important aspects will be their list of no-load stocks, the DRIP starter guide, and their “DRIP ratings.”
Best Direct Stock Purchase Companies
And, you do not need to use a service to find out how to buy stock directly. For example, you can buy stocks directly from Apple and there is a Coca Cola direct stock purchase plan. The Johnson & Johnson DRIP is another option. The point is that while there are many companies that offer direct stock purchase and dividend investment plans, the key to success in investing in stocks in this category is to choose the stocks first and then see if they let you buy shares directly or allow reinvestment of stock dividends.
Coca Cola
When to Be Careful about Buying Stock Directly
As a cautionary example, we recently posed the question, when is a high dividend yield dangerous? How to invest in stocks is not simply to jump on an investment that is currently offering a high dividend but rather to choose an investment based on strong intrinsic stock value which will translate into long term safety, value, and profits. If you find an exceptional stock with the promise of great appreciation over the years, it may be wise to invest in that stock even if it does not offer dividends, dividend reinvestment, or direct purchase of shares. The fact of the matter is that young, startup companies commonly do not offer such services until they have grown and matured. How to buy stock directly from such companies may be simply to proceed in a normal investment manner until they offer DRIP and direct investment plans.
Who Should Buy Stock Directly and Who Should Not?
Should your first stock purchases be with companies that let you buy shares directly and reinvest dividends directly? In fact, should all of your investments follow this plan? Over the years we have written about how to start investing in the stock market and noted that the first thing to do is to get your financial house in order by paying off credit card debt, putting some money in the bank, in buying your own home. Then, at least part of any investment portfolio should be very conservative, in regard to which we wrote about how to invest without losing any money.
When you invest in stocks, you should choose companies whose businesses you understand due to your own unique insights or because you have studied the company. Successful long term investors typically limit their investments to companies where they, the investor, have a clear idea of what the company does to make money and how their business plan will continue to succeed into the future. And, investors need to keep track of how their companies are doing. Sears used to be the greatest retailer in the world and now is bankrupt. Kodak was the king of camera film, processing, and prints and lost out to digital cameras. The first choice is to pick a stock you understand and that will appreciate, hopefully pay dividends, and not provide any downside surprises. Then, learning how to buy stock directly from that company is a really good idea.
The Long Term Value of Buying Stock Directly
When you intend to invest for the long term, buying stocks directly reduces the cost of every purchase. This means that you will not be paying a 2.5% commission to a broker or $4.75 to an online broker for purchasing stocks.
The S&P 500 has provided an average of 10% appreciation over the years. Over a forty year span, $1 invested turns into $45.26. This is the value of exponential growth. But, what if you are not investing $1 but rather $0.975? Then the end result is $36.23!
The “extra” 2.5% that a person can invest each month compounds over the years and can make a difference of about 20% in how much of the money invested in your 20s will be worth in your 60s. In other words, there is a great value in learning how to buy stock directly and avoid fees and commissions.
Investments That Let You Sleep at Night
Would “Medicare for All” Kill Your Health Care Investments?
The next U.S. presidential election is 19 months away and politicking is already in full swing. An issue that was raised by candidate and Senator Bernie Sanders in the 2016 presidential campaign has come back with a bang. It is “Medicare for all.” Sanders, and now several others, are proposing that all Americans be covered by a health care program run by the U.S. government instead of private insurance under the current Affordable Care Act (aka Obamacare). While this may or may not be a good idea for taking care of sick people, investors need to wonder, would “Medicare for all” kill your health care investments? Just having the issue mentioned in the early days of the 2020 campaigns has driven down health care stocks. Here are the news and some thoughts about the healthcare system, Medicare for all, and how Medicare for all would kill your health care investments, or not.
Comparison of Health Care Costs by Country
Image: Sanigest International
Health Care Stocks and the Possibility of Medicare for All
Bloomberg writes about how health stocks crumble on the possibility of a “Medicare for All” solution to America’s health care issues.
“Presidential primary politics,” said Evercore ISI analyst Michael Newshel, are “more in focus than fundamentals.”
The slide began in earnest on Tuesday when UnitedHealth Group Inc., [which is] treated by investors as a bellwether for the insurance sector, waded into the debate over “Medicare for All,” which would expand government-administered coverage to most of the population and rewrite the businesses of U.S. health insurers, hospitals and doctors.
While it’s a longshot to become law despite the backing of some contenders for the Democratic presidential nomination, the proposal has the power to upend company stock prices. Together, the shares of hospitals and insurers lost $28 billion in market value on Tuesday, according to data compiled by Bloomberg. The Tuesday losses capped the worst five-day stretch since 2011 for health insurers, despite UnitedHealth reporting earnings that beat analysts’ estimates and raising its 2019 forecast.
How Health Care Companies Are Affected by the Threat of “Medicare for All”
Companies like UnitedHealth Group Inc. have invested heavily in systems to manage the costs of health care and, in fact, how health care is delivered. This money has been spent and complex systems are in place to evaluate doctors, hospitals, medicines, and treatment plans for effectiveness and efficiency. In other words, these folks have spent decades now looking critically at how health care is delivered and forcing changes by altering payment based on treatment results and costs. In fact, UnitedHealth has such a treasure trove of information that they sell their expertise to other health insurers and managed care companies to help those folks provide better care while reducing costs. And, the end result for UnitedHealth Group has been higher profits and a share price that went up ten-fold in the last decade (before the recent “Medicare for All” scare).
Why Does Sanders Want Medicare for All?
Although roughly half of the 40 million uninsured, non-elderly, American get health insurance under the Affordable Care Act, there are still around 25 million uninsured younger Americans and the numbers went up last year. Sanders wants the USA to use a system like Canada, England, Germany and other developed nations have. Each of these countries has a universal health care system. Senator Sanders chooses to call his approach “Medicare for All” instead of a universal health care system, but they are one and the same. In these systems, well-to-do individuals can have private insurance and go to private doctors and private hospitals but the vast majority of their citizens receive the majority of their care under the government system.
Countries in Green Have Universal Health Care
Would “Medicare for All” Kill Your Health Care Investments or Not?
The concern is this. If such a plan were to come into being in the USA, the health care insurers and managed care companies like UnitedHealth Group would lose business, but how much? In the USA two-thirds of “insured” people have private health insurance. Because 8% of Americans are still uninsured, it means that about 60% of Americans have private health insurance. In Canada that number is about 27% for folks with comprehensive coverage but 70% of Canadians have some degree of supplemental coverage as the Canadian system covers about 70% of health care costs.
Thus American health companies would lose more than half of their clients that have complete coverage but could pick up clients for “supplemental” policies if a transition to a “Medicare for All” system in the USA followed the Canadian model.
(HealthAffairs.org and Health Care in Canada: Wikipedia)
As a quick glance at the figures for private health insurance in Canada versus private health insurance in the USA demonstrate, there would still be a place for private insurance, and that niche would probably grow and become more profitable due to the nature of universal health care systems.
Universal Health Care Cost to Taxpayers will Protect Your Healthcare Investments
We recently wrote that the Trump tax cut was a bust for investment and hiring but nevertheless will have substantially increased the national debt to $22 Trillion. The interest on an ever-increasing national debt is currently at $479 Billion a year. Servicing all forms of U.S. debt takes 10% of the yearly budget.
(Interest on the National Debt: The Balance)
Bloomberg quotes a study saying that “Medicare for All” would cost $32.4 Trillion over ten years.
The latest plan from the Vermont independent would deliver significant savings on administration and drug costs, but increased demand for care would drive up spending, according to the analysis by the Mercatus Center at George Mason University in Virginia. Doubling federal individual and corporate income tax receipts would not cover the full cost, the study said.
Sanders’ plan builds on Medicare, the popular insurance program for seniors. All U.S. residents would be covered with no copays and deductibles for medical services. The insurance industry would be relegated to a minor role.
Your Investment in Health Care Will Be Protected by the Definition of “Non-essential”
The problem with universal health care systems is that they need to be managed in such a way as to deliver “essential” medical services to everyone at an affordable cost to the government. The problems in such systems come from what ends up be defined as “essential.” In the Canadian system, drugs and psychological/psychiatric care are not covered! “Essential” is too often defined by the economic needs of the system and the willingness of taxpayers to pay for the health care of others.
Another issue is that “non-essential” health care services tend to be used to a greater degree when one does not need to pay any money to receive that service. The Canadian system uses “co-payments” to discourage excessive use of non-essential services. This would not be a feature of the Sanders proposal as it currently stands.
The bottom line is that a universal health care system is expensive to operate and such systems tend to require citizens to pay larger and larger shares of the cost out of their own pockets or pay for private insurance to cover against excessive risk.
So, would “Medicare for all” kill your health care investments? We don’t think so.
Choosing Undervalued Investments
Choosing undervalued investments that the market has ignored or misunderstood can be very profitable. But, the key to this manner of investing in stocks is to find investments with hidden value and not just use a stock screener to find cheap investments. There are always reasons why the market prices a given stock as it does. Investments that are really undervalued are being ignored by the market because they are small stocks, stocks that no analysts are following, or stocks that the market in general does not understand and therefore gives them a too-low stock valuation.
Because the stock is being ignored, the company could be making significant changes that will result in long term profits and no one would know. The key to choosing undervalued investment is to recognize and exploit such situations. And, the funny thing is, many such investment opportunities are hiding in plain sight and not just in small cap or mid cap stocks. Choosing undervalued investments in large cap stocks is possible as well. In those cases the issue is one of the market not understanding a stock’s long term growth potential.
Choosing Undervalued Investments
Image: US News and World Report
How to Go about Choosing Undervalued Investments
When looking for undervalued investments do not assume that you need to look for penny stocks under $1 or stocks that nobody has ever heard of. Although screening for cheap stocks is not a good way for choosing undervalued investments, there are sources of information you can tap. You can subscribe to an investment advisory service such as Morningstar Stock Investor, Kiplinger’s, or simply read the Motley Fool’s advice. The point is that you can get good ideas from these folks without a lot of effort. But, then you need to do your own homework.
Situations That Result in Undervalued Investment Opportunities
The Motley Fool has some good advice about finding an undervalued stock. The first step is to understand just why the stock is undervalued, as opposed to correctly valued and cheap.
One of the central ideas of value investing is that the market misprices stocks from time to time. There are many potential reasons why a stock can become undervalued, but these are a few of the more common ones:
- Missed expectations: If a stock reports quarterly results that fall short of expectations, shares can drop more than the situation calls for.
- Market crashes and corrections: If the entire market drops, it’s a great time to look for undervalued stocks.
- Bad news: Just like when a stock misses analysts’ expectations, a bad news item can cause a knee-jerk reaction, sending shares plunging more than they should.
- Cyclical fluctuations: Certain sectors tend to perform better at different stages of the economic cycle. Sectors that are out of favor are good places to look for bargains.
In each of these cases, the market drives a stock price down below what it is worth over the long term. This can be simply a panic response to a falling market or in can be an over-leveraged investment group that is forced to sell at a discount in order to cover margin calls on options trades that went badly. In either case, these are classic situations in which choosing undervalued investments can work out well.
Stock Market Crash
Image: Market Watch
Choosing Undervalued Investments in Your Areas of Expertise
The most important part of making money by choosing undervalued investments is to always work within your area of expertise. This can be you profession. A computer scientists will have more insight in this area than someone else. Or a medical doctor ought to have more insight into the pharmaceutical industry or medical products companies. But, your area of expertise can be one in which you have studied the investment opportunities, have invested for years, and in which you have experience with rising and falling markets. The point is that when you are investing on your “home turf” you will have a much better sense of when an investment is undervalued.
Specific Guidelines for Choosing Undervalued Investments
There are a whole set of “metrics” that you can apply to come one investment to another or than investment to its market sector as a whole. Using these is not the whole story but a good place to start.
P/E Ratio
This is the share price of the stock divided by annual earnings (price to earnings ratio). A really high P/E ratio usually indicates and overpriced stock and a really low P/E ratio typically goes with an undervalued investment.
P/B Ratio
The price to book ratio is the share price divided by the company’s equity per share. This metric has to do with the margin of safety of a stock. Companies with lots of cash on hand and very low debt have low P/B ratios can be good undervalued investments to consider.
PEG Ratio
Price to earnings growth is based on its P/E ratio which you can calculate and its earnings growth projection is an estimate which you need to work out or trust someone else to provide for you. The argument for using this indicator is that there are stocks that are growing rapidly and therefore attracting lots of investors at higher share prices. The argument is that you are paying a lot for this stock today but its growth will still make you rich. Choosing undervalued investments using this metric takes a lot of faith and, some would say, gullibility.
ROE
Return on equity is the company’s net income for the year presented as a percentage of total shareholder equity. This is a useful metric as it gives you an idea of how well the company generates revenue in light of the total money invested in its stock by investors. This metric can be used to compare companies within a sector, but beware of using it across the board because different kinds of businesses typically have different returns on equity.
Debt to Equity Ratio
This is another margin of safety metric. It is the total company debt divided by total shareholder equity.
Current ratio
This one has to do with short term cash flow and the ability of a company to pay its immediate debts. It is current company assets divided by current liabilities. When choosing investments that are undervalued and otherwise seem like good prospects, beware of this one because it could predict that the company will run out of money and credit before accomplishing the changes needed to grow profitably.
(The Motley Fool)
Non-metric Indicators and Predictors of Stock Value
Established companies may or may not have an advantage over upstarts in an industry. But, many areas of high tech are “high cost of entry” businesses. When a company has money in the bank, low debt, a strong brand name, and the ability to reduce prices to freeze out competition, they have a huge margin of safety. Over the long term this argument can apply to a variety of businesses but is one of the reasons why successful long term investors step in and buy more shares of companies like Microsoft or Walmart when their prices go down.
Another indicator to follow is when company executives buy or sell stock in the company. It is reassuring to see the folks in charge buying more stock during a market downturn instead of selling out and heading for the door. Keep track of this when choosing undervalued investments.
The Virtue of Patience in Choosing Undervalued Investments
We often mention Warren Buffett in our articles. He is one of the richest people in the world and unlike the others in the top echelon like Bill Gates, the Walton family, and Jeff Bezos, Buffett’s wealth does not come from a single company in a single market niche. His wealth comes from investing and his holding company, Berkshire Hathaway. Buffett has become incredibly rich over the years by successfully choosing undervalued investments which he commonly goes on to hold forever.
The point of mentioning Buffett has to do with the general approach to choosing undervalued stocks. Buffett only invests in a company when he has a clear idea of what they do, now they make money, and how they will continue to do for a long, long time. When he and his staff look for new investment opportunities, they look for intrinsic stock value which is determining a stock value based on the assessment of forward looking earnings and then comparing that value to the current stock price.
He has been quoted as saying that he throws out 95% of all investment prospects as “too difficult to call.” This is a good example for the normal investor to follow. Be patient and find stocks with good intrinsic value that have been beaten up or forgotten by the market. Luckily for investors who are mere mortals and not Warren Buffett, we only need to find a handful of stocks to invest in and not a hundred in order to reinvest billions in profits every month!
Best Way to Find Good Stocks
The stock market has been going up for a decade ever since the depths of the Financial Crisis. During that time S&P 500 has more than tripled in value. Many investors who were hurt badly by the stock market crash of 2008 to 2009 have hesitated to reenter the market. And, many who might have invested in stocks are unsure of how to find good stocks and how to avoid losing everything should the market correct or crash again. A valid concern for investors today is not buying overpriced stocks in an aging bull market. Likewise, investors want to find stocks that still have growth and earnings potential that will last over the years. What is the best way to find good stocks with these priorities in mind? And, are there sources of stock investing advice that you should routinely ignore?
Best Way to Find Good Stocks
Finding good stocks to invest in can be broken down into three steps. What information sources do you use? What criteria do you look for? And, how do you verify what are the best stocks to buy right now and for the long term?
Useful Information when Searching for Good Stocks to Buy
There are lots and lots of business and stock investing-related websites. They provide lots and lots of information. But, they also have the tendency to promote individual stocks, investment management companies, and their own unique points of view.
Information about the Economy, Markets, and Stocks
A good place to start if you are looking for unbiased information about stocks, the markets, the economy, trade, and more is Bloomberg News. The best way to find good stocks is not to immediately start looking for hot stock tips but rather to educate yourself about the things that drive stock profits and stock prices. The business section of The New York Times is a good source of unbiased information as is The Wall Street Journal. To the extent that these sources of information try to sell anything, other than online subscriptions, is when they tend toward one side or the other of the political spectrum. But, each of them is an excellent base from which to start. Our first choice is Bloomberg.
Specific Stock Investing Information
If you have a stock in mind and want to know its price history, dividend, and a thumbnail sketch of the business, both Google Finance and Yahoo Finance are good sources of information. These are good news sources but not as in-depth as the Times, Journal, or Bloomberg. But you can look up information about specific stocks such as this graph of the Apple stock price going back to 1981.
Google Finance Apple Stock Price: All
The information that you find on a chart on Yahoo Finance or Google Finance is not colored by the opinions of someone who is pitching that stock. Rather it is basic and useful which is the best way to find good stocks.
Sources of Stock Tips
If you have followed our advice so far you have educated yourself about the economy, the markets, foreign trade, and other factors that drive profits and stock prices. And you know where to go (Yahoo Finance and Google Finance) to check out stock price history, P/E ratio, and dividends. But, where do you find information about good stocks for dividends, cheap stocks on the rise, or simply the best stocks to buy today. Here is where the stock commentators are useful. These folks follow the markets and have lots of useful information along with their own strong opinions. CNBC has good investing information as do Market Watch, Barron’s, Investor’s Business Daily, and The Motley Fool. Jim Cramer’s “Mad Money” is full of useful tips and entertaining as well.
For those who are not interested in doing a lot of research on their own, following these sources for stock investing tips can be profitable. They commonly write about good stocks for cheap, good stocks for day trading, and what they consider to be the best stocks to buy today. However, we strongly suggest that you use their tips as a starting point and not an endpoint in picking profitable stocks for the long term.
Criteria for Choosing Stocks
The basic things to consider before choosing stocks are these. What are your investing goals, horizon, and risk tolerance? And, what do you know personally that will give you solid insight into specific sectors of the stock market? In one of our core articles about investing in stocks, we note that time spent considering how long you will be investing before you need money for retirement, college for the kids, or money to start your own business will affect your choices. And, when your work, your hobbies, or your life experience give you an advantage over other investors in any given market sector, grab that advantage with both hands and hold on!
Risk versus Reward in Stock Selection
When investing, there should always be a balance between risk and reward. Part of your money should be in investments that are as secure as you can find. We dealt briefly with this in our article about how to invest without losing any money. Then, you will want to look at any prospective investment and consider how the company makes its money and how it can be expected to keep doing that over the long term. This is where having your own insights into a specific line of business are useful and those insights should always be used.
Specific Stock Selection Criteria
Some investors prefer to look for good stocks for cheap. But, these may or may not be the best stocks to invest in today. The best dividend-paying stocks should be part of your investment portfolio. But, when is a high dividend yield dangerous? Read the article for insight into how failing stocks sometimes sport high dividends before they fade away. As we noted, you should always look for stocks in sectors where your knowledge and experience give you an advantage. This is because you will have better insight into how a company makes a profit and if they are likely to continue to do so over time. And, this leads us to our last part of the best way to find good stocks.
How to Verify Good Stocks to Buy
So, now you have a few stock prospects that you picked up from following Bloomberg and The New York Times, listening to Jim Cramer’s Mad Money, and even a stock tip or two from family and friends. How do you verify that any or all of these are good stock picks for your time frame, risk tolerance, and area of expertise?
The Fundamental Value of a Stock Investment
When you buy a stock you are looking for it to reward you in two ways. You want its stock price to appreciate over time and you would be pleased with dividends that you can reinvest during your working years and collect during retirement. For these things to work out you need a stock that makes money over the years, increases its profits as it goes, and has a substantial margin of safety in terms of low debt, money in the bank, a famous and strong reputation and brand, and has a business model that you clearly understand.
Intrinsic stock value is what you are looking for. This is a calculation based on your assessment of forward-looking earnings. This approach evolved in the years after the 1929 stock market crash and in the years of the Great Depression. For those who paid attention, it replaced the idea that one would simply “play the market” in hopes of making a profit. Investors who follow this approach use fundamental analysis to determine if a company will continue to sell its products and services at a profit over the years, add more products and services, and manage the business wisely in order to most efficiently use those profits to reward shareholders.
Our best way to find good stocks may sound time-consuming but, if you are into investing for the long haul, what is your hurry? Experts like the famous investor Warren Buffett have said that they commonly throw out 19 out of 20 stocks that they consider in an intrinsic value calculation as “too difficult to call.” Here is where your own expertise comes into the picture. You are not trying to find investments for a multi-billion dollar portfolio. You are looking for three or four stocks whose businesses you understand, which have good track records, and are likely to keep making money for their shareholders for at least as long as you choose to stay invested.
Investments That Let You Sleep at Night
When Is a High Dividend Yield Dangerous?
Dividend stocks are generally good investments. When a company is well-run and routinely making money, it can afford to reward its shareholders with quarterly dividend payments. Companies that have been paying and routinely increasing their dividends for decades or even more than a century are cornerstones of a strong investment portfolio. When looking for dividend stocks, investors often screen for the highest yields. But, when is a high dividend yield dangerous? In this article, we are going to look briefly at dividend stock investing and dividend reinvesting. Then, we will look at when to avoid a too-high dividend when choosing stocks.
Dividend Stocks
A common misconception is that stocks are either ones that appreciate in value or ones that pay a dividend. This is true but only to a degree. For example, as Microsoft grew from a little startup to the tech giant that it is, its stock price skyrocketed and it did not pay a dividend. When it reached the plateau common for successful companies, its stock price slowed its climb and the company started paying dividends (2003). Interestingly, Microsoft stock today sells for four times the price today that it sold for when dividends started. This is a better appreciation than the S&P 500 over the same time span! So, investing in dividend stocks is a good idea. And, higher dividends are better than low dividends but when is a high dividend yield dangerous? It has to do with long term investment and dividend reinvestment plans.
Reinvesting Dividends
Dividend stocks are not investments where you try to time the market and make a quick profit. They are long term investments (5 to 10 years at least). Although a quarterly dividend check is a nice thing to receive during your retirement, most long term investors reinvest their dividends in company-sponsored dividend reinvestment plans. Because these plans reinvest every cent of your dividend with fractional shares, your investment grows exponentially, fueled by stock price appreciation as well as reinvested dividends. The key issue here is that you expect to hold onto this investment for decades. So, it has to be a safe investment! Thus, you do not want to be tempted by a high dividend yield in a failing stock!
Dividend Stock Screening
The Yahoo Stock Screener is a readily available tool for finding stocks with healthy dividend yields. (And, there are many more.) When using such a tool an investor can screen for various criteria such as market cap, dividend percent yield, stock price, market sector, and more.
To create three examples, we screened for U.S. stocks, large-cap, share price greater than $25, and dividends greater than 2%, 5%, and 10%.
In the 2% category, the screener returned 492 stocks. In the 5% category, it returned 57 stocks. In the 10% category, it returned 6 stocks.
Large Cap, U.S. Stock, Dividend Greater Than 10%
Four out of six of these are Annaly Capital Management which is a real estate reinvestment trust. They borrow short term repurchase agreements and reinvest the proceeds in securities that are asset-backed. They have been in business for 22 years. Selling at just over $10 a share their share price is virtually unchanged from when they started but the stock did trade as high as $20 before the financial crisis and in the $17 range until 2013 when it returned to its $10 range.
Energy Transfer Operating LP stores and transports natural gas. They have been in operation since 1995 but became publicly traded only in 2006. Google Finance only shows stock prices since 2018 and it has traded in the $21 to $25 range.
Icahn Enterprises L.P. went public in 1998 at $10 a share and today trades at $73, having been as high as $117 in recent years. The controlling shareholder is the company’s founder, Carl Icahn, the famous takeover artist. The company is a conglomerate of metals, energy, casinos, food packaging, auto parts, real estate, rail cars, and home fashion products.
In the case of this stock screen, Annaly is not a growth company in that it trades for the same price today as when it went public. In fact, since it traded for $19 a share with the same dividend, you might think of it as a 5% dividend stock fallen on hard times.
Energy Transfer works in a somewhat protected niche in the oil and gas sector by getting paid for storing and transporting natural gas. However, these folks are commonly at swords points with the environmentalists in regard to their natural gas pipelines. The long term fate of this company is tied to the energy industry nevertheless.
Icahn Enterprises is tied to the smarts and success of Carl Icahn which brings up the question of how well the company will do when he is no longer part of the business.
We did not “fudge” these numbers to come up with examples but simply ran a screen like you would. Now, we will look at stocks that might really be dangerous investments.
When Is a High Dividend Yield Dangerous?
A recent article by The Motley Fool looks at three “dangerous high-yield dividend stocks.” They start by making the same point we did, that dividend stocks are a good part of a strong portfolio and that the ability to pay dividends year after year correlates with long term business success. And, then they note that a too-high dividend should be a warning sign.
Dividend stocks also have a bit of a dark side. Namely, yield and risk tend to be correlated to some extent. This is to say that high-yield (4%-plus) and ultra-high-yield (10%-plus) dividend stocks may lag in the return department when stacked up next to companies paying out say 2% a year. Remember, since yield is simply a function of share price, a flailing business model with a declining share price can lure in unwitting investors with a high yield.
These are the three dangerous dividend stocks they mention and a brief summary in each case of why you should avoid them.
First Dangerous High Dividend Stock: Gamestop
The point that The Fool makes is that Gamestop is tied to brick and mortar retail stores that sell games and accessories.
GameStop’s business model has been completely upended by the emergence of digital downloads from the cloud. In other words, the need to go to a gaming store for new games or accessories is dwindling fast.
Like a lot of companies tied to brick and mortar locations, these folks have tried, without a lot of success, to sell more online.
The company’s stock has sold in the high 50s both in 2007 and 2013 but right now is back where it started in 2002 in the $10 a share range. Their 15.1% dividend is a result of the stock dwindling from $56 a share in 2013 to $11 a share today.
Gamestop Stock Price
So, if you screen for high dividends and find Gamestop, remember that this stock is in trouble and is not a long term buy and hold prospect.
Second Dangerous High Dividend Stock: BP Prudhoe Bay Royalty Trust
This stock sports an 18.4% dividend yield. It traded for $126 a share as recently as 2012 and today sells for $27 a share. This is another case of a stock that has gone down (80%) in share price without changing its dividend so the company looks great when viewed through the dividend lens. But, it has issues that should concern long term investors.
The problem with this investment is that the money comes from Prudhoe Bay oil production which is soon to run out. The company’s own 2017 annual report suggests that dividends will cease this while the 2018 annual report pushes the cessation of dividends back to 2022. Either way, this is not a great long term investment and anyone who invests at current prices stands a good chance of losing a substantial portion of their investment.
BP Prudhoe Bay Royalty Trust Stock Price
Third Dangerous High Dividend Stock: Barnes & Noble
The nation’s largest bookstore chain has taken repeated hits from the likes of Amazon.com and other online booksellers. Despite repeated downsizing, attempts to operate online, and a healthy 11% dividend as of today, Barnes & Noble is losing the battle and is not a great long term investment of the kind usually associated with dividend stocks.
Barnes & Noble Stock Price
So, how dangerous are these high dividend stocks? What happens when a company begins to lose business is that as their profits fall the company cuts jobs, cuts stores, and eventually cuts dividends. What happens in many cases is that management does not want to scare shareholders is dumping the stock and sending the share price downward. So, they preserve the dividend and come up with a story about how they are going to fix things.
In the cases of Gamestop and Barnes & Noble, the handwriting is on the wall no matter what management says. The companies will not fold and go away but they will dwindle with lagging stock prices and dividends readjusted to meet reality.
In the case of the Prudhoe Bay Trust, the situation is imminent because the company itself is predicting that the oil is running out and that in a very short time the 18% dividend will go to zero!
The High Stock Dividend and High Investing Risk Take-Home Lesson
The bottom line to this discussion is that investors need to beware of extremely high dividends. High dividends commonly come associated with a stock price that has fallen or with a business model where there is not much expected growth but a good current cash return. Utilities commonly fall into this category as does the capital management company we picked up in our own screen.
Whether or not you choose to invest in any of these stocks with so-so prospects but a high dividend yield will depend on your own view of the fundamentals of the company. To the extent that you have unique expertise and can see a genuine “light at the end of the tunnel” in the form of a high takeover bid or a true recovery of the business, these can be spectacular investments. Otherwise, take care.
Which of Your Safe Investments Will Amazon.com Kill Next?
We invest to make more money, do the things in life that we want, and have enough for a comfortable retirement. It has always been good advice to balance your investment portfolio with a combination of the very safe and the somewhat risky investments with growth potential. We often mention our article about how to invest without losing any money. Although the main focus is on cash in the bank, treasuries, and corporate bonds we also give a nod to value investments which are “safe stocks.” Unfortunately, many investments previously thought to be safe have been destroyed in the era of online sales. Our question right now is which of your safe investments will Amazon.com kill next?
What Are You Paying for a Safe Investment and Is It Really Safe?
This is a valid question in our extended bull market. Investors are paying a premium for companies with strong balance sheets and a long history of success. But, is the price you are paying going to protect you? Forbes writes that in many cases safe stocks are no longer safe.
You probably know that fast-growing stocks in exciting industries may be pricey. But boring, slow-growing stocks are often expensive, too, if they’re perceived as safe.And while you might not realize it, there’s a good chance you’re paying through the nose to keep your money safe.
Their first point is that investors pay a price for perceived investment safety. Then the problem is whether or not the price you pay is really buying safety as they look at P&G versus Amazon.com.
They make the point that the average P/E ratio in the S&P 500 is 21 while the P/E ratio for P&G is 25. A main selling point for these folks is that when the stock market crashed a decade ago P&G fell by a percent or so. The risk Forbes sees is that Amazon.com is moving into P&G’s product line by delivering dish soap, diapers, and batteries to people’s door every day. If you wonder which of your investments will Amazon.com kill next, wonder if Procter & Gamble is on the list.
A List Investments at Risk of Being Killed off by Amazon.com
Kiplinger goes beyond Forbes by looking at dozens of companies whose very existence is threatened by Amazon.com and online sales in their article, 49 Companies Amazon Could Destroy.
Amazon is willing to try its hand at almost any sort of business, does well at the bulk of them – and threatens to destroy dozens of other companies with its success.
From groceries to online pharmacy sales with a foray into video game development as well, Amazon.com tries its hand at anything and usually succeeds. If you have several safe investments in your portfolio and Amazon.com decides to move into that niche, how safe are you. Here is the beginning of the list that Kiplinger put together.
O’Reilly Automotive (ORLY), AutoZone (AZO) and Advance Auto Parts (AAP)
As delivery networks get better and inventory management technology improves, these previously safe businesses are now worried.
Kroger (KR), privately owned Albertsons and the grocery arm of Walmart (WMT)
People are getting more and more comfortable with ordering all sorts of food items and even snacks to be delivered to their home, especially with Amazon Prime and no charge for delivery.
Audiobooks.com and Playster
These folks are directly threatened by Amazon.com and their own company, Audible.
Barnes & Noble (BKS) and Joseph-Beth Booksellers
These folks are still hanging on despite worse sales figures every year. It is only a matter of time.
Beam, Dailymotion, Hitbox, Mixer, YouTube Gaming and More
This niche is about people paying to watch other people play video games. And Amazon.com has the most popular platform, Twitch. This is one more niche that they intend to own.
Best Buy
Despite an impressive turnaround, Kiplinger thinks that these folks will be driven down by Amazon.com in the end as people will opt for lower prices and home delivery.
Duracell, Energizer Holdings
This last one gets us back to the safe stock niche. These are leaders in the market and Duracell is one of Berkshire Hathaway’s holdings. Although Amazon.com does not have a well-recognized battery brand behind them, they do have pricing, delivery, and customers who are simply used to buying from Amazon.com.
Which of your safe investments will Amazon.com kill next? Take a look at the Kiplinger article for the complete list.
What Are Safe Investments in a Competitive World?
Any student of investing knows how Sears went from being the retail giant of the world to an afterthought. Likewise, we all know how digital photography virtually removed Kodak’s reason to exist. But, we have always believed that a product that people will always consume with a strong brand name will last forever. Procter & Gamble is a well-run company that fields a lot of brands and essentially wrote the book on business management. Coca Cola is known and consumed everywhere on the planet. But, in both cases, management needs to keep up with the times, effectively manage product lines and listen to what consumers are saying. A sad of example of an old company not doing that is the Kraft Heinz fiasco.
Sears Was the Best and Then It Was an Afterthought
We always suggest that investors use the principle of intrinsic stock value to guide their investing. We also mention in that article that the trick to making the concept work is to learn how to anticipate future earnings. When experts like Warren Buffett throw out 95% of their evaluations as too difficult to pick, what is the average investor to do?
Kraft Heinz Did Not Listen to Its Consumers
First of all, the average investor does not need hundreds of stocks but rather just a handful. Understanding how the company makes its money and how it will withstand threats, like Amazon.com, are basic to good analysis. And, the other rule is to pay attention as you go. With stocks like Procter & Gamble you can sleep at night but should spend a little time each year thinking about whether to add more to that stock or buy something else.
What is Intrinsic Stock Value?
Intrinsic stock value is a concept that emerged from the carnage of the 1929 to 1932 stock market crash. It is a way to invest rationally as opposed to investing by guess work, which is closer to gambling. To get a sense of the way this concept changed the face of investing we need to go back to an era where investing in the stock market really did resemble gambling at the casino.
“Playing the Market” in the 1920s
A common expression during the steady rise of the American stock market in the roaring twenties was to “play the stock market.” Many people believed that one only needed to pick a stock and wait for it to become more valuable. It seemed that no matter what stock a person bought, they were making money by “playing the stock market.” It was a much better deal than going to the casino because at the casino there was a much greater chance of losing your money.
All of that lasted until 1929 when the stock market crash started from Black Thursday (October 24) to Black Tuesday (October 28). The Dow Jones Industrial Average began the 1920’s at 100 and peaked in 1929 at 381.17. It then lost nearly half its value down to 198.69 in the 1929 crash. (Dow Jones history 1920-1929) Then, despite a brief recovery, the market and the Dow continued to slide until the Dow reached 41.22 in July of 1932. (Wikipedia Wall Street Crash of 1929) A huge number of wealthy investors were wiped out during this period but some regrouped, learned from their mistakes, and moved on to create safer and more profitable ways to invest. One who stands out from this era is Benjamin Graham.
Dow Jones Industrial Average: 1920s
Benjamin Graham, Intrinsic Stock Value and Value Investing
It was in the aftermath of the stock market crash and during the dark days of the Great Depression that Benjamin Graham introduced the idea of value investing in Security Analysis, a book he coauthored with David Dodd and with help from Irving Kahn. In the book he wrote about intrinsic value, margin of safety, and the fundamental analysis of stocks instead of buying on sheer speculation.
Benjamin Graham, Father of Intrinsic Stock Value
(Consejos de Inversión Bolsa Mania)
Intrinsic Stock Value
The revolutionary idea that Graham taught was that the intrinsic value of a stock was totally independent from its market price. In Security Analysis the authors argued that an investor could determine the intrinsic or real value of a stock by looking at factors like the company’s assets, earnings, and dividends paid. These would indicate the ability of the company to make money over the coming years which would in turn determine the eventual market value of the stock. The point was to estimate a company’s future cash flow based on analysis of past and current performance as well as current assets and business plan.
Mean Reversion
Graham believed in efficient markets. Despite the frequent irrationality of investors in bidding up stock prices based on greed or letting them fall in fits of panic, the price of a stock eventually moves toward its true value. Graham taught that investors should calculate the intrinsic or true value of a stock and then compare it with the current stock price. When the current price of the stock is less than the intrinsic value the investor should buy. And when price of the stock is more than the real or intrinsic value he should sell or avoid the stock. The mean reversion is the belief that over time the intrinsic value of a stock and its market price will converge. This will happen in periods of market efficiency.
Efficient Markets
Graham was not just a theorist who lectured at Colombia Business School in New York. He was a successful investor in his twenties making as much as $500,000 a year! He was also wiped out, like other investors, in the stock market crash. It was from his own experiences that many of his ideas and his later success emerged. And one of these ideas was that markets may overvalue a stock or undervalue a stock but markets will eventually find the correct or rational price which will be the intrinsic value of the stock.
Margin of Safety
Graham’s concept of intrinsic value was not just based on expected cash flow but also on the stability and financial security of a company. Businesses with assets like factories as well as cash in the bank instead of a lot of debt have a margin of safety. Likewise, a company with a strong and well-known brand name is likely to do better during economic downturns and be better positioned to rise again as the economy improves. Such stocks will make money year in and year out and have increased intrinsic value.
(Investopedia Benjamin Graham)
Determining Intrinsic Stock Value
The dictionary defines intrinsic stock value as its fundamental value. Add up predicted future income of a stock and subtract the current market price. In looking for the true value of a stock instead of its book value or market value one uses fundamental analysis which is another idea that came out of Graham’s work. Using fundamental analysis one can say that intrinsic value is the expected cash flow of a business discounted to current dollars, a discounted cash flow valuation.
The problem in applying an intrinsic value calculation to a stock is that all too often the medium and long-term prospects of a company and its earnings are not clear. None other than a student of Graham and one of the most successful investors ever, Warren Buffett, has said that he throws out the vast majority of possible investments as too difficult to call! To make the intrinsic stock value concept work in the real world investors need to have a clear idea of how a company makes its money and how that business plan will continue to work. In doing this the investor looks at how a company manages its assets, the viability of its products and services, its R&D, marketing, and competitors.
Intrinsic Stock Value Formula
After writing about the concept for years, Graham provided a formula in 1962 and updated it in 1972. Here is the original 1962 formula for calculating intrinsic stock value.
V = EPS x (8.5 + 2g)
V is the intrinsic stock value
EPS is the trailing 12 months earnings per share
8.5 was the P/E ratio at the time for a “zero-growth” stock
g is the company’s long term rate of growth
Here is the 1974 revision.
V = EPS x (8.5 + 2g) x 4.4 / Y
In 1962 the average yield of high grade (risk free) corporate bonds was 4.4%. Y was to be the current yield of AAA corporate bonds.
(Investopedia Benjamin Graham)
It is noteworthy that Graham added the interest rates of bonds to his calculation as government spending for new social programs as well as the Vietnam War (Guns and Butter) drove interest rates sky high and ushered in a period of “stagflation.”
Applying Intrinsic Value to Investing
Graham’s 1949 book, The Intelligent Investor: The Definitive Guide to Value Investing is an investor’s Bible. In it he says that the intelligent investor buys from pessimists and sells to optimists. Because the smart investor has done his or her homework this investor knows the true value of a stock which is the value that the market will eventually arrive at via mean reversion.
The “V” for intrinsic stock value is used to find the Relative Graham Value or RGV. Simply divide the intrinsic value of a stock by its current market price. This is the RGV. An RGV of less than one means that the stock is currently overpriced and should be avoided or should be sold if it is in the investor’s portfolio. An RGV of greater than one is indicative of an undervalued stock for which the market has not yet caught on. This is a stock to buy and hold at least until the mean reversion occurs and the market price catches up with the intrinsic value of the stock.
Intrinsic Value Is Not Just a Buy and Hold Investing Tool
An ideal investment is one that makes money and allows you to sleep soundly at night. Calculating intrinsic value helps on both counts. But market can be irrational in both up and down directions. As such a stock that is undervalued and a buy according to intrinsic value could become an overvalued stock when market euphoria drives the price up beyond where fundamentals would support the price. Even long term buy and hold investors need to pay attention to the well-chosen stocks in their portfolio to make sure that they still are good investments based on their intrinsic value.
Does Intrinsic Stock Value Work for Every Stock?
The answer to this question comes from Mr. Graham’s famous student, Mr. Buffett. Warren Buffett and his long term partner in picking investments, Charlie Munger, say that about five percent of the time they can reliably pick a winner using this approach and the rest of the time they simply throw out the possible investments as too difficult to call! A good example of how applying an intrinsic value approach works in investing, look at how well Buffett’s company, Berkshire Hathaway has done over the last 28 years. The stock has appreciated from $7,000 a share to $307,000 a share over that time.
Berkshire Hathaway, an Example of Intrinsic Value Investing
(Berkshire Hathaway Class A, Google Finance)
Intrinsic stock value is a valuable tool for smart investors. Using it requires work and attention to detail. And, by using it, investors typically make more money and sleep better too!