A Quick Word about Value

A friend and I were speaking about a topic as old as the stock market today - 'Value.' 'Value Investing' - seeking investment in stocks that one feels are under-valued - is probably the oldest and most widely used methodology. Despite this, I don't think it's the best way for the individual investor to go.

I have to start out by saying I have a problem in principle with the term 'under-valued.' The best thing about the stock market is you immediately know the value of any stock simply by checking the bid price. That's the value, period. It may seem like a semantic argument, but I believe it goes a bit deeper.

I think the concept is rooted deeply into the psyche of the value investor, right there next to 'buy and hold.' The value investor evaluates a stock, determines what they believe to be a 'fair value' based on a number of factors (which by the way may be very sound), and then will buy a stock depending on how far it is below their assessment of it's 'real' value. If the price of the stock drops after the initial purchase, the value investor may add to their position, as it is now even 'cheaper.'

At this point I want to be completely fair and say first that many folks are successful value investing. I don't know how, but they are. Value Funds have outperformed Growth Funds over time - I have an idea why this is true. Not all value investors average down, and not all value investors work without a stop loss point or 'buy and hold.' I'm generalizing, and I'll continue to do so. If you're a value investor don't get mad, just make a ton of money and prove me wrong! I'll be the first to congratulate anyone who's successful trading stocks, whatever their methodology.

Back to the topic at hand. I believe strongly that the market itself sets a stock's value based on the quoted price. I don't buy a stock because I think it's under-valued - I buy it because I believe that demand will outweigh supply. This is the only thing that will drive a stock higher. The reason for the demand may be that big money institutions find the stock under-valued - I won't argue with them, I'll just hop on board and enjoy the ride. It's the fact that buying interest is stronger than selling interest that I look for. The reason I think that value investing works for mutual funds and other institutions is that they have the money to generate the buying support a stock needs to move higher - a sort of self-fulfilling prophecy. I don't know about you, but unfortunately I don't have that kind of cash.

Again you may feel this is just playing with words. I think the distinction is important because it determines which stocks you will buy and how you will hold them or sell them.

For instance, take a stock (FRPT), trading at $3 down from $30 less than a year ago. This stock's fundamentals are outstanding - triple digit eps growth the last 6 quarters, forecast to grow earnings 462% this year and 60% the year after that. It's PE is 6. It's forward PE for 2009 is 4. There are no outstanding news items I know of to justify the fall. As a value investor, this would be the kind of stock I would look at when it was trading at $25, or $18, or $11... Even now, it's the 'deal of the century' - though I think most sane investors would not buy a stock trading under $10.

The point is, this stock was 'under-valued' by almost any measure from $30 all the way down to $3. It didn't matter, because demand for the stock did not exceed supply. As a value investor, with the mindset that cheap is getting cheaper, how do you know when to pull the ripcord and bail out?

I think the value investor (any investor, for that matter) would be well suited to maintain a stop loss rule and consider technicals along with fundamental evaluation. A saavy value investor should be adept at finding stocks which seem to justify a higher price - combine this with an assessment of the stock's chart pattern and price and volume action and now I think you're on to something. Wait until you see the big money come in and move that stock up on volume well above average. Look at the up/down volume and other signs that tell you institutions are accumulating the stock. That's the time to move in.

Then, in growth or value investing, if the stock turns on you consider your evaluation wrong and get out. I'm like everyone else - I don't like to be wrong - but there's no place in the market for ego or emotion. That's why I try to maintain a set of rules I follow, to take emotion out of the equation as much as possible. I've read several books from some of the great traders: Livermore, Darvas, O'Neil, Loeb, and all of them echo the same thought - cut your losses close.

This is one rule I've never broken. I set a stop no further than 8% below my purchase price, and I've never moved one lower. This allowed me to suffer 'only' 20% loss of capital in my first 6 months back trading stocks last year despite being right in only about 1 out of 10 stocks. I'll talk more about my 2007 performance (or lack of, to be more accurate) in the near future. Hope you found some 'value' in tonight's post (never afraid of taking the easy one.)

-Geoff