Trash or Treasure
One Man’s TRASH is Another’s TREASURE
Determining the exact value of a business is certainly a tall order for any analyst or investor. In fact, most would agree that determining the approximate value of a business is as much art as it is science. If you agree that value determination is an inexact science than you must truly be intimidated by the task of determining what drives a company’s stock price, an odd combination of business value measures and market sentiment.
Market sentiment is related to the bahavior of crowds and crowd psychology. At any particular point in time the market may be overly optimistic or pessimistic about the prospects of a given industry or company. This is nothing new–Charles Mackay wrote a classic book on this subject Extraordinary Popular Delusions and the Madness of Crowds in 1841, more than 150 years ago!
Unwarranted optimism and extreme pessimism results in market volatility. Some see volatility as risk, other as opportunity. The volatility reaches its peak in the areas of newer technologies and small capitalization stocks where information is either hard to come by, or hard to understand…or both. Many successful investors have used crowd psychology, periods of excessive market pessimism and optimism, to guide their buy and sell decisions.
So, Why Bother with Valuations?
Stock prices, in the short term are often driven by momentum, rather than valuation. Markets are not very efficient in the short term, however, they tend to be very efficient in the long term. That’s why it is difficult to outperform the market if you are investing time frame is very short. Most agree that short term price movements are impossible to consistently predict. Meanwhile, many investors have managed to outperform the market by focusing on buying stocks during periods of pessimism when valuations are low and patiently waiting, sometimes for years, for the sentiment to turn in their favor.
Well then, What Value does a Broker Analyst Add?
We should all recognize that brokers and their analysts make money by encouraging frequent trades. A great way to realize this goal is to generate ideas and concepts that instill emotions from fear to greed on a daily basis. Everyone has a motivation when they are making a recommendation, and part of the investors job is to understand just what that motivation might be. We should open our eyes very wide and understand it will be rare to come across research that combines some type of value discipline with a long-term investment perspective. You can listen, but you have to filter.
Why Listen to a Broker Analyst at all?
There is always value in listening to individuals who, through their knowledge of a particular industry or company, can really increase your understanding of the prospects for that business. You probably won’t get value from the “buy/sell/hold/stag” recommendations (in fact, you should shield your eyes from such words), and maybe not even from their numbers they forecast for future earnings and such…however, what you do get value from is a clear and deep understanding of long-term industry and company trends, the profitability outlook for individual companies, and their positioning within their industry. So, don’t look for your broker analyst to fill their organization with a 300-man strong analytical team toting MBAs with high intellect and limited experience. Analysts will add the most value when they can offer something more than just the concensus view.
Sir John Templeton always said that you will never achieve a superior investment record by doing what everyone else is doing. This seems obvious, but it’s one of those things that is easy to understand in theory, but nearly impossible to implement in practice. It is just unbelievably painful for an analyst today to go against the market when most peo0ple are saying that’s the wrong thing to do–they live in a small world with tremendous peer pressure that favors mediocraty over boldness.
How can the Indivudial muster enough COURAGE?
Courage…
Courage to go against the crowd comes from having a disciplined investing approach. If you have devised a method to identify companies with superior growth and value combinations, this will give you confidence in making an unpopular call.
At WallStraits, we use a small-cap screen called PEG, a ratio of the Price/Earnings multiple to the earnings growth rate over the last several years. We have done very well by identifying companies able to grow their earnings by more than twice the PE ratio each year…growth that is superior in comparison to value perception by the market.
PEG Examples
Earlier this year we purchased Unisteel Technology as it hit our growth/value PEG radar screen. Soon after it’s early 2000 IPO, the shares sank from $0.50 to $0.36 making their PE below 15 and earnings growth over 50%. Today (18 September 2000), Unisteel management announced earnings growth in the first half of 2000 of 48% and the signing of another big customer—IBM. The share price has lost some of its unwarranted pessimism and recovered back over its IPO price, but the value is still attractive.
Boardroom is the latest company to catch our PEG eye. It too made its IPO just a month ago, and has now dropped well below the IPO price even though the business performance track record is stellar and the future looks bright. If your evaluation process is pragmatic, you don’t care about other’s opinions and you take what the market gives you. When your screen uncovers a gem, a little “diamond”, you look it over closely and if your best judgement tells you it is indeed a diamond being offered to you for the price of ordinary glass—you buy.
History versus Future
Yes, only the future counts, but historical perspective and performance are an indicator…
The typical valution measures, such as PEG compound ratios are only histroically accurate, true…but they offer insight into the future. A company that has demonstrated excellent growth for several years in different economic environments is more likely to produce similar results in the future than a company with an irratic up and down history.
Trash Today…Treasure Tomorrow
One of the biggest mistakes an investor can make is assuming that current conditions, either optimistic or pessimistic, will continue in perpetuity. The economy, the business, everything is dynamic and things are never static, but always changing. The next time a broker analyst says an investment is “dead money for six months”, don’t count on it. In such a dynamic business and economic environment six months is a long time and any number of unexpected events could be a catalyst for rapid change.
The other big mistake many investors make is trying so hard to pick the “top” or “bottom” of a stock or the market. Again, a disciplined approach or methodology will help you focus more on the process of screening and sorting growth/value gems. When you find a gem, it’s already a pretty rare thing so pay the bargain price and tuck it away. Don’t become overly concerned when that it may drop another 20% to become a “better bargain”. That becomes speculation, not investing.
Too many times people think, yes this stock is cheap today, but the sentiment is so negative that I will wait for a better value tomorrow. Consequently, they too often delay a particular decision because they tend to believe that the recent performance will be perpetuated, and because of a fear of being too early or too far ahead of the market. Don’t be afraid of getting into a good thing too early. It’s OK if someone else gets in a little cheaper than you. It’s better to buy too early and wait for some months than to miss the opportunity altogether.
Be Prepared For Criticism
At WallStraits, we’re pretty hardened to criticism. We’re used to being regularly criticized for buying based on our philosophy of screening for value/growth combinations and taking large positions when the sentiment is very negative. We were riticuled in 1998 for buying KLW Holdings at $0.18 (now at $0.90), for buying CSE at $0.38, now at $1.30, for buying JIT at $0.67 (now at $3.30) and so many more.
No, we’re not right all the time. We make our share of mistakes. Today, we’re still patiently waiting for PEG qualifiers like Lee Hwa, Omni Mold, Cytech and Boardroom to recover. They are all trading below our purchase prices. But, we are confident in our methods and comfortable waiting as others now have the chance to get in at better prices than us. We are used to treasuring what others are trashing on a pretty regular basis.
