It seems to be commonly accepted that value investors spend their time searching the 52 week low list for new investing candidates. There are some highly respected and successful value fund managers that use this exact approach (which I am not discrediting). However, I would like to submit an opposing technique – we are contrarians after all. Generally we think of value names in those companies that are experiencing internal or external setbacks – things like economic downturns, net losses, legal problems, etc. Yet there are companies that are humming along just fine, but the market simple hasn’t put a premium on its shares. I disagree that a company needs to be hitting its lows for it to be cheap. In fact, it’s very possible that a poorly performing stock may indeed by overvalued. As value investors we are trained to ignore the market’s volatility and short-term think to look beyond the noise for bargains. But there are times when the market can provide clues that we should at least acknowledge, if not take advantage.
When we evaluate a potential opportunity, we need to be able to objectively value it on a standalone basis considering earnings sustainability, capital structure and so forth. If you think about it the price in relation to its one, five year, or ten year historic high should be irrelevant. A business is worth its cash flow potential and the ability to grow that cash flow. A business (specifically its managers) shouldn’t care what value the market puts on it – unless it’s the rare condition where equity price can violate bond covenants.
When I first began the study of value investing, I thought it meant buying businesses that were damaged. This can be an expensive lesson – buying companies hitting new lows only to watch them go lower and lower – the dreaded value trap. I came to discover that (although counterintuitive) as the stock price is punished it may indicate a higher risk situation rather than lower risk. Risk is a big part of the decision process and very difficult to quantify. As we have discussed in previous writings, it is a mistake to confuse risk with volatility. We know that as a stock heads lower the risk doesn’t necessarily increase. But it doesn’t mean there isn’t any risk attached – it’s just a different form of risk.
Taking positions in companies that offer exceptional return on your price paid and are fundamentally sound is truly a good risk /reward tradeoff. So the next time you’re searching for good value candidates, try the 52 week high list. You might just find value opportunities that very few other value investors have spotted.
William J. DeRosa, Jr. is the General Partner of Anthem Asset Management, LLC is an independent investment management company. He has also served as Director of Equity Research and Senior Portfolio Manager at various buy-side asset management firms. Mr. DeRosa is a Chartered Financial Analyst and is a member of The CFA Institute.
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