How Do You Pick Your Stocks?

Market volatility can disrupt the basics of value investing

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Mar 14, 2018
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Investing in the stock market is always about one or two things for most investors: capital gains, dividends or both. For this reason, some investors hunt for stocks that are likely to appreciate over time depending on their risk-return trade-off profiles, while others are more interested in the routine dividend payments a company can offer to shareholders. Then, of course, there is another class of investors that try to find the right mix of the two. Due to the dynamic nature of the modern financial markets, a new class has emerged that is in the market for the purposes of speculation. The goal is to capitalize on market volatility.

While speculative investors are crucial to the market in terms of providing short-term liquidity, legendary investors like Warren Buffett (Trades, Portfolio) entered the history books because of their value investing ideals. It is the one method of investing that has paid off in many ways throughout history, even when everything else failed.

This is the method of investing that intrigues me most especially given the current market conditions. Ideally, the objective here is always to try to find cheap stocks depending on various valuation metrics. The most common methods investors use include price to intrinsic book value and the price-earnings ratio. These provide a reasonable guidance toward identifying stocks to invest in, but they are not conclusive.

Intrinsic book value is the most widely used method of business valuation.

To most people, this might not seem to be the most common method of valuation. When it comes to value investing, however, it is probably the preferred method for many investors. The general concept of value investing involves identifying undervalued stocks. You cannot do this by simply looking at the price-earnings ratio or other performance metrics.

The intrinsic value of a stock helps investors determine if the prevailing market price is above or below the company’s actual valuation per share. It is also widely used to calculate the value of privately held businesses using the discounted cash flow, net assets or the dividend growth models. Companies that want to issue an initial public offering also tend to use this method to come up with the initial price per share, so it makes sense why most value investors and buy-side equity analysts use it.

On the other hand, the price-earnings ratio is popular with sell-side equity analysts. Here, the parameters of determining whether a stock is undervalued can change dramatically. Stocks that trade at low price-earnings ratios relative to rivals or their historical averages can easily be deemed to be cheap. However, when using this method, history has taught us not all cheap stocks are cheap.

Stocks with low price-earnings ratios are not always undervalued. Some present potential value traps while others are justifiably priced cheaply relative to their historical averages. In other cases, stocks can have high price-earnings ratios compared to rivals and still present a better value.

Take, for instance, the shares of Amazon Inc. (AMZN, Financial) compared to those of Altaba (AABA, Financial), the company that remained after Verizon (VZ, Financial) acquired Yahoo’s internet business. Amazon has a price-earnings ratio of about 347 times while Altaba currently trades at a price-earnings ratio of just 2.81 times. This is a classic example of a valuation fallacy when it comes to using the price-earnings ratio as a comparison metric.

Altaba has been in trouble since Alphabet Inc.’s (GOOG) (GOOGL) Google took charge of the global search engine market. It has since continued to decline in value after losing a huge chunk of market share to Google search. This resulted in the company selling its internet business to Verizon for $4.48 billion last year.

On the other hand, Amazon has continued to disrupt various markets after reinventing retail in the late 1990s. It has continued to grow its portfolio of products and services by capitalizing on its growing userbase.

With Amazon, investors see an opportunity that could get bigger with time. For Altaba, it appears set to continue playing second fiddle to Google in the search and advertising market, which justifies its cheap pricing.

In summary, there is no perfect valuation method. The situation varies for every stock and that is why most investors tend to use more than one valuation method before fully committing to buying a stock. In a dynamic market where stock prices make little sense, things can become a lot more complicated throwing the old-school basics out the window.

Disclosure: I am not a registered investment advisor. This is my objective opinion and should not be viewed as an investment advice. I have no position in any stock mentioned in this article.