Hopeton Morrison, ContributorWHERE MARKETS have been retreating as we have seen locally for the last 10 months, the practice of 'value investing' becomes an excellent investment methodology. If you recall the dot.com buying binge of the late 1990s where markets worldwide rose to dizzying heights, that was certainly not a time when value investing was popular. But needless to say although millions of investors lost fortunes with the dot.com collapse there would have been few if any value investors among them.
There are several reasons why stocks become undervalued (or for that matter overvalued). Two important ones are:
Some firms get overlooked by analysts. In a small market such as ours this will not be a big issue as the number of stocks to be analysed is small. But if you invest globally, many excellent small companies are overlooked by busy analysts.
The market often over-reacts to both good and bad news. Either way, the value investor usually reacts too. Where the news is bad, other investors with a different investment motive such as momentum investors or growth investors will usually sell and sometimes in dramatic fashion. That of course invariably opens up significant values for the value driven investor. Similarly where the news is good, share prices usually go the other way. And here the value investor must revaluate his/her portfolio and decide whether it is prudent to hold on to an overvalued stock. Often the prudent decision is to sell.
Remember that value investment speaks to the purchase of stocks that by all indications are cheap. The investor is driven by the price/value dynamic. When investors purchase value stocks they are driven by key indicators such as low price earnings (P/E) ratio, high dividend yields or/and solid asset backing. Our focus today is on the first of these, the P/E.
The P/E shows the relationship that exists between the price of a stock and what a company earned over its last year. It is a ratio that an average investor can work out by dividing the market price for a share by the earnings per share. This is then used to compare relative values between different stocks.
The locally published stock market report is not as detailed asthat found in the international financial press such as in the Wall Street Journal for example which carry significantly more information. Where these publications report P/E ratios these are known as trailing P/Es as they speak to past performance rather than to the future. But as in so much in investing, past performance is no indicator of future performance. In that regard some institutions also provide forward P/E ratios by computing reported earnings for the past with projections for future.
Benjamin Graham is acknowledged to be the founder of the value investing methodology. He advises that value investors should buy when the following is taking place:
Company sales and earnings are growing reflecting higher Earnings per Share (EPS)
As earnings increase the P/E drops below its own previous low.
P/E also drops below that of the industry.
Where the P/E closes under 10. Listed companies send each shareholder a copy of their annual reports and this information is highlighted in the audited accounts in those reports.
Perhaps the most famous proponent of Value School Investing is Warren Buffet of Berkshire Hathaway and a few of his principles are espoused very clearly as follows:
1. Learn about the businesses that you want to invest in and invest in those that you understand most thoroughly.
2. Buy only if you expect returns that are above average
3. Buy shares only when you expect returns that are above average and always buy at less than what they are worth.
4. Don't get caught up with the short term focus. Buffet espouses a 5 year time framework although many other proponents of this approach settle for a three year time span.
5. Seek out value in the market rather than focus on price
This is a good time for value investing in the Jamaican stock market as this methodology of stock picking works best when the market is low.
Hopeton Morrison is general manager of St. Thomas Cooperative Credit Union Ltd. and lecturer in the School of Business Administration at the University of Technology. Please send comments and questions to: hmorrison@stccu.com.
