How to Buy Stocks with a Bargain Hunter’s Attitude
We all look for the best bargains when we are in the market for an appliance or clothing or an automobile. After all, why should we not save money when we can? Ironically, when it comes to buying stocks, most investors are likely to go with the stock advice they get from friends or media, without paying too much attention to the value.
I say this is ironic. Most everyday purchases are pure expense. They fill a current need, but they are unlikely to create wealth over long term. Whereas well chosen stock picks are an investment that will compound over the years. If you know anything about the power of compounding, you will know that even a 1% advantage at the start can result in significant value over a period of years. For example, $10,000 invested today, at 9% annual returns, results in a total value of the investment of $56,044 in 20 years. The same $10,000 invested today, at 10% returns turns into $67,274 in 20 years. This means the shareholder wealth is 20% higher if you just start with a 1% advantage.
Given that most serious investors have portfolios that will span 30-40 years or perhaps even more, shouldn’t you look for as much advantage in the beginning as possible?
So where can we find this advantage? To answer this question, it is important to understand the difference between price and value.
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Price =/= Value
Price does not equal value. If you are a bargain shopper, you already are aware of this concept. Price is what you pay, and value is what you get. This seems to imply that the value of a stock or a business is very subjective, and to the most part it is true. However, the stock market is made up of countless investors making these subjective value judgments and ultimately it reflects in the price of the stock at any given point of time. Price is where demand and supply meet and it can be asserted that an equal number of investors (in terms of buying capacity) believe that the value of any given stock is higher than the current price, as the number of investors who believe otherwise.
Fortunately, the price of the stock over time correlates with the value that becomes apparent and better defined as the underlying business performs. If the business does well and continues to create more value for the shareholders than it consumes, the stock price will eventually rise to reflect this. If the business destroys net value, the stock price over time will reflect this as well.
The trick in investing is to be right more often than you are wrong. To be able to do this, you need to be able to come up with a measure of the intrinsic value of the stock. Intrinsic value is just a way of saying what the business is worth in the private market where the buyer has the perfect information about the current business situation and asset values as well as a good reading of the future growth.
How to Determine Intrinsic Value?
- Bad news: you cannot determine intrinsic value.
- Good news: no one else can determine intrinsic value.
Finding intrinsic value of a stock is as much art as it is science. The value of a business lies in the ability of the business to generate returns for the shareholders. Since most of these returns are in the future, and inherently unknowable today, investors rely on many metrics, indicators and rules of thumbs to arrive at a valuation. A value investor prefers to bank on the items that are certain such as value of tangible assets, cash on hand, etc. Since future earnings, and growth, and even dividends are uncertain, a classical value investor will only use these in cases where additional point of reference is needed or when potential investment opportunities using balance sheet valuation are scarce.
How Much You Should Pay for the Stock?
Once you determine the intrinsic value of the stock, you need to establish what you are willing to pay for the stock. Quite a bit of this depends on your judgment of the risk in the stock as you evaluate the stocks to buy in your shortlist, and how comfortable you are with your analysis. It pays to be realistic and conservative at this point. If there are aspects of the stock that are risky, than make sure your intrinsic value calculation leans conservative. For example, if you feel that the company may capture 20%-40% of the market share in 2 years, you may want to use the 20% for your analysis.
For example, if you feel quite confident in your analysis, you may be willing to buy the stock at any price below your estimate of the intrinsic value. However, it is very possible that despite all your thoroughness, there are a few things you may have missed or perhaps future will not turn out as you expect it to be. A Margin of Safety provides insurance against these risks and should always be applied to the intrinsic value to arrive at a price that you should be willing to pay up to.
A good rule of thumb for margin of safety is 30% of the intrinsic value. If you are more risk averse or a beginner investor, you may want to increase your margin of safety to 40% or even 50%. In some other cases, you may chose to go with a smaller margin of safety.
Example: You may calculate the intrinsic value of the stock of XYZ company at $10/share. If you use a margin of safety of 30%, you will be willing to buy the stock when the price is at $7/share or below. There are many cases today of stocks actually trading far below their intrinsic value.
Why Not Pay the Full Price to Participate in Growth?
I remarked earlier that growth is uncertain. I will add to this by saying that it is virtually certain that growth will slow and disappear at some point in the future (every business goes through a life cycle). The only question that remains is when. Will it be 2 years from now, or will it be 20 years from now? And how will the company react to this situation? Will it continue to add to its product/service portfolio and find new growth areas? Or will it enter a steady state of no growth, cash generating business and be happy? And finally, is the growth value enhancing or value destroying?
My main contention is that not only we can’t be sure of the answers to these questions, there is really no need to. The price is missing a Google or Microsoft out of the 100 other losers we picked for growth. Alternative is value investing that gives better odds of success and is less risky as it is based in tangible information that we have today, and not some nebulous growth projections.