what makes a stock a “value” stock

The essential idea behind growth stock investing is to find companies where your research convinces you have earnings growth prospects that are far better than most investors think–and whose expectations determine the (too low) current stock price.

Value stock investing is based similarly on taking advantage of faulty consensus expectations. But traditional value investing revolves around left-behind, underperforming, poor-earnings (or no-earnings) companies. And it focuses on assets, not earnings. As one of my value-oriented friends explained to me once, “There are no bad companies; there are only bad managements.” What he looks for are revenues and assets. The assumption is that in the case of a sub-par earner, one of three things will happen: the board of directors will replace the management with one that’s more competent; if not, activist shareholders will replace the board; or the company will be subject to a hostile takeover. Put a different way, the value investor thinks he know what will happen, just not when.

As I see it, there are two main flavors of value: with a catalyst or without. Some brave souls are willing, if they see a pile of trash (so to speak) selling for cheap, to buy even if there’s no credible plan for change. Most, I think, wait for a catalyst for change to emerge. Of course, the price will be higher once the market can scent a hint of change is in the air. But they regard forgoing the gains from getting in on the ground floor to be worth the assurance that the elevator isn’t broken.

There are two accounting quirks to be aware of when dealing with tech companies. Because of a whole series of scandals in the 1970s, the cost of creating software that might have a useful life of, say, ten years, is expensed immediately rather than put on the balance sheet and written off bit by bit over the estimated useful life. This is very unusual …and makes the income statement look uglier. Also, stock-based compensation is expensed immediately, as well, even though the vesting period may extend over years. It’s also a non-cash charge. This kind of compensation tends to be a big deal for tech firms, and therefore a big reported earnings depressant.

A third thing. If the company sells software subscriptions, that revenue is usually recognized over the term of the subscription–even though the costs of creating the product subscribed to are recognized immediately.

The bottom line here is that the flow of funds statement should be required reading for investors, who, I think, tend to concentrate exclusively on the income statement.

more on Monday

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