Value investors like to describe themselves as buying companies worth $1 for, say, $.20 and selling them for $.80. Less ambitious practitioners say buying for $.30 and selling for $.70. But the idea is the same–buy at a deep discount, sell at a slight discount.
What remains unexpressed, but what’s crucial for value investors, is that the firm in question is not being assessed on any pie-in-the-sky future developments, but on an evaluation of what the company as it stands now is worth.
Three types of situations get value investors particularly excited:
–periods of general stock market undervaluation,
–overall business cycle slumps, or specific industry group declines, when the market fears that an (inevitable) upturn won’t happen and decides to unload the underperforming stocks into the market for whatever they can get, or
–companies that are industry laggards and which would fare far better if run by more competent managers.
In a sense, all of these situations involve temporarily damaged goods.
In each case, value investors also have plenty of data for figuring out what normal or reasonable prices for now-undervalued companies should be. The data might be projections from past industry or economic cycles about how far earnings might rebound during an upcycle and how far price earnings multiples might change (usually expand). In the case of badly run firms, the comparison is with healthy companies in the same industry.
In every instance, however, it’s a relatively straightforward thing to set a target price–what the company would be worth in better times.
The more difficult question is at what price to buy.
Investors will certainly demand a premium, say, 20% or 30%, for taking the risk of making a purchase while a business may be doing badly or while the overall market is cringing in fear.
Beyond that, value investors seem to me to fall into two types:
–those who are willing to buy at what they consider a rock-bottom price, regardless of the near-term outlook, and
–those who are waiting to see an initial ray of sunshine, or a “catalyst,” that convinces them that the worst is past.
In the first case, the skill is in judging the bottom. In the second, it’s finding the turn upward before the market in general does. But in both cases, it’s the decision to buy that’s the key to success.