Why Value Investing always beat Growth Speculating

They say that successful investors are not those who are able to forecast declines or call tops but those who are able to pinpoint definite gains and targets to be reached. Once met they would then make a decision to either continue holding the company or sell it off.

In other words: Buying a stock, anyone can do. It’s selling one that takes a genius.

Thus we are left with two general methods in stock picking. Growth and Value.

Growth “investors” act more like speculators. Betting on trends and predicting future situations. Generally supported by a high prices-to-earnings ratio these stocks offer nothing more than a quick dollar. This type of analysis need more faith than education. A quick change in sentiment can change a price dramatically. Furthermore, prices usually include future earnings. This leaves little room for surprise announcements and achievements.

Value investors hunt for bargains much the same way frugal buyers search for good merchandise. They look for issue selling at distressed prices due to current sentiment that may soon change, problems that could easily be fixed or simply those that have been overlooked or ignored. When they do find one they know they’re getting what they pay for.

Growth stocks usually benefit short-term traders with short quick jolts while Value stocks offer much better and steadier returns to long-term investors over many years.

Here are a few math abilities needed to be a security analyst:

To appreciate this, it helps to understand some basic valuation theory. The value of a stock, theoretically, is the “present value of future cash flows.” Loosely translated, this is what all the cash a company will pay to shareholders from now until the end of time would be worth if it were delivered in one lump sum today.

To determine the “present value of future cash flows,” an analyst needs to know the following:

1) the amount and timing of the future cash flows

2) an appropriate “discount rate” with which to determine what the cash flows are worth today. (Thanks to inflation, risk, and opportunity cost, a dollar expected to be received in a year is worth less than a dollar delivered today, and a dollar expected in 10, 20, or 100 years is worth a lot less than a dollar today.)

and usually

3) A “terminal multiple” with which to value the cash flows that will be received after an explicit forecast period (usually five or 10 years).

Simple put into things we can see, Earnings per Share tell us what it’s worth today, the price tells us what it will be worth tomorrow. The Price-to-earnings ratio then tells us how may years into tomorrow.

It can thus be seen from good old analysts like Ben Graham why many value investors will never buy a share with a price-to-earnings ratio of more than 15. Who can predict that far into the future?

So how can one buy a great company for a good price?
You either need guts and money to gamble (something any growth investor can offer you) or patience and diligence (something only a value investors knows well).

Over the years, and I refer to tens of years not just the last seven, P/E ratios have generally varied between the single-digits and the triple-digits. During the Tech boom some stocks sold at 44 times earnings, while as prices began to subside were still selling at prices well over 100 times their earnings. This means that investors (some mere speculators) were expecting profits (if any) and investor demand (otherwise read “lunacy”) to continue for another hundred years!

Meanwhile, in the late 70s ratios were beaten down to bargain levels, sometimes 5 or 6. This was at times when a 10% return in the overall market sounded more like wishful thinking.

With ratios at currently 18-20 for the indexes it would seem that lower ratios seem in the cards. This does not mean that prices must fall (although they most probably will) and it does not mean bargains are not out there (although much harder to find). But with all the current interest in such issues the small investor might as well just speculate on top of the crowds and large institutions.

But when you do go out and buy your stocks, be it today or in 10 years from now, Buy at Value!


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