Trying to follow in the footsteps of value investment legends like Benjamin Graham, many value investors buy stocks of well-known companies that are selling below their book or liquidation value. They buy the shares and wait, quite patiently until other investors recognize the intrinsic value of the company and its stock price begins to rise. This is akin to buying a value stock and locking it into a “Value Vault” so to speak until the full value of the investment is reached. When the company stock rises to a price where it’s considered to be reasonably valued, they took it out of their vault and sold for what hopefully a nice profit. This sounds like a smart idea, but there are two significant problems to this approach of value investing that are often overlooked. They are the main two reasons that many value investors fail to come close to beating the stock market averages of the S&P 500 and similar stock indices.
The first problem with this approach is that it ties up their investment capital in stocks that can sit for months and sometimes years without much price appreciation. This is known as the opportunity cost. By tying up their money in a stock that doesn’t appreciate in price, they lose the opportunity to put their money to work in investments that can show quicker returns and end up with an underperforming portfolio.
The second problem is that many of the stocks selling below their book or liquidation value are money traps because the company suffers from high debt, lack of growth prospects or poor management. They appear to be cheap but are in reality reasonably priced.
Famous value investors such as John Templeton and Warren Buffett recognized the flaw of the Value Vault approach. Instead, they preferred to travel down the road of what I like to call the Value Arch. The Value Arch entails buying leading stocks that have a competitive advantage supporting them (arch covering them) but whose stock price has dropped due to temporary problems or bear markets. These are the real value investments.
Warren Buffett describes this investing approach as “one man’s poison is another man’s meat.” His best buying opportunities had occurred during cyclical market corrections or when a company faced a temporary problem. During these times, the company goes out of favor and is overlooked by the investment community.
The best value investment opportunities occur with reliable companies that have consistent earnings growth, a healthy balance sheet without a lot of debt and a “monopoly” within their industry. Spotting a company with a monopoly in its industry is relatively easy; they are the ones that sell products or services protected by a patent, a strong brand name or a business model that is hard to duplicate. This Warren Buffet Stock Screen can help you find the best value stocks to buy while avoiding investment traps.
Another approach to the finding Value Arch stocks is to look for short-term catalysts, a favorite strategy of John Templeton. Catalysts can include multiple analysts giving the company an earnings upgrade, the release of a new product or hiring new management, a lot of insider buying or a large company stock buyback plan. These events or situations will allow others to recognize the value of the stock, or give it a chance for the share price to increase in a relatively short time.
So stop wasting your time buying value stocks with high debt, low growth prospects, commodity products or bad management. Instead of buying these types of shares, putting them in the Value Vault and waiting patiently until someone else uncovers the “hidden” value you have found, buy Value Arch stocks.
Instead, buy leading companies with strong balance sheets and a substantial competitive advantage during temporary price declines due to market corrections or one-time setbacks. These are the best value stocks to buy if you want to beat the market.
The Worthington Stock Letter is an excellent source of potential value stocks for investors to buy that has put us on recent big winners.