For those that saw my introduction post, you will know one of my roles here at Pynk is to bridge the gap between the Investment Committee and this incredible community.
Here at Pynk we use multiple investment disciplines, and as part of our mission to enlighten Pynksters to embrace and develop their own investment ideas and approach, this week we are focusing on an interesting angle in equities investing.
Isn’t successful investing just about numbers? Don’t you just have to look at a bunch of investment ratios and numbers to find the ‘cheap’ stocks that will go up? The answer is yes and no…… but, actually, mostly no!
A lot of people think if you buy shares when the price is pennies, then you’ve got a really good chance of making meaningful returns. More formally, finding and buying cheap shares is known as ‘value investing’. The simple argument goes that the price of a ‘value’ share is so low that the worst-case scenario is already priced in. A small improvement in expectations of future profits can see big share price gains.
Catching a falling knife?
Mohnish Pabrai, a modern-day value investor sums this situation up nicely when he describes it as like tossing a coin with two outcomes of “heads I win and tails I don’t lose much”. This makes sense: usually no one is expecting much from these cheap companies so it seems plausible that not much can go wrong. But the problem is that whatever has gone wrong with the business so far to make them cheap, (eg in the case of Debenhams, a UK retail chain, shares were falling because consumers preferred other stores or online shopping), can continue to adversely affect them. Blindly buying cheap stocks doesn’t always pay off as many cheap shares have become cheap for a good reason. They are often struggling businesses with uncertain futures. Looking at this another way, you could argue that the price of the share has to be very cheap as investors are being asked to put their money in a risky situation with less than great prospects.
Having said all that, sometimes there are new good reasons why things are likely to pick up compared to the past. Formally, this is known as when there is a ‘catalyst’ to value creation. Company prospects might be starting to change for the better and therefore the share price can justifiably rebound and often quite strongly. In order to avoid catching a falling knife, we want to be sure things have improved for the company before deciding the shares should be worth more.
P/E? PEG? FCF? P/S?
These terms can seem a little complicated at first glance, but all that these ratios are doing is expressing what the price of buying a company’s shares is - so you can compare different shares like you would similar products in any store……
The easiest way to think of it is that when buying shares, we are just buying their earnings. Investors use all these valuation ratios to try to see what they have to pay for a particular company’s earnings stream.
Simplistically, the lower these ratios are, the less you are paying for the underlying earnings the company makes in the future. You might not be paying much because earnings are falling or not expected to rise much and vice versa.
What makes it slightly more complicated is that not all earnings are created equal. Some companies are in a situation where because of factors such as their market position, their popular brand, their competitive pricing, or their innovative technology, investors can be confident that they can grow their earnings year after year.
If we believe that to be true, it would make sense for us to pay more as we are actually buying more as the company is likely to grow larger every year.
All roads lead to back to understanding what you are buying
“It’s better to pay a fair price for a great business than to pay a great price for a fair business” Warren Buffet
All roads in many successful investment strategies lead back to understanding the business you are buying before deciding what would be a fair price for it. So it’s important to ask yourself: is this share cheap for good reason or are things finally looking up for the business?
An expensive mistake would be to ignore what is actually happening within the business and just buy ‘cheap’ shares.
Many of the ‘cheapest’ shares in the market are facing a worsening future and you could still lose money however much they have already fallen because, as business conditions continue to deteriorate, prices could fall further.
Sometimes things are expected to change for the better at the company or sector level. This is when cheap shares can be good value investments. For value investing to pay off there usually needs to be some kind of catalyst to realise this higher value.
Don’t forget the magic of compounding returns
There is a logical reason why investors are prepared to pay more for a business which clearly has many years of pretty certain growth ahead of it. It’s value upside isn’t just about not being so cheap anymore relative to others, but about the possibility that it can keep on appreciating in value over the years as earnings rise. Sometimes this compounding returns investors many times their money.
The downside of paying more for a business in the hope that it has years of compounding growth potential is that the room for disappointment in these situations is high: the market is expecting a lot from them and if future profits disappoint, then investors could get badly burned.
Anyone can do it, Just Look Around You!
How can you tell which share is good value? Actually, it’s a lot easier than it seems.
Information really helps and for many businesses, it’s quite obvious even to the ordinary person when they are prospering relative to their competitors.
This is especially true if you use the products and services yourself. For example, anyone could have seen why people were buying from Amazon rather than their local bookstore. Conversely, it was quite obvious how few people were shopping in Marks and Spencer compared to the big queues after lockdown outside Poundland. By really looking around you, especially in your area of expertise or among the products and services you buy yourself, you have a great opportunity to find potential investment ideas which you really understand. It’s a huge advantage if you understand exactly why the winners are winning against their competition and the losers are losing and why this might continue. This kind of understanding lowers the risks of losing money on your investments.
Having found companies with great prospects, it’s important to remember that things can and do change over time. So something that was once very popular, you can see for yourself when more people are preferring other choices, or that competition has begun to really heat up.
For example, Starbucks enjoyed spectacular growth in many countries but gradually it was obvious that fewer people were choosing Starbucks as newer café chains opened up close by.
By understanding the business, you are in a better position to make judgements on what could go wrong and even see when that starts happening. Having more winners than losers amongst your investments in shares is the cornerstone to making good returns.
I’m fairly new into Pynk and the community and this is my first post on investing principles, so welcome any feedback you might have, what you would like to see more/less of in this community, and experiences on this topic.
Disclaimer: Please bear in mind that this information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision. When investing, your capital is at risk and you may recover less than the initial investment.