Key Challenges with Value Investing

Dec 13, 2015 -

Value investing is an investment methodology whereby you invest in businesses that the market has undervalued. The whole idea behind this is that the stock market is not efficient. As a value investor, you can take advantage of periods where businesses go "on sale". Then sell when a business has been overvalued by the market. In theory, all of this sounds logical and might even sound easy to do, but there are a number of challenges one can face in the process of this.

Just as there will be periods when there are companies that trade upwards of 100 times their earning potential, there are also times when they will be trading at a price to earnings ratio (P/E) of under five or less. This means that the price of the stock is lower than five times the amount of net income the company is generating. In investing terms, one aspect of measuring a business' value is how long it takes for the company to recoup the investment. For example, if you invest $100 in a company that generates $10 a year. If you didn't sell your stake in that company, it would take you 10 years to recoup your investment. This is the concept of P/E ratio. Arguably a 10 P/E ratio is a reasonable value for the company.

Benjamin Graham, the father of value investing, once said that in the short run, the market is like a voting machine--tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine--assessing the substance of a company.

One of Warren Buffet's holdings is International Business Machines Corp. (IBM). IBM has been trading below a 10 P/E ratio for much if not all of 2015. The company is currently undergoing a restructuring and deleveraging the businesses that do not have high gross margins in favor of those that do. In other words, selling its hardware in favor of cloud computing products. As a result, they have been experiencing declining revenues over the past few years. However, cost cutting measures has actually led to a higher net income when comparing 2015 vs 2014 financials. In fact, in Q3 2015 year to date IBM reported net income of $8.7 billion versus $6.5 billion in the prior comparable period. All the while, it continues to repurchase shares, which means there is less of it out there. It doesn't take a genius to understand that your shares become more valuable (in a scenario where all other factors remain constant).

If you had purchased IBM in May of 2015 at its high of approximately $171 your investment would be down over 20% in mid-December of 2015 as the stock price hit $135. In fact, you'll have to look all the way back to late 2010 and early 2011 to get prices of $135. Meaning if you had purchased IBM in 2011, 2012, 2013, 2014, or 2015, your shares are most definitely underwater. That is five years! Nowadays we are used to instantaneous information, profits,everything. How do you have the patience for that? At the present moment, it looks like there is no end to this decline in sight. You will have to be able to sit through this temporary, but seemingly long storm. Chances are you did not pick the bottom of the stock.

While we just did a 20,000 feet extremely high level summary analyzing IBM's business above, there is always a chance that we could be wrong. With any investment there is risk. Yes, IBM has been has constantly reinvented itself and yes it has survived over 100 years of business. However, there is no guarantee of tomorrow. Chances favor the stock to grow exponentially over time, especially when you continue to see it generate profits. However, we could be wrong in our investment. The challenge of it all is having the stomach to ride out these large declines in the value of your stock during this holiday season.
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