Ask Colin

How is your plan to buy stocks selling below value carried out in a market where most stocks are at or above fair value?

The detailed question was:

I am hoping you could please elaborate for me in regards to your presentation '153-through-a-glass-darkly' on the criteria 'bought at a low price relative to value' on page 15 where you list out your investment plan.

My understanding is that the margin of safety in phase 2 of the bull market is less than in phase 1, as the stock price has generally been rising since the start of the bull market. Can you please elaborate on whether the decisions you make from analysing the margin of safety is different in phase 2 of a bull market compared to phase 1.

The context from where I am coming from is that I am very conscious of not paying too much for good businesses. However, I am finding it difficult to find such stocks because (1) the fundamental analysis indicates the stock is valued ok (ie not expensive but not that cheap either) and (2) the monthly price charts suggest that I should have bought earlier (although I was not following the stock market at these earlier times).

I am also well aware that I am only a novice and the market is volatile, so I have quite a tight risk management rule in my investment plan that stipulates that I cannot buy another stock until the sell stop on my current stock/s are above my break-even price (ie purchase price plus stockbroker fees). On the other hand, I am also conscious that novice investors sometimes tend to be too hesitant and I am probably more hesitant than someone who started investing in a raging bull market and attributes their strong returns largely to their skill despite being only novice.

There are broadly two kinds of investors, which are at the extremes, with everyone else somewhere between them:

Value investors

They buy good businesses when they are cheap and sell them when they become too highly valued. This approach requires great patience and discipline, but can be very rewarding. It will mean sitting on our hands and patiently waiting for long periods when markets are fairly valued or overvalued. Even then, there may be some good opportunities, but they are hard to find. This approach also requires a great deal of skill and is beyond most private investors for whom investing is not their profession.

Momentum Investors

They buy stocks that are rising in price. Value is not important, just that the price is rising. This does not require fundamental analysis skills and is probably based on charting and technical analysis. Somewhat unfairly they are often described as following “greater fool theory” – they buy at foolish prices and make their profit by selling at a higher price to a greater fool.

Most private investors eschew fundamental analysis and find charting an easy way to avoid it – they become traders who gain from price change, unlike investors who buy part ownership in a business and gain an income stream and, from the compounding of retained earnings reinvested in the business also enjoy capital growth.There are many who fall somewhere between the two extremes. They have some idea of value, but are essentially momentum investing aka trading.

Value investors find the best bargains immediately after bear markets, when even good businesses are sold off. Then the market moves toward fair value and the value bargains are harder to find. However, they can be there when the market sells off a stock for some reason that is temporary. Again it takes some skill to identify them.

So, what must the would-be value investor do in the long middle part of a bull market when most stocks are near fair value, some over-valued and some, for good reason cheap? I think this is your question. The answer, I think, is two-fold:

  1. Keep looking for stocks that are cheap – value significantly lower than price. They are very hard to find and it requires skill.

  2. The more practical answer – find really good businesses that are not over-valued i.e. around fair value. Ideally buy in market weakness when the good can be sold off with the all so rans. Sell them if they become very over-valued.

In Building Wealth in the Stock Market I present a simple way to do this, based on PE ratio, dividend yield and debt to equity. This is for the private investor with minimal skills. Combined with risk management, it will keep  them in the right area.

On the members website I try to teach in greater depth about analysing investments. This will take much greater time and effort and frankly, most private investors will not go there. For example, someone asked me about analysing a stock I own at a meeting recently. They were already a member. I said to read the stock journal. Their response was “but it is 60 pages!”. You see, most want an easy, quick way to be a good investor. There is no such thing. I am still learning after 51 years at it.  

I hope this discussion helps with the issues you are wrestling with.  

Keywords: