Buying shares because they are cheap can be a dangerous investment strategy. People love a bargain and too often this can lead novice investors to buy a share they consider cheap, only to see the price drop even further.
Despite the dangers of bargain hunting, it can be a legitimate and rewarding investment strategy. This article will discuss this approach to long-term investing, and outline the difference between speculative optimism and a carefully devised investment plan based on value investing.
It is important to understand that buying a share simply because it is less expensive than it was last week or last year is not an intelligent investment strategy. Many good companies have dropped in value and been considered "bargains" only to drop further in value and then be called "long-term investments."
As discussed previously, the most important aspect of value investing is to have an investment plan. An investment plan will provide you with the necessary guidelines to ensure that you will know when to buy, monitor, and exit your investments.
Share prices fluctuate from day to day and can also establish prolonged trends in a particular direction. The main assumption that value investors make is that, despite the short-term fluctuations in price, the underlying value of a company does not substantially change.
Value investors search for companies that are "undervalued" by comparing the current price of the share with the value of the underlying assets of the company.
To take a simple example, if a company had assets worth $1 million and had 1 million shares on issue, you could say that each share should be worth $1.00. If you could buy one of those shares at the stock exchange for 80 cents, then you would effectively be buying one dollar worth of assets for 80 cents. You would be getting a measurable bargain.
Investing in this manner is a widely accepted and practiced method of selecting shares. Legendary investor Warren Buffet describes it as " buying a dollar for fifty cents." Investors such as Buffet use a value approach to limit the risk of a general market down turn. The idea being that a half-priced share will withstand a negative market better than a full value share.
There are additional risk management strategies available to investors who chose to invest in undervalued companies. Dividend yield increases as a company becomes undervalued. Many value investors restrict their investments to companies that pay regular dividends. This can help to ensure that a company is cheap because it is undervalued, rather than because it is a bad or profitless company.
Value investing can certainly have its problems. One of the most difficult requirements is accurate and reliable information. Value investors use a variety of ratios to determine the value of a company. Three of the most often used are Price/Earnings ratios (also known as P/E ratios), Asset backing, and Dividend Yield. These are helpful and are usually readily available from web sites and stockbrokers. However it is also important to ensure that you have a thorough understanding of what the company does, how it earns its money and what its potential is. Even the ratios of a terminally sick company can look appealing at first glance.
It's important to understand that value investing is not a buy, hold, and forget strategy. Value investors must be constantly aware of their investment position. If you bought a share for 50 cents that was you "valued" at $1.00, and the price of the share increased to $1.00, you would have a clear reason to sell. The market has turned your carefully thought-out investment plan into profit, and now you should take that profit.
There is little use in buying a share cheaply and then not selling when a profit is made. Successful value investors carefully monitor their investments and are prepared to sell when the market moves against them or when their plans are realised.
An interesting aspect of value investment is that it is more effective under different economic conditions. In a period when business is booming and investors are confident, there are likely to be less undervalued shares available for purchase. This will typically mean that investing for growth can be more effective than investing for value.
Where the economy is less buoyant or in recession the market is often weaker, and value investors can make strong returns when the market and economy recovers. It is important to be aware of the overall market conditions and to implement the most appropriate strategy.
Value investing can be a rewarding and profitable strategy, but it is essential to understand the risks that are inherent in buying cheap shares and to stick to an effective investment plan. The next article will discuss a less active approach to investing in the share market by buying into managed funds and unit trusts, which can allow a passive return over a longer term.
This article was written by Nick McCaw from Intelligent Investing