The two main methods of picking individual winners in the stock market are:
- Charting or so called technical approaches, and
- Fundamental or value approaches.
Charting techniques attempt to predict which stocks are going to go up and which are going to go down in the very immediate future. Charting relies on momentum and signals in the price pattern and volume of trades to predict which way the market for a particular stock is headed. Chartists (at least in their purest form) are not at all concerned with why the stock is going to go in one direction or the other. This method simply tries to predict which way the crowd is going and then attempts to buy into rallies and sell as stocks enter decline phases.
Charting is appealing in that it promises to predict the future. If charting can be made to work reliably then vast fortunes can be quickly made. In the ultimate scenario, imagine if charting would allow you to reliably predict just one big gainer on the market each day. By simply buying a big gainer each day and switching to another big gainer every day, you could easily double your money each week. If you started with $1000 and doubled it each week then after 10 weeks you would have over a $1,000,000. In short order you would be the wealthiest person in the world. So even if charting works only imperfectly, we can see the immense appeal of it.
But the problem is that it’s not at all clear that charting works at all. Despite legions of followers, it is derided by academics and documented cases of great fortunes made with these methods are notable by their absence.
Fundamental or Value techniques completely ignore trying to predict what the crowd is doing. Value investors look at the fundamentals of the company including sales, earnings, book value, growth, risk and overall outlook. The value investor uses present value techniques to calculate an estimate of the true value of a stock and then buys those stocks that are trading below their true fundamental values. Short-cut value methods include simply buying low P/E or low price to book value shares, but more skilled value investors consider many factors to calculate an estimate of the stocks true intrinsic value.
Value techniques require an investor to have faith in his or her own analysis. (Or in the analysis of a Value advisor). Value investors tend to be patient and are willing to ignore the market in the short term based on a belief that in the long term the market will recognize and fully value each stock.
A common misconception is that value investing excludes growth stocks. In fact value investors recognize the value of growth. They typically seek growth stocks but will only buy them when they are under-valued in the market.
Value investors explicitly believe that the market price of shares is often “wrong”. Value investors believe that the current market price is simply the intersection of supply and demand. It is the price set by the marginal seller and the marginal buyer. The market price is dictated only by those few investors that decide to trade at or near the market price. On any given day most investors choose not to buy any given stock and most investors who hold a stock choose not to sell it. Under these circumstances there is little reason to accept the notion that the market price is somehow divinely correct. The market can and certainly does get it wrong with great frequency, otherwise there would be no “bubbles” in the market.
If you are ready to take the Value Pledge, then the following descriptions should apply to you.
- You are capable of valuing a company based on its sales, earnings, dividends, industry attractiveness, growth, management, risk factors and overall outlook. (Or at least you are willing to apply simple rules of thumb such as a low P/E given the expected growth or to follow the advice of a Value oriented
advisor). - You have confidence in your methods (or your advisor).
- You care a lot about about earnings and other developments in the companies situation and you care not that much what the market thinks the company is worth at any given point in time.
- You view the market price as simply an opinion on what a stock price should be and you view your own opinion (or that of your advisor) of the stock’s value to be a least as valid as that of the market.
- In cases where the stock price falls but your own valuation of the stock has not changed you are not distressed and you view it as an opportunity to acquire more shares at a bargain price. You know that the market has to eventually recognize the value but you willing to wait a very long time, if necessary, for that to occur.
Warren Buffett likes to buy stocks that are worth (according to his valuation) say $10.00, when they are trading at say $4.00. He calls this buying dollar bills for 40 cents. He says that people either “get this” (immediately) or they don’t. If you “get this” and are willing to undertake the work and discipline involved (or to trust a Value oriented advisor) then maybe you are ready to take the The Value Pledge.
December 8, 2001
Shawn Allen, CMA, MBA, P.Eng.