Value investors are, generally, people who are sceptical of complicated analyses that try to predict events into the distant future. As far as the value investor is concerned, the future is highly unpredictable. Consequently, they deal with the here and now.
Value investors look for stocks that have been, in their opinion, unfairly undervalued by the market. The thing that matters most to the value investor is to pick up a dollar's worth of stock for less than 100 cents; limit the risks of buying the stock, and to wait for the market to acknowledge that it has made a mistake.
And here is the crucial part. They sell as soon as the value has been sufficiently recognised. They are not concerned with the yet-to-come because the value investor knows that it is highly uncertain. So here are some important dos and don'ts of value investing.
DO HAVE A PLAN
It may come as a shock to even the most seasoned investor that there is no official definition of a value share. Just as there is no official definition of a good curry, we all know one when we see one. There are, for example, different degrees of spiciness, depending on how far up the Scoville scale you care to ascend.
Don't ask how much you could make from a share but how you could limit the downside. One of the hardest things in value investing is to define what is meant by "unreasonably" cheap.
We can choose from a burn-a-hole-in-our-mouth curry to one where the spices dance delicately on the taste buds of our tongues. Similarly, value investors range from those who are in search of deep value to those who are happy with just a moderate degree of undervaluation. But you have to devise a cogent plan at the outset.
DON'T COMPLICATE THINGS.
In the main, a value share is one that is cheaper than its peers. The peers could be other shares within the same sector. It could be shares in the overall market. How you choose to define the peer group is subjective. But whatever you decide, stick with it. Don't change horses in mid-stream.
DO CHOOSE YOUR FUNDAMENTALS CAREFULLY
The market is awash with ratios that value investors could use to ascertain value. From something as traditional as price-to-book and price-to-earnings to more esoteric ratios such as enterprise value-to-Ebitda, investors are spoilt for choice. But whatever ratios you choose, be sure you understand what they mean.
DON'T BE GREEDY
Don't ask how much you could make from a share but how you could limit the downside. One of the hardest things in value investing is to define what is meant by "unreasonably" cheap. But once you have done that, then you have essentially cracked value investing.
DO MINIMISE THE DOWNSIDE
The key to value investing is to minimise the amount of money you could lose. You are unlikely to find too many shares in the market that will satisfy all your value criteria. If you do, then chances are that your yardstick for a value share might be too lax. So tighten them. The purpose is to minimise the downside by limiting the amount that a value share could fall further.
DON'T FORGET TO READ, READ AND READ
The value of an undervalued share has to be discovered before it can rise. So spend time reading brokers' reports but be sceptical at the same time. Brokers could provide some useful insights into the future prospects for the company. Don't try to look too far into the distance, though - look only one year ahead. If the stock is being covered by several analysts, choose the ones with the lowest forecast. You are, after all, a contrarian.
DO LOOK FOR YIELD
It could take a while before the market agrees with you that your chosen stock is undervalued. It might not even happen. So, while you are twiddling your thumbs, you want to be compensated for your commitment and time. A decent yield, especially one that is significantly higher than the market, is a good reward. It could also help protect the stock from falls.
DON'T IGNORE DEBT
Look for companies with little or no debt. If possible, look for companies that have cash or cash equivalents that exceed borrowings. A company might not be doing too well. But as long it has enough cash to meet its daily requirements then it is unlikely to go bust. That is not true if a company should be sitting on a pile of debt.
DO BE CONTRARIAN
As a value investor, you role is to think differently. You cannot be a value investor if you are buying what everyone else is buying. But that doesn't mean doing the opposite to everyone will always guarantee success.
Only in certain circumstances will you be right. But be conscious of the fact that occasionally , the majority might be right. It can happen.
• This is a regular monthly column on stocks and investing by Mr David Kuo, chief executive officer of The Motley Fool Singapore.