The Difference Between Price And Value

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“All you ever do is drone on and on about what to be worried about. But what should I actually do? And how will I know when it’s right to buy stocks again? And how will I know what to buy?”

That’s a small sampling of some of the questions your editor gets via email. We can’t answer them directly. But in today’s Daily Reckoning we’re going to do something a little different. We’re going to talk about how to buy stocks below their intrinsic value.

What?! Intrinsic value!? Is there really such a thing with stocks? Isn’t value solely determined through exchange, between the price at which two parties agree to conduct a transaction?

To help us with these questions-and more-we turn to Greg Canavan, the editor of Sound Money. Sound Investments. Greg is what you might call an old school value investor. We first met him when he sent us an e-mail a few years back. A scintillating discussion on the return on net tangible assets ensued.

It wasn’t boring at all. We were both after an investment edge: how can you as an investor find company managers who make the best use of shareholder capital and equity? How do you measure those things? And how do you turn them into buy and sell recommendations on Australian stocks?

When Greg came to us later with the idea of writing and researching a letter on deep value stocks in Australia we liked it so much we wanted to publish it. But he declined that deal. See our endnotes for the arrangement we agreed on.

In the meantime, with the Aussie market at a key point-and the whole credit bubble itself in purgatory–we hope Greg sells a lot of subscriptions. If he does it means a lot of people will be reading what he writes.

If you’re one of them that should help you become a better investor. The truth is that Greg is doing a kind of analysis on Australian shares that we don’t think individual investors will find anywhere else. We’re glad to publish it because it’s the sort thing that SHOULD be published for Australian investors. It can help you know what to buy and when to buy it, or what to sell and when to sell it.

More importantly, it shows you that there’s a difference between market price and value. Granted, not every investor agrees with this. But as a publisher, our job is to find smart investors with unique and well-researched ideas and publish them and let you decide.

After all, we have no idea who’s right. But you can tell who’s doing their homework and who is just making it up as they go along. As you’ll see below, Greg has done his homework. But as ever, we’ll let you be the judge.

Finding Intrinsic Value
By Greg Canavan
Editor, Sound Money. Sound Investments

The global economy is recovering and a new bull market is underway. You should be loading up on stocks, right? But wait.

What about all the bad debts still in the system from the GFC? What about the huge increase in government debt that was required to pull the global economy up off the floor? Won’t that pose problems down the track? This is just a bear market rally based on artificial stimulus, surely?

These are probably the two most dominant opinions in the markets right now. Consensus opinion thinks the worst is over and it’s off to the races for stocks. Others are suspicious about the size and speed of the rally from last year’s lows.

I believe we’re experiencing the last legs of an extended bear market rally.

Stock markets around the world topped out in late 2007 when the great credit bubble that had been expanding for more than 30 years ran out of momentum. If history is any guide, it will be many, many years before we see the 2007 highs again.

I think there is a reasonable probability that markets will experience large rallies and declines, but ultimately go nowhere, over the next decade. I think we will see a fundamental re-engineering of the international monetary framework that we have been operating under since the early 1970s, and that at some point the international system will return to a ‘sound money’ footing. (Hence the Sound Money part of the business name).

But let’s face it, it doesn’t really matter what I (or anyone else for that matter) think will happen over the next ten years. It’s all crystal ball stuff. And can you as an investor make money from such big picture predictions? No really…and certainly not consistently.

In such a challenging environment then, with so many conflicting signals about the health or otherwise of the global economy, how can you increase your odds of making consistent and relatively low risk profits in the stock market?

It’s a question I have asked myself plenty of times. And when I realised the answer was a pretty simple one, I decided to stake my career on it. So I set up Sound Money. Sound Investments.

Now, the ‘answer’ is not one of the fabled ‘secrets of investing’. There are no such things. The only place you will see these supposed secrets is on book covers.

Ben Graham, the father – or perhaps the grandfather – of value investing, gave us the answer many years ago. But for some reason, people are always ready to dismiss the wisdom of those who have spent a lifetime studying the markets. Not that Ben has been forgotten. Rather, he has just been ignored.

So what is it? What is this answer to making consistent profits in the market?

As far as I’m concerned, the most important insight that Ben Graham passed on, and the most important concept for any serious investor to grasp, is that there is a difference between a market price and a company’s intrinsic value.

If you take anything away from reading this, it is to understand, and believe, that point.

I’ll repeat. There is a difference between the price you see quoted everyday on the stock market and the real value of a company. Good investors, those who consistently make money, know this truth. They simply buy companies when the market price is below their estimate of intrinsic value.

So how do you estimate intrinsic value? I’ll get to that in a minute.

But first, I want to show you the benefits of knowing the difference between price and value. It’s all very well to say ‘buy low, sell high’, but let’s face it; very few people do it consistently.

Why?

Human Emotion.

Emotion and irrationality are your enemy when it comes to investing. In volatile markets unchecked emotions can do considerable damage to your portfolio.

How many times do you see panic selling at the bottom and panic buying close to the top? Such behaviour is a guaranteed way to lose money yet time and again you see people doing it.

Understanding the difference between price and value goes a long way towards taking emotion out of the picture. And once that occurs, you will be able to take advantage of other investors’ emotional flaws, rather than have others take advantage of yours.

Knowing what you are buying, why you are buying it, and how much the investment is really worth (its intrinsic value) is the key to making sure your emotions don’t cost you big time.

Ok, so how do you determine intrinsic value?

It’s easier than you think. All you need is some common sense, some high school maths, AND a framework whereby you view investments as companies, not ‘stocks’.

The starting point is to view your investment as a ‘business’, not a ‘stock’. As Ben Graham said, “investment is most intelligent when it is most businesslike. …every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise.”

Warren Buffett reiterated this view in his famous ‘Graham and Doddsville’ speech given in 1984, when talking about those investors who had followed Graham’s principles over the long term. “While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock.”

Once we conceptually view potential investments as businesses, the next area of focus is on that businesses profitability. By profitability, we mean return on capital and more specifically, return on equity. Forget all the other measures that analysts blab on about. These are the most important.

This is because you, as a shareholder, are investing in the equity of a business. That’s why the stock market is referred to as an ‘equity’ market. The return on that equity matters and it determines a company’s intrinsic value.

I’ll show you a simple example.

You have some money to invest and have the choice between a term deposit, paying 6%, or company ABC. Company ABC earns a consistent 10% return on its equity. You know the option to invest in the company is more risky than the term deposit. To account for the risk, you want a higher return. So your required return to invest in ABC is 10%.

From here it’s pretty easy. You want a 10% return from investing in the equity market and company ABC generates a consistent return of 10%. Now you don’t just dive in and buy the company because its return on equity matches your required return. You need to determine its intrinsic value.

In this case, company ABC’s intrinsic value is the same as its equity value, because the return on the equity is 10%, the same as your required return. If you buy at or below the equity value, and the company performs as expected, you will achieve your required return of 10%.

How do you know you’re buying below equity value? Just make sure the company’s share price is less than the per share equity value of the company.

But, if you buy the company at say, 2x its equity value (and most companies in the market trade well above their equity value, so this happens all the time) your actual return will be 5%. You’ve paid twice the intrinsic value of the company, so you only get half your required return.

In practice it’s a tad more complex than that but if you can understand the argument, and the concept that there is a difference between a market price and an intrinsic value, you’re probably ahead of 90% of investors.

But because 90% of investors are out there bumping into each other…day trading, speculating, guessing, or trying to make their short term returns look good for the quarterly performance tables, most of the time the market is not interested in your assessment of intrinsic value.

You must be willing to accept that the market can make you look stupid in the short term. And here, another of Graham’s sayings comes to mind. “In the short term, the market is a voting machine, but in the long term it is a weighting machine.’

Patience and conviction (and thorough research) will always win out in the end. Successful value investors tend to have plenty of those two attributes.

This is the philosophy I follow in my weekly Sound Money. Sound Investments Report. I do have a big picture view, but it does not determine the stocks I recommend. The focus is always on value.

For example I think gold is in a genuine bull market. But even with the gold stocks I recommend I focus on return on equity to make sure I’m not buying financial duds. And gold mining is a very tough business…there are plenty of duds out there.

Right now, and for the past few months, I have been telling my Members that the market is overvalued and to take a very defensive portfolio stance. Market prices are well ahead of intrinsic values, meaning that poor long term returns will result from buying at these levels.

Just last week I showed a comparison between the prices of the top 20 stocks on the ASX versus their individual intrinsic values. On average, prices are around 16% above intrinsic value.

I am very confident that prices will come back to levels that represent good value. That may happen in one month or six months, it doesn’t really matter. Money is made in the buying, so patience is key.

And knowing a company’s true value will make it easy for me to recommend stocks at a time when 90% of other investors are selling…purely because they focus on price, not on value.

********************

If you like the cut of Greg’s jib, you can sign up for a free trial of his report here. And you should know that in addition to knowing how to value a business, Greg turns out to be something of an entrepreneur. He was more interested in owning a business than being an employee, which we can respect. So we made a deal.

We agreed to make Greg an authorised representative under our Australian Financial Services License if he agreed to let us publish, from time to time, his investment analysis and insights. For the purposes of total transparency, yes, there is a financial consideration too. Every time Greg sells a subscription, he pays us a referral fee.

Naturally, we hope he sells a lot of subscriptions. In fact, we think the free trial offer he’s making is nuts. If you’re serious about investing and you understand what Greg is offering, you’re either interested or not. Either one is fine. But if you’re interested in thinking a little differently about how you manage your wealth, sign up for a free trial now.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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6 Comments on "The Difference Between Price And Value"

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CJ
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Thanks for the honesty about your commission. Can’t get much more direct than “Every time Greg sells a subscription, he pays us a referral fee””. This is the sort of honesty that needs to be more common in the financial services sector.

Sambo
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Value investing… a more elegant form of speculation? It is right up there with the ‘buy and hold forever’ attitudes in my opinion, although not quite as naive. I do like the point of treating shares as a company rather than just stocks. But the thing that is truly ‘assumed’ when value investing is: ‘Are the numbers right?’. When you value invest against the profitability of a company, you invest against many things such as: – future company profitability (can the company continue to profit?) – industry profitability (will industry profits be affected my some event?) – debt servicing –… Read more »
Stillgotshoeson
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Comment by Sambo on 28 April 2010: Value investing… a more elegant form of speculation? It is right up there with the ‘buy and hold forever’ attitudes in my opinion, although not quite as naive. I do like the point of treating shares as a company rather than just stocks You have stocks in a comapny because you value the company, or your a trader and ride sentiment. Buy and Hold has it’s place.. Yeild is relative. I still have 180000 GMG shares (had 280000) that I purchased for 25 cents each in March last year..I am toying with the… Read more »
Sambo
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I’m not saying I disagree with any of the strategies…they can all work to make money. Speculation and long-term buy-and-hold strategies rely on capital appreciation, whereas value investing relies more on income growth. Either way you can make money. When the markets are volatile, speculation is the way to go. When the markets are bullish, buy and hold and speculation are great too. But when the market is punishing one and all, value investing is best. My other point was that value investing has its issues too – relying on data that may not be accurate and may not stay… Read more »
SV
Guest

Good when you have a way of valuing a company. But quite often I read in value investment reviews “we like this company because the management is good”. put a value to that! in case of GMG, they probably ascribe a negative “value” to its management.
Another grey area is risk assessment. What if the credit market seize up again? you can’t assign a “probability” to that – its a once-off large event.
how do you value small stocks with new technologies?… and so on.

Sambo
Guest

Right on SV!

There is no riskless method of investing. But plenty of research goes a long way to reducing that risk.

Although being too-big-to-fail seems to be a pretty popular form of risk management nowadays :(

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