Investors who say they are focused on the long run often look for value stocks. They believe that they should buy stocks that are undervalued, hold the position for years and eventually sell at a large profit when the market recognizes the value of the stock.
This strategy is reasonable but it depends on the market recognizing the value. The stock market investment is really a place where investors use money to express their views on stocks. Ben Graham, the great investor Warren Buffett’s business school professor, expressed this in a memorable way.
Learn more about How to Trade in Stock Market like Warren Buffets Teacher?
Graham said that, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” What he meant was that the short term could be unpredictable and is driven by popularity (or momentum in market terms). In the long run, value wins out as investors act thoughtfully.
Many investors argue that Graham is correct. They point to Buffett’s success as proof that Graham’s methods are profitable in the long run. But, picking long run winners requires two distinct factors to fall into fall into place.
First, the stock must be truly undervalued. Value investors use a variety of metrics to find value. They may use the price to earnings (P/E) ratio, for example. Sometimes, a stock with a low P/E ratio is undervalued and at other times the low P/E is a sign of trouble in the company.
Second, even if the investor discovers true value in a stock, they need other investors to agree with them in order to be able to sell at a profit. If other investors agree, they too will buy and push the price of the stock up over time.
If either of those factors fails to materialize, the investor will not realize a profit that beats the market.
They could, of course, be wrong about the company. Many investors find a stock that appears to be undervalued only to discover that they were wrong and the company is, in fact, in deep trouble. The low valuation, in this case, was warning of problems in the future.
If they find value and other investors to buy, their money is in a value trap and it can take years to make a large return. This one is impossible to predict. There will be times when the market fails to recognize value, perhaps because the company is in an industry known for losses.
Let’s look at an example of low valuation and consider how the problems of value investing could be reduced by adding technical analysis of stocks to the investment selection process.
Value Can Identify a Poor Investment
The chart below shows the P/E ratio of Chipotle Mexican Grill, Inc. (CMG). Forward estimates are used to calculate the P/E ratio. Many Wall Street firms employ analysts to study companies and assess the company’s future prospects. These analysts often publish estimates of future earnings.
There may be dozens of analysts following a large company like CMG. To determine what is known as a consensus estimate of earnings, some firms that provide data services to investors will calculate the average of the earnings estimates prepared by all of the different analysts. This average value, as calculated by Standard & Poor’s, is used to find the P/E ratio in the chart.
Source: Standard & Poor’s
In 2009, near the bottom of the bear market, CMG’s P/E ratio fell to 18.5. This was about a third of the ratio the stock traded at a year ago.
To determine whether a P/E ratio is low, some value investors calculate the PEG ratio. This metric compares the stock’s price to earnings (P/E) ratio to the company’s reported earnings per share (EPS) growth rate.
The PEG ratio recognizes that investors are willing to pay a premium for growth. In fact, companies growing earnings at 30% a year, for example, should have a higher P/E ratio than a company that is growing earnings at 3% a year.
The PEG ratio recognizes this fact. The ratio is found by dividing the P/E ratio by the EPS growth rate. A ratio of 1.0 indicates a stock is fairly valued. PEG ratios less than 1 highlight stocks that are undervalued no matter what their P/E ratio is. PEG ratios greater than 1 show a stock is potentially overvalued.
Low P/E stocks with slow growth can still be overvalued and high PEG ratios will warn investors of the overvaluation. At the market bottom in 2009, analysts believed CMG would deliver average earnings growth of 22.5% a year. This made the PEG ratio just 0.8 and indicated CMG was undervalued.
In the next chart, the price of the stock has been added as a gold colored line.
Source: Standard & Poor’s
The chart shows that CMG would have been a great investment, gaining more than 770% since the market bottom. But, many investors would have sold long before those gains were achieved. The next chart shows just the price action in the stock.
Many investors, even those who claim they are focused on the long term, would have sold in one of the steep declines marked on the chart above. These investors would have enjoyed large gains, but they could maximize the wealth in their portfolio by having a sell discipline.
Adding Technicals to Make Sell Decisions
One way to reduce the risk of steep declines is to add a technical indicator to the chart. The next chart adds a slow stochastic indicator at the bottom and could be used to define the sell discipline. This would have avoided the steep sell offs in the stock.
Stochastics is a popular momentum indicator. It typically uses two lines, a fast and slow calculation. This generates a large number of trading signals. The chart shown above uses monthly data and uses only the slow stochastics.
This indicator turned down below the overbought line before the large declines. This is what technical analysts expect because they believe momentum leads price. That means momentum should fall before price and in this case, as it often does, momentum led price.
Combining Value and Technical Analysis
One technique long term investors could consider is to use value to determine what to buy and technical analysis to determine when to sell. In the example above, this approach would have resulted in a gain of more than 1,100%, more than the long term buy and hold value investor earned.
Of course, after selling CMG, an investor would have a large amount of cash. The process could then begin again by searching for an undervalued stock using the PEG ratio. When the PEG ratio is less than 1, that indicates other investors, in the form of Wall Street analysts, have identified value.
The low PEG ratio satisfies the first characteristic of successful long term investment identified above. This ratio can be applied in the same way as any other fundamental metric to find buy candidates.
The fact that PEG ratio is low indicates analysts following the stock agree the stock is undervalued. When other investors share your opinion that a stock is undervalued, the trade will have a greater likelihood of success. This addresses the second characteristic of successful investments identified above.
While this approach was applied to a long term analysis, the same process could also be followed to find shorter term trade candidates. That combined approach is used with indicators that have a proven track record of success in Stock Trading Tips PPK System. You can learn more about this trading service by clicking here.