Valuations: What stocks are worth
Brian Kilb: I think one of the things I appreciate most about my time with the firm is the consistency of the message. I think if one of the things we’re trying to help you all with is confidence and security, then that consistency is a really important factor.
But that’s why we talk about things like Efficient Frontier and balanced portfolios and our independence. And the two things that drive stock prices: Interest rates and earnings. So I don’t want to change that. I want to add to it today. I want to add a third element, which is valuations and the idea of value.
Warren Buffet said, “Price is what you pay. Value is what you get.” And the difference between those two things, which is critical, is the difference oftentimes between a good company and a good investment. I think one of the reasons people find investing challenging is they really don’t grasp the idea that something is worth something, that a company is worth something.
Think about it. The stock market is one of the only markets I know of that when prices go up, people buy more. When prices go down, people sell. It’s because they don’t have that thing to tether themselves to. They don’t have that idea of value. And that idea of value should be a very rational, very objective exercise.
So we ask ourselves the question, then what is a company worth? When you think about what’s going on in the marketplace every day, that market price, that’s what other people are paying. But what should you pay? We often like to talk about intrinsic value, or the idea that a company has some inherent value. That it’s a calculated value. That it’s objective in nature. And that’s this idea of valuation. And without that valuation sense, people make decisions based on emotions such as fear and greed.
In 1934, two gentlemen, Benjamin Graham and David Dodd wrote a book called “Securities Analysis.” And one of the things that was most important about that book is they offered a formula for defining value. That they made it, for the first time, an objective, analytical exercise to own securities. Now I’m not going to go through the formula with you, but I think it’s important to know that that formula and most every formula since contains some of these same key variables, and that is, to understand that the market is a discounting mechanism.
What do you when you buy a company? You buy your share of future earnings. But hey, wait a minute, that share of future earnings, those dollars you get in year eight or nine or ten aren’t the same as those dollars today. So we have to discount that by a rate. That’s the interest rate in the equation.
Now, also, you might have that investment and compare it to another investment, so you have to discount by some rate of return that you absolutely want to have or have to have to buy that investment.
I think the other thing people forget about sometimes is, “How long am I going to own this thing?” That should also be a very important part of the valuation equation. And I think the important thing to remember is it’s a lot of science, not just a lot of art.
Talk about value in a different context as well.
So it’s good, I think, to be reminded about what value stocks are. Those value stocks are, in the most simple of sense, the cheaper half of the investment world. It’s cheaper. Why are they cheaper? Well, they’re more stable earnings, oftentimes. More predictable earnings. Because they’re more predictable, oftentimes you’ll have lower growth expectations for those stocks and as a result, you don’t have to pay as much. Those companies, because they’re in more predictable industries, because they oftentimes retain some of the money to pay your dividend, have stronger balance sheets.
So when should we consider value stocks in the typical market cycle? Um, little bit of a difficult graph to read, but focus on the green bar at the bottom which references economically sensitive assets. I’m going to call those value stocks for now.
Typically, as the economy recovers and rises, banks lend more money, people have more money to spend, when they spend more money, the economy continues to grow. So those are typically when value stocks prosper. Later in the cycle, when things start to slow a bit, you’re oftentimes forced to pay a little bit more for growth in the hopes that you’re going to get paid back handsomely for those bets.
Stock valuations: Time to buy or sell? a Money Talk Video with Dave Sandstrom
Retaining value in your stock portfolio, a Money Talk Video with Marc Amateis
The case for active funds amid volatility, a Money Talk Video with Kyle Tetting
Value & Growth: Going Deeper, a Money Talk Video with Brian Kilb and Marc Amateis
Investors and the business cycle, a Money Talk Video with Dave Sandstrom
Balancing value and growth, a Money Talk Video with Brian Kilb
Types of stock, from the Financial Industry Regulatory Authority
But the reason I throw this cycle graph out right now is to draw your attention to the far right. When things get a little ugly at the end of the cycle, your value stocks are going to hold up much better. They’re cheaper. They have less distance to fall. And you want security at the end of the cycle. Value stocks are the place to go.
Now there’s two problems with that. One, every business cycle doesn’t look the same. I think the other is it’s difficult right now to make sure that you can distinguish between value stocks and growth stocks. And to give you a brief example of that, let me compare three pretty classic growth stocks: Netflix, Microsoft, and Apple.
Microsoft and Apple, pretty classic growth stocks, now pay dividends. That’s a little bit different. Forward PE on Netflix is 80. Sounds like a growth stock, right? But Apple’s 17. Classically sounds a little bit more like a value stock. So it’s a little difficult to compare and contrast and to really pigeonhole things into terms such as value. But the concepts, nonetheless, are highly useful.
So where to find value in today’s markets? Be careful of one thing: Because growth has dominated so much, a lot of people are cheating. A lot of value managers and even core managers are cheating over to the growth side. So make sure if you’re looking for value, that you indeed buy a value fund with value stocks.
So in ending, you know, why value value stocks? Provide good defense -in your portfolio. There’s a certainty of income I like. There’s a more objective way that we can look at earnings in those stocks. So make sure you use valuation metrics to make good investment decisions. Make sure you get good value for your stocks. And don’t forget that value stocks are an important part of anybody’s portfolio.
Brian Kilb is president and chief operating officer of Landaas & Company.
(initially posted October 10, 2018)
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