Sometimes factors can cause a stock to get beaten down to the point of being undervalued. Value investing is about finding stocks that are worth more than their current share price.
Investment legends like Sir John Templeton, Benjamin Graham and Warren Buffet realized decades before behavioral finance became a respected academic discipline that systematic psychological errors tend to create market inefficiencies. Templeton, Graham and Buffett reasoned that herding behavior (including momentum traders and short-term speculators that chase price trends) and overreaction bias (the tendency of people to overreact to bad news) are strong forces in the market that can push stocks far below their fair value.
Based on these observations, many of the world’s greatest investors look for stocks that are beaten down by the market due to bad news or negative rumors. Benjamin Graham, the father of value investing, constantly searched for companies that once fetched sky-high valuations but that crashed when the companies were unable to deliver on investors’ expectations.
Warren Buffett famously said, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
Take Trinity Industries, for example.
Sales and earnings were rising at a decent clip in mid-2013, but investors paid no attention to the stodgy 80-year-old industrial company that makes railcars and barges. The company’s price to earnings ratio (P/E) was less than 10.0, and dividends had been paid regularly during the past 20 years.
A change in Trinity’s fortunes were brewing, though. Demand for tank cars used for transporting oil was picking up, as a result of increasing oil fracturing in the U.S. and Canada. Management recognized the potential and ramped up production to meet demand. Trinity’s stock price was just beginning to move when J. Royden Ward decided to recommend the company in Cabot Benjamin Graham Value Investor because of its undervalued stock.
His evaluation of the company indicated that 18.47 (adjusted for stock splits) was a fair price to pay in July 2013. Other investors began to notice Trinity’s rising sales and earnings coupled with its low valuation. Trinity’s stock price started to rise steadily. When the stock reached Roy’s sell target of 39.55 in June 2014, he issued a sell alert to advise subscribers to sell Trinity. The resulting 114.1% gain during the 11-month holding period easily beat the Standard & Poor’s 500 Index increase of 17.7%. Roy’s maximum buy and minimum sell targets take the guesswork out of investing. Buy at the recommend buy price and sell at the recommended sell price—buy low and sell high.
Value investing is about recognizing opportunities, spotting deep discounts and finding the next Trinity. One way some investors measure a company’s value is its price-to-earnings ratio, or P/E. But P/E is a very simplistic measure of a stock’s value. Experts dig deeper, examining a company’s sales, cash flow, dividend, book value, debt levels, historical valuation patterns and more to determine if a stock is undervalued.
Warren Buffett was Benjamin Graham’s student at Columbia University in 1950, and later worked for Mr. Graham to learn how to find bargains in the stock market. Benjamin Graham’s system of evaluating companies has been the foundation of many successful investing systems over the decades.
A key concept of the Benjamin Graham investing system is the idea of Margin of Safety, which is achieved by buying only when a stock is below its maximum buy price. If you implement just this one practice in your own investing, you minimize your potential losses, while maximizing your potential profits.
To help you find the next Trinity, Roy Ward writes the Cabot Benjamin Graham Value Investor, a service for value investors. Roy is a second-generation disciple of Benjamin Graham. In 1969, Roy developed a computerized model of stock selection based on formulas created by Benjamin Graham, and since 2003, he's been spreading his wisdom far and wide as chief analyst of the Cabot Benjamin Graham Value Investor.