This is a posting from user bullishbabo's CAPS Blog

There are quite a lot of investment approaches here on CAPS.  The only one that makes sense to me is buying something for less than it's worth, or less than its underlying value.  If you think a stock may be worth $15 to $20 and you can pay $12, you're paying less than it's worth.  If it were that easy, everyone would obviously do exactly this. Anyway, this post is meant to be a look into my personal investing beliefs.

If you ask someone what a stock's worth, he might say that it's worth the net present value of future cash flows. However, it can be broken down.  Honestly, I believe it's all about earnings or assets.  Earnings are more important in my eyes, but you must also look at earnings quality: debt-fueled expansion, cost-cutting, and previous one-time charges can give false earnings numbers/growth that aren't sustainable.

As far as assets go, there have been plenty of posts about NCAV (net current asset value) bargains, which are stocks that trade for less than net working capital (stock price < current assets - total liabilities).  I think asset plays are great, but I prefer my companies making money.  It's great if companies are trading at such a discount to assets, but it's only great if the company doesn't continue to burn through capital for a prolonged period of time.  Specific assets may include real estate, stock or bonds in other companies, and much more.

So far, I've been pretty vague on actual valuation techniques.  I can't do justice to those who are far greater than I am (it would also take too freaking long), so I suggest reading Graham's The Intelligent Investor and Security Analysis.  If you haven't read these two books, you're not a serious student of investing.  You should obviously learn how to read financial statements, how to peruse company filings to see if a company knows what it's doing or if it's full of BS, how to examine a company's capitalization structure, interest coverage, and how to stay objective in the face of much faulty analysis that's spewed by many popular news sites (it's all about valuation!!).

What don't I look at?

1. Macroeconomic factors:  There are many highly-regarded economists on either side of many major issues.  Both sides often make great points, but I often don't see a clear winner.  Valuation is much easier: is the stock price too low for these earnings or assets? To be fair, this is the one area I'd look into if I had more time for analysis.

2. Technical analysis: I disagree with most technical analysis.  I do think it works in some instances, but I think it's more of a self-fulfilling prophecy than anything else.  Beyond price and volume information, I don't look favorably on technical analysis.

3. The whole market as a whole: I think it's ridiculous to look at a number for the S&P 500 (such as 1150) and call a "top."  The market as a whole is the supply and demand of many irrational people.  Undervalued markets can keep falling and overvalued markets can keep rising.  It's ridiculous to call a top or a bottom, because humans are irrational and so is the market.  It makes a lot more sense to value individual companies.  (Note: There's obviously a lot of research that backs these "top" and "bottom" claims, but I think they're hogwash)

4. Others' research (such as CAPS blogs): You should do your own research.  If you look only at other people's research and invest actual money based on it, you deserve to lose money if your stock tanks.  You should do your own due diligence on every pick so that YOU know why you picked the stock.  If you don't have the time or ability, you should not be picking your own individual stocks and you should go buy an index fund.

5. "Expert" opinions: experts often issue buy ratings AFTER stocks go up and sell ratings AFTER stocks go down.  That's completely ridiculous.  I don't have the links, but I've seen evidence of experts' predictions being wrong the majority of the time.  The future is simply something you can't predict, yet Wall Street is all about future earnings (forward PE, anyone?).  I also love how a large company can miss earnings by a little bit (which is elaborate guesswork at best) and the company can tank 7%.  Did this large company's value go down 7% intraday because of a small earnings miss? Absolutely not.

6. CAPS picks: Many people (myself included) carry ridiculous numbers of CAPS picks.  I guarantee you these people don't own most of these picks.  Personally, I own fewer than 10 of my CAPS picks.  I don't short in real life, so that means I only own fewer than 10 of my green thumbs.  I've mentioned very often that I'm into micro caps, and most of my watch list is unrateable in CAPS.  I'm sure many others have many reasons for not owning many of their picks, so I would tread carefully when looking at others' picks.  As I've mentioned already, further due diligence is required.

I could go on and on, but moving on...

So what would I do?

1. Learn solid valuation techniques.  Graham's books will get you there a lot more quickly than anything else I've seen. 

2. Value individual companies.  Once you train your eye, you can tell pretty quickly by looking at a company's financial statements if it's worth a further look.  With some companies, I can go to Morningstar and look at 10 years of income statements and see in 10 seconds that this company is definitely not a "buy" and is not worthy of further research.  Most important are earnings and assets, but there's obviously more to it.  Keep looking at financial statements and you will indeed become faster.

3. Once I find a company I like at first glance, I'll give it a closer look.  I look at sales and earnings growth, common stock dilution, hopefully look at debt going down, look at the health of the balance sheet, and see if it the company is the following 3 things: healthy, profitable, and undervalued.

4. If you have more time, read the annual and quarterly filings.  You can get a sense of the company's corporate governance policies and whether it keeps promises to shareholders.  A good company will buy back stock when it's low, keep its promises on growth plans and say why it failed if things didn't go as planned, keep executive pay and stock options under control, have insider buying, have a viable growth strategy, and much more.

5. If a company is clearly undervalued, I place it on my list of possible buys.  Just because a company is undervalued does not mean that I buy.  I only buy if it's the most undervalued.  If I'm looking to add 5 stocks to my portfolio, I do not indiscriminately buy the first 5 undervalued stocks I find.  I find the 5 that are most undervalued and only add those.  If you're selling holdings to buy other stocks, you should sell your least undervalued holdings in order to buy the most undervalued holdings out there (it's all about valuation!!!)

6. If there are enough undervalued companies to build an entire portfolio, do it.  If not, there's nothing wrong with holding cash, bonds, or whatever.  You should really only buy stocks when you can get a discount.  If you have to pay more than 100 cents on the dollar to buy something, I'd rather just hold the friggin' dollar.

Thoughts on the current market:

It's definitely not like it was in March.  Stocks are a lot more expensive now than before, with many stocks having gone up as much as five- or tenfold.   I'm personally still buying carefully, as I've still found bargains where I'm paying 50 cents on the dollar or less.  However, I'm buying knowing that my holdings have the possibility of going WAY down if the market were to crash again.  I seriously doubt it'll retest March lows, because stocks were just so irresistibly cheap in March.  I saw so many stocks trading 25 cents on the dollar even by pretty conservative valuation methods.  Anyway, I'm confident that the stocks I buy are worth more than the price I pay, and that the price will eventually rise to reflect what I believe is the value.

I'd recommend buying undervalued companies as you find them, and holding till they reach or exceed fair value.  This is the only approach that makes sense to me, and that's what I'll follow.  Market analysis such as what the market will do next and why, trying to make money up and down, and other techniques? I'll leave these to others.   

Small sidenote:

I find it sad that solid valuation pieces such as this and this from a solid fool such as Jakila don't get all that many recs, while so many nonsense posts are consistently getting 25-50 recs.  It's downright ridiculous, I tell you!

 

http://caps.fool.com/Blogs/ViewPost.asp … 0192916388

It's All About Valuation, Stupid!

November 16, 2009 – Comments (22) | RELATED TICKERS: V , ALU , E