Fundamental investors seek stocks at or below “Fair Value”. That is the sensible thing to do. Buying companies at or below their worth is one of the best ways to limit risk, which is key to investment survival and prosperity.
Once you get past the conceptual agreement about fair value driven investing, you hit a wall. There is no fixed definition of fair value. People have different views on the matter.
In the short-term, the market will price stocks any way it pleases, seemingly without regard to value. In the long-term, however, the market will tend to find value price points.
Some stocks start overvalued and seem to stay there forever, until they decide to crash back to earth. Some stocks seem to be wonderful values, but have been in the basement forever with seemingly unrecognized value.
Nonetheless, we prefer to risk being wrong or early seeking fundamentally undervalued stocks than being wrong or late on momentum stocks.
By adding dividend yield to the value selection process, you can also get paid to wait for the market to come around to seeing fundamental value.
To a certain degree changes in market prices are driven by changes in expectations about future results. In terms of risk management, we think it is a safer place to be with fundamentally sound stocks for which the market has low expectations than with high expectation stocks.
Disappointments cause stock prices to be punished. High expectation (momentum) stocks may have more risk of disappointment than low expectation (value) stocks.
Three popular independent services that provide opinions on value are Standard & Poor’s, Value Line and Morningstar.
To illustrate the problem associated with relying on one service or the other for fair value, consider this experiment comparing fair value calculations by Standard & Poor’s and Morningstar on the 30 stocks in the Dow Jones Industrial average (NYSEARCA:DIA) as of November 19.
Morningstar assigned significantly higher fair value to Proctor and Gamble (NYSE:PG), American Express (NYSE:AXP) and Verizon (NYSE:VZ) than did Standard and Poor’s. Standard and Poor’s assigned significantly higher fair value to Merck (NYSE:MRK), Hewlett Packard (NYSE:HPQ) and AT&T (NYSE:T) than did Morningstar.
In 12 of the 30 stocks, Morningstar and Standard & Poor’s were in disagreement as to whether the fair value was higher of lower than the market price.
In only 8 of the 30 stocks did Standard and Poor’s come within 10% of each other on the fair value they assigned.
Clearly, fair value is not science. Value like beauty may be in the eyes of the beholder. At best, it is an art.
When you read a financial article where an expert says that some stock is worth this or that, keep this experiment in mind. Opinions on value can be are all over the lot.
In spite of the problems finding consistency in value opinions, we believe that finding out what others think about fair value is useful; however it should not be relied upon blindly. Treat fair value opinions from others as a tool to help narrow your own research. Look into the fundamental investment prospects of each stock on your own before committing funds.
To do your own fundamental screening, a good place to obtain a comprehensive and reasonably priced data set for fundamental information is the American Association of Individual Investors. With lesser detail or customization potential, your broker-dealer may provide effective value screening tools.
In the end, nothing beats careful study of the 10-K and 10-Q SEC filings for companies that make your short list — and don’t forget to read the footnotes which can shed important light on the financial statements.