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Searching for Value in a Down Market
Buying on the dips is a favorite
strategy of committed stock investors. But when looking for investment
bargains, it's important to avoid a value trap.
As
volatility in the stock market continues, some investors may be
tempted to buy on the dips. But this desire raises an important
question: Is a low price by itself a true measure of a value stock? If
an investor plans to hold a stock for the long term, how can an
investor gauge its future potential compared with the broader market?
Value Investing Defined - Value
stocks are those that have fallen out of favor in the marketplace and
are considered bargain-priced compared with book value, replacement
value, or liquidation value. Value fund managers typically invest only
when they believe the underlying company has good fundamentals. Many
value investors think that a majority of value stocks are created
because investors overreact to negative events, which can include:
- Disappointing earnings.
- A negative outlook for the industry.
- A regulatory setback.
- Substantive litigation.
The
idea behind value investing is that stocks of good companies will
bounce back in time when a company overcomes a short-term obstacle and
investors ultimately recognize fair value. But this recognition may
take time or, in some instances, may never materialize.
Comparative Analysis - Investors
looking to avoid a value mistake may want to compare a stock's recent
trend with a peer group or with a broad market index. Here are some
other suggestions:
- Consider whether a stock has dropped more than the average stock in the S&P 500 during the past three months.
- Examine whether earnings estimates are being revised downward faster when compared with a peer group.
- Compare analyst estimates of future profit
margins to historical margins. If expectations for future profits
exceed past earnings, the company could end up disappointing investors.
Another
technique for potentially avoiding a value mistake is to look for
stocks paying dividends. Dividends historically have been seen as a
sign of management's confidence in healthy cash flow over the long
term, as well as an indicator that management's interests align with
shareholders. Even if a stock price languishes for a period of time, a
dividend provides an investor with something in the way of a return.
Note that dividends are not guaranteed, and a company can reduce or
eliminate a dividend at any time.
Perhaps
the best strategy for avoiding a value mistake is to combine value
stocks with growth stocks, international stocks, and other types of
equities to pursue diversification. Although there are no guarantees,
owning some of each could help to balance an equity portfolio over the
long term.1
Source/Disclaimer:
1 Foreign investments involve greater risks than U.S. investments,
including political and economic risks and the risk of currency
fluctuations, and may not be suitable for all investors. Investing in
stocks involves risks, including loss of principal.
December 2011 — This column was authored in cooperation with Financial Planning Association.
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