I first published a modified version of this on my website sharechap.com
Value investing is at its core the marriage of a contrarian streak and a calculator.
- Seth Klarman
I have written a couple of blogs recently on how I pick shares. In the first part I looked at how gathering knowledge is a good thing to start with. In essence the better researched that you are, the better chance you have of success. As Peter Lynch put it memorably, If you don’t study any companies, you have the same success buying stocks as you do in a poker game if you bet without looking at your cards. In the second blog I began to look at value and how you can start to find those undervalued companies that have a decent chance of growing into their true value. You actually need to train yourself to think independently of the herd, because if everyone else had thought they were undervalued and had bought the stock, the price would be a lot higher than it is. This is why it pays to be a contrarian- to try and think differently to the herd. Joel Greenblatt sums this up well: You can’t be a good value investor without being an independent thinker – you’re seeing valuations that the market is not appreciating. But it’s critical that you understand why the market isn’t seeing the value you do. The back and forth that goes on in the investment process helps you get at that.
The telling phrase is it’s critical that you understand why the market isn’t seeing the value you do. Once you've cast your net and developed good knowledge of the kind of companies that you are looking for and seen that they are undervalued, you must ask the question why? If the Market is relatively efficient at pricing, then why is this stock so cheap?
As an aside, the basic yardstick of whether a share is cheap is the Profit to Earnings (P/E) ration. In other words, how many years will it take for you to get your money back on the price paid for a share in earnings (whether by dividends or cash reinvested back into the business). Generally a company on a P/E of less than 10 is considered to be cheap. If it's below five then…
