There’s nothing more beguiling than a cheap looking share. And in times such as these, where we have seen prices of shares on our watch list rise well above where we hoped to achieve a favourable entry point, the allure of such apparent bargains becomes more powerful. That is human nature I suppose. If I went into the supermarket tomorrow to find that my favourite bottles of wine had all doubled in price, I’d be far more tempted to buy one of those cheaper ones that nobody wants. But if temptation got the better of me and I’d spat out the first mouthful before pouring the rest away, I’d have received no value and be pretty annoyed that I let my standards slip. Perhaps it wasn’t such a great bargain after all.
I think this is where the use of the word “cheap” can cause problems when it comes to investing, although we are all guilty of using it. It perhaps wouldn’t be so bad if we all used the term to express our view that a share is selling at a substantial discount to what we believe is its intrinsic value, but instead we usually see it applied to basic valuation metrics such as the P/E ratio or yield: referring to apparent “cheapness” where they are at a discount to the market for example. What’s worse is that we often compound the problem by comparing such ratios between companies with very different business models.
The use of such misleading labels only serves to create the false notion that we must be getting a bargain for such shares. But, like the bottle of wine, we need to ensure that it isn’t deservedly cheap otherwise the bargain is illusory.
Although many investors will concede that this is an obvious point to make, in my experience most of them will focus more on cheapness than “quality”. Whilst paying a bargain price for a share is of great importance for value investors with a shorter term horizon wishing to realise capital gains, the long term buy and hold investor will likely achieve better results by paying a fair price for a share of a good business that will compound in value over time.
What is quality?
This is a question which tends to cause some disagreement between value investors, some of whom disagree that such thing exists at all, perhaps concerned that it…
