The value investor should make an investment only after very careful consideration of the value of the stock. This needs time and patient research until the point is reached where the investor is satisfied that the stock is a bargain and the investment should be carried out. Having gone to all this trouble to pick the right value stock, the investor may be tempted to sit back and consider this a job well done. This attitude would be a mistake. Each investment must be monitored regularly to ensure that the reasons why the investment was made are still valid.
After the investor has purchased the stock the economic conditions may change and render the stock less attractive. The investor may find that a mistake was made in calculating the intrinsic value or that some of the assumptions made about the future of the enterprise or the industrial sector in which it operates have turned out to be incorrect. The investor should have a plan for monitoring each investment and should have an exit strategy in place.
Value Partners Asia ex-Japan Equity Fund has delivered a 60.7% return since its inception three years ago. In comparison, the MSCI All Counties Asia (ex-Japan) index has returned just 34% over the same period. The fund, which targets what it calls the best-in-class companies in "growth-like" areas of the market, such as information technology and Read More
Mistakes in evaluating the stock
The value investor attempts to find a stock whose market value is well below the intrinsic value. In computing this difference many estimates and assumptions need to be made. The result may be that the margin of safety allowed by the investor may later be shown to be insufficient. The market value may be much nearer to the intrinsic value than expected or even above it.
The assumptions made by the investor in evaluating the stock may prove to be incorrect. The investor may have failed to see certain trends or may have assumed that the existing management will remain in place for a long time. Unexpected changes in the management may lead to a different business strategy. The trends in the industrial sector may change as a result of the introduction of new technology. A competitor may unexpectedly acquire a powerful competitive advantage and eat away at the enterprise’s market share. Gradual changes in the economic environment in which the industry operates, affecting demand for the products, could cause a fall in earnings over time.
The value investor should monitor the stock regularly using the same type of tests as were used originally to pick the value stock. The industry or management changes may have affected the intrinsic value and the investment may look much less of a bargain than before. A decision may need to be made on retaining the investment or selling the stock. In some cases the stock may appear more of a bargain than before and further purchases could be made.
The investor is also likely to keep a watch list of stocks that could become potential value stocks if the market price falls further. These can continue to be monitored at regular intervals. An investment could be made when the stock fulfills the relevant criteria.
A different assessment of the stock as a result of regular monitoring might show the value investor that a decision has to be made on whether to keep or sell the stock. The investor should be clear in advance that when certain criteria are no longer met the stock should be sold. If the investor sets up an exit strategy at the time of buying the stock and sticks to this exit strategy through the monitoring process then a decision to sell can be made on the basis of reason rather than emotion.
The exit strategy may come into operation when investor calculates that the intrinsic value of the stock is no longer at the level originally calculated and that, compared to the current market price, there is no margin of safety. There is no longer any reason to keep the stock. Each individual investor may specify certain criteria on the basis of which the decision to sell will be made. The important point for the value investor is that the decision is based on reasoned analysis. If the investor has a disciplined approach to monitoring investments decisions on buying or selling will be done by the head and not the heart.