Value Investing: How To Buy Cheap And Reap The Rewards


By Benzinga

Making precise market-timing calls on the stock market and trading them successfully is something that very few people have been able to do. There is a reason that great traders are often accorded rock star status.

The average trader faces the same odds against him being a long-term success as every kid who picked up a guitar and drove their parents crazy for a few years trying to learn the first chords of “Smoke On The Water.” Making precise timing calls and executing them successfully is a very rare skill in the financial world. Most individual investors would be better served taking a longer-term approach by focusing on cheap stocks.

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The very best results are achieved by those who buy when stocks are cheaply valued, out of favor, selling when conditions are closer to the euphoria and overvalued conditions that are usually present in elderly bull markets. The problem we have as individuals is determining when it is time to be aggressive buyer and when we should be lightening up the load and conserving cash in our portfolios. Fortunately, there are a few big picture indicators and measurements that can help us determine when it’s the buying season and when it is time to sell.

Helping Out

There are a few measurements that can help us determine the level of under and overvaluation that exists in the stock market. None of them are precise measurements, but can act as a barometer to warn of potentially stormy weather on a sunny day or as an indication that the storm is ending soon.

One of the better ones is the ratio of market capitalization to total gross national product (GNP) is favored by none other than the Oracle of Omaha. Warren Buffett said in an interview back in 2001 with Fortune magazine that, “The market value of all publicly traded securities as a percentage of the country’s business, that is, as a percentage of GNP, has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.”

Right now, while far below the monster reading recorded back at the height of the internet bubble, the ratio stands at around 115 percent similar to market tops in 2007.

Related: A Better Way To Get Into The Private Equity Mindset

Q Ratio

Another measure that has a great deal of validity when measuring the market from a long term perspective is the Q Ratio. This measures the market in terms of asset value and compares the market value and replacement value of the same physical asset.

Mark Spitznagel of Universa Investments has published several studies of the Q ratio and subsequent market performance. This is significant, as he correctly predicted the 2000 and 2008 market collapses using this indicator as his guide. He found that when stocks are overvalued on aggregate (as identified by the Q ratio), their returns have been lower, with 99 percent confidence, than when they are less overvalued, not to mention undervalued.

Right now, the Q Ratio stands at 1.07, which is the highest since the internet bubble years of 1999.

The Value Line Median Appreciation Potential (MAP)

The MAP is reported every week by the research service. It indicates the gain expected by the service for the median stock in their universe over the next three to five years.

Dan Seiver of Cal-Poly studied this index as an indication of stock market value and found that it was predictive. When the reading was over 100 percent, it was a great time to buy stocks; when it was below 55 percent, it was time to consider selling shares. The index reading today stands of just 35 percent.

These types of indicator are much more big picture than short-term signals. Stocks will probably keep going up after these numbers are indicating it’s a good time to consider selling, and the market is highly likely to go lower for a time after they reach levels that indicate favorable buying conditions.

However, for a long-term investor buying safe and cheap when these indicators say buy and starting to sell when they reach historically high levels can lead to market beating returns. This is achieved with far less risk than traditional buy and hold portfolios or frustrating and expensive attempts to trade the market in the short term.

(c) 2014 Benzinga does not provide investment advice. All rights reserved.

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