Forming a portfolio , an investor is faced with a choice: “How to correctly distribute your capital?”. A huge amount of securities are traded on stock exchanges. The strategy of “buying in a growing market and selling in a bear” is as straightforward as it is not working a hundred years ago . The question of selecting promising “applicants” requires certain analytical studies.
Of course, the most attractive for traders are “growth stocks” . These are papers where the EPS rate is growing faster than the growth rate of the market as a whole . High yield attracts participants of exchange trades. Popular tools are actively used for speculative operations – this contributes to increased volatility with high demand and, as a result, rapid growth of quotations. There is always the temptation to buy when everyone is buying. If the company’s market capitalization is growing dynamically, the likelihood that such a trend will continue in the future is quite large. However, at the moment when the issuer gained popularity , the stock quotes of its securities may soar too high.. Investing in such instruments involves the risk of “buying too expensive . ” The increase in the gap between the intrinsic value of the asset and stock quotes leads to its “overvalued” .
Undervalued stocks have a potential attractiveness for long-term investments . These are the best candidates for inclusion in the portfolio.
Assets whose market capitalization at the time of appraisal is lower than their book value or objective, real value determined by experts are considered undervalued .
Stocks can be undervalued by the stock exchange for various reasons.
Papers of lesser-known companies than the “tops” included in the Dow , S & P or NASDAQ indices , or new issuers, often trade at prices close to their book value. This makes them a profitable acquisition. The purchase of such assets has a prospect – the market will ever appreciate them , which means that there is a potential possibility of making a profit in the future. At the same time, there is a risk that such securities may be traded at their minimum levels for a long time, not finding support from the stock market, some of them may disappear altogether from stock trading without fulfilling the listing conditions.
First-tier stocks , even in a growing market, may be undervalued due to a short-term decline in their market quotes. This may be cyclical in nature or due to the influence of short-term factors of a non-fundamental nature. Buy these assets “at a discount” – a great success.
Use of cost ratios
Investors use P / E ratios – the ratio between market price and earnings (market capitalization / net profit or market price of one common share / net profit per share), P / B – the ratio of market price and book value of shares to determine undervalued stocks. For long-term investments, “applicants” with low multiples are most suitable.
The majority of “growth stocks” are characterized by a high P / E ratio . For inclusion in the portfolio, you should select the instruments from which this indicator does not exceed 20. A low value of the P / E ratio indicates an undervaluation of assets.
When the level of this indicator increases significantly compared with the average value, this means that the growth rate of market capitalization is much higher than the growth rate of profit indicators and it makes sense to pay attention to the tools that are less popular at the moment, but with a reasonable “Price to EPS” ratio . Studies have shown that stocks with a low value of the P / E multiplier showed a higher yield in the long term than securities with a high value of this indicator.
The value of the coefficient R / V optimally should not exceed 1.5 . It is very important for an investor to determine the objective value of the paper in order to buy when market quotes are equal or lower than the real value and sell when the price is much higher.
By itself, the undervaluation of securities is not the only and sufficient selection criterion for the formation of a portfolio. To invest in an absolutely unpromising business, only because the market objectively assesses its failure – a meaningless undertaking. Therefore, along with popular multipliers, it is necessary to explore other important factors and circumstances.
One of the founders of a systematic investment approach is Benjamin Graham . He expounded his theory in the books “Analysis of Securities” and “Reasonable Investor” . Summarizing, we can say that Graham considered the paper for investment in terms of the following criteria:
– business reliability – a stable financial condition (the current liquidity ratio is equal to or more than 2), no losses for ten years, profit growth (at least one third in a ten-year period);
– Mandatory positive history of dividend income over a long period(recommended for at least 20 years);
– low value of P / E multipliers (less than 15) and P / B (less than 1.5).
Graham’s approaches were used, adapted to changing market conditions, and developed by his students and followers — Warren Buffett, Joel Greenblatt, John Neff, John Templeton, Phil Carret .