Warning: Not All Value Stocks Are Created Equal
Now that you are well versed in value investing, the concept of margin of safety and how to do Intrinsic Value calculation work, you must be made aware of yet another very important point.
Not all value stocks with a substantial margin of safety are created equal.
For example, you will have companies selling well below their intrinsic value, but on their way to an eventual bankruptcy. You will have stocks selling very cheaply, but with no chance for a recovery any time soon. You will have stocks that seem to have a large margin of safety, yet it is an illusion. You might have stocks that offer very little margin of safety, yet they are about to take off to the upside like a rocket ship to the moon. You get the idea, many outcomes are possible here.
For my own purposes, I like separating Value Stocks into the following easy to remember categories…..
Dead Man Walking:
Initially these stocks might look like a great investment opportunity because they are selling as if they are about to go out of business and/or file for bankruptcy. On the surface they might be everything a good value investor is looking for. They might selling at a huge discount (80-90%) to their Intrinsic Value and you might be salivating over the opportunity, thinking about how much money you are going to make.
However, stop for a second and take a closer look. It is very rare that a market will present you with such wonderful buying opportunities. It will happen, but very seldom. Most likely than not, you are missing a vital piece of information that the market sees.
You will need to go back and figure out if this a great investment opportunity or if this is a company that will be filling for bankruptcy 6 months from now.
You will need to be very careful here. You will need to double down on your fundamental research and figure out what you are missing. I guarantee, you are missing something. Once you find that missing part you will need re-evaluate your fundamental research and Intrinsic Value calculation in order to determine if your original conclusion was right.
If you still believe in your original conclusion, I recommend that you buy as much as you can. You might have found one of those once in a life time opportunities.
At the same time, if the missing piece of information makes a significant negative impact on your previous work you would want to steer clear of this stock.
Conclusion: Typically you want to avoid these stocks like a plague. They are cheap for a reason. They will stay cheap for a long time or will soon file for bankruptcy. Yet, if your fundamental research continues to confirm your original research you might want to shift this stock into a Rocket Ship category.
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