When is a bargain not a bargain?

Once you have assembled a list of likely bargain candidates, you have to determine

• which to put your money into and 
• which to avoid and move on.

Many of the companies in your initial list are cheap for a reason;; they have fundamental problems that make them decidedly not valuable.

On the list of value candidates whose stock price had fallen significantly in the past were Enron, Global Crossing, MCI, US Airlines and Pacific Gas and Electric.   These companies ended up filing for bankruptcy and shareholders lost a significant portion of their investment if not all their money.


To achieve your wealth-building goals, you have to determine 

• why a company's shares are cheap and 
• which ones have little chance of recovery.

1.  Too much debt

The first and most toxic reason that stocks become cheap is too much debt.  In good times, companies with decent cash flow may borrow large amounts of money on the theory that if they continue to grow, they can meet the interest and principal payments in the future.  UNFORTUNATELY, the future is unknowable, and companies with with too much debt have a much smaller chance of surviving an economic downturn.  

Ben Graham explained that he used a simple yardstick to measure health.  A company should own twice as much as it owes.  This philosophy can help you avoid companies that owe too much to survive.


2.  Company falls short of analysts' earnings estimates.

Analysts seem to be more focused on short-term earnings gains than future long-term success   These quarterly or yearly earnings estimates have been proven to be notoriously unreliable.  Routinely, large and good companies get pushed to new stock price lows because they missed the estimates of the thundering herd of Wall Street  Missing earnings is not fatal, and it tends to create opportunity for the value buyer; if the trend continues, however, the shares will likely continue to fall.


3.  Cyclical stocks

Some cyclical stocks may show up on your list of potential bargains.  They are highly dependent on how the economy is doing.  Industries like automobiles, large appliances, steel and construction will experience lean times and stock prices are likely to reflect this fact.   Although we have had recessions of varying lengths and depths, the economies of industrialised nations have always rebounded.  It is important to note that in the bad times, cyclical companies with heavy debt loads may well face insurmountable problems.  Adhering to a policy of avoiding overly leveraged companies will serve you well.


4.  Labour contracts

Stocks may also fall because of labour contracts.  During good times, some companies and industries cave into labour union demands that were affordable at the time.  Little did they realize that they were mortgaging their future.  As new competition unburdened by costly labour contracts enters their industries, their profits disappear.  In many cases, the unions have been unwilling to grant concessions.   It is never easy to give back something you have, even if not doing so threatens the very existence of the company you work for.  Although holding on to expensive contracts may or may not benefit management or the unions in the long run, the one person that most assuredly does not benefit is the stockholder.  

Many large corporations (old-line industrial companies) have pension liabilities - benefits promised to workers - that they simply will be unable to pay  Generally speaking, if a company has excessive pension liabilities or there exists a contentious labour environment, it may be best to put these companies' shares on the no-thank-you list.


5.  Increased competition

Highly profitable industries attract new competition.  The most serious form of this comes when an industry in one country has high-priced labour or expensive regulatory rules.  Other nations unburdened by such costs can often produce and export the same goods cheaper.  Think China.  Throughout the world, countries have seen foreign manufacturers of automobiles, appliances and other goods make significant inroads into their market.  If a company is facing strong competition from a more efficient competitor with lower costs, it is perhaps best to utter those comforting words "no, thank you" and move on to the next candidate.


6.  Obsolescence

Obsolescence is another potentially fatal cause for falling prices.

Although the last large scale manufacturer of buggy whips or hand-cranked automobile starters made a very fine product, there was simply no longer a need for its product.  There may be some small demand for these products, but a company that depended on them for most of its sales would soon be out of business

Consider the field of technology.  The rate of "creative destruction" has never been faster.  Newer and better products turn up every day making the older products obsolete  The new products are a boon to the consumer but the bane of the legacy company.  

Today, we can go online and order any movie from NetFlicks and never have to leave the comfort of your own home.  For this reason, you should avoid companies that are subject to technological obsolescence.  The world is simply changing too fast to depend on products and services that someone else can deliver better and for less cost.  Avoid these.


7.  Corporate or accounting frauds

These are perhaps one of the most dangerous reasons for share price drops is corporate or accounting fraud.

Although these crimes against investors are the exception and not the rule, and most CEOs are dedicated leaders who care about their companies and their shareholders, fraud does happen.  In recent years, the world has experienced some of the largest cases in history, Enron, Parmalat, Tyco, WorldCom and others.  Regulators have since done much to help prevent future occurrences but there will always be some form of shenanigans.

Criminals exist in every walk of life.  There is almost no way to uncover fraud before it becomes public.  By the time it is discovered, it is too late  The best the investor can do is to steer clear of financial reports that seem overly complicated.


8.  Companies you do not understand or are not comfortable with

If there is something you do not understand or are not comfortable with, put these in the no-thank-you pile.   If a company has too many problems - too much debt, union and pension problems, stiff foreign competition, they too go to the no-thank-you pile.  You have the luxury of filling your portfolio with stocks you are comfortable with and want to own for the long term wealth building it offers.



Summary

You should approach your list of investment candidates with a healthy dose of scepticism.

You should stick to businesses you understand and for which there is an ongoing need (products or services).

You should also like food, beverage, and consumer staples like detergents, toothpaste, pens, and pencils - the stuff you consume on a daily basis. Many of these products engender brand loyalty that keeps the same product day after day, week after week.  We are all creatures of habit, and we will usually repeat our consumer preference when we go shopping.

Your best friend in the whole investing world is your no-thank-you pile.  Knowing your no-thank-you pile gives you the value investing opportunities to build your wealth building portfolio.

Companies to avoid

Avoid these companies described below.  That is not to say there are no good investments to be found, but the chances of this happening are much lower, increasing the risk of us running into a dud.

Some examples are as follows

1,  Companies with an excessive growth focus.

Growth is good and beneficial if it is the result of a job well done, which generates resources over time which are reinvested increasing the strength of the company, but this tends to be more the exception than the rule.  The obsession with high growth targets is extremely dangerous.   Once again there is an agency problem:  who are the company's management working for - themselves or the shareholders?  Growth is only a good thing if it is healthy.


2.  Companies which are constantly acquiring other companies.

If the acquisition is not focused on increasing the competitive advantage of the main business, it can end up becoming a rueful folly, or what Peter Lynch calls 'diworsification', diversifying to deteriorate.
Growth ca also ring with it two other problems:  first, more complex accounting can more easily conceal problems; and second, each acquisition eds up becoming bigger than the last, increasing the price and therefore the level of risk.

It is worth reiterating ow detrimental it can be when some mangers feel the pressure or the desire - after selling a substantial part of the company - to buy another of a similar size, instead of returning the money to the shareholders.


3.  Initial public offerings

According to a study, companies who float on the stock market via an IPO post 3% lower returns than similar companies after 5 years. 

There is a simple reason for this:  there are clear asymmetries in the information available to the seller and what we know as purchasers.  The seller has been involved with the company for years and abruptly decides to sell at a time and price of their choosing.  The transaction is so one[sided that there can only be one winner.

4.  Businesses which are still in their infancy.

Old age is an asset: the longer the company has been going, the longer it will last in the future.  A recent study shows that there is a positive correlation between the age of a company and its stock market returns.  It takes a  certain amount of time for a business to get on to a stable footing, depending on the level of demand and competition.  Until this happens, we are exposed to the high volatility inherent in any new business, with an uncertain final outcome.

5.  Businesses with opaque accounting.

Whenever there's significant potential for flexible accounting, being ale to trust in the honesty of the managers and/or owners is essential.

Long-term contractors in the construction sector, or in infrastructure or engineering projects, are examples where there is scope for flexible accounting, with latitude to delay accounting for payments or being forward income.

We can include banks and insurance companies in this category, where the margin for accounting flexibility is very significant and it is relatively simple to cover up a problem for a while, compounded by having highly leveraged balance sheets.

Prior to investing in these types of businesses, it is absolutely imperative to be certain we can trust the mangers or shareholders.  No one forces us to invest in them, so the burden of proof is on the company.

6.  Companies with key employees.

These are companies where the employees effectively control the business, but without being shareholders (the latter could even be positive).  For example,, many service companies reportedly have very high returns on capital, ut only because capital isn't necessary:  investment banks, law firms, some fund managers, consultancy companies, head-hunters, etc.

The creation of value in these businesses benefits these key employees, while the opportunities for external shareholders to earn attractive returns are limited, despite supposedly high returns on capital employed.

7.  Highly indebted companies.

"First give me back the capital, then return something on it."

Buffett also remarks that the first rule of investing is not losing money and the second and the third ..

Excess debt is one of the main reasons why investments lose value.  We do not need to flee from debt at every opportunity, when it is well used it can be very helpful, but it should not have much weight in a diversified portfolio. 

By contrast, markets don;t particularly like companies to hold cash rightly fearing that such financial well-being might lead to bad investment decisions. 

{To sleep well and to make the most of incorrect market valuation, ensure that over half of the companies in the portfolio have ample cash.  Do not be worried about excess cash, provided that capital is reliably allocated.}

8.  Sectors which are stagnant or experiencing falling sales.  

While it is not worth paying over the top for growth, on the flipside, falling sales can be very negative.  Quite often these companies can cross our radar because of the low prices at which they are trading but over the long term, time is not on our side with them..  Sometimes sales will recover but mostly the opportunity cost is to high, given that the situation can persist for sometime.

9.  Expensive stocks.

It is obvious but worth spelling out.  In reality, expensive companies have historically obtained the worst results, because good expectations are already priced in and because it is less likely that the price will jump from - say- a P.E ratio of 16 to 21 than from 9 to 14.

That is not to say that good results cannot be obtained from buying the above types of stocks, but it is an additional hurdle which some may preferred to avoid.


The above are not the only examples of companies to avoid,, but they are a good starting point.

Bargains in Bonds and Preferred Stocks: How to profit from these bargains?

Bargains in Bonds and Preferred Stocks

The field of bargain issues extends to bonds and preferred stocks which sell at large discounts from the amount of their claim.

It is far from true that every low-priced senior issue is a bargain (there are default risks on non payment of interest and/or  principals).

The inexpert investor is well advised to eschew or stay away these completely, for they can easily burn his fingers.

There is an underlying tendency for market declines in this field to be overdone; consequently the group as a whole offers an especially rewarding invitation to careful and courageous analysis.

In the decade ending in 1948, the billion-dollar group of defaulted railroad bonds presented numerous and spectacular opportunities in this area.

Warren Buffett: "Avoid these bargains."

Bargain Price

In the final chapter of The Intelligent Investor, Ben Graham wrote:  "Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Many years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses.

    

In the summer of 1979, when equities looked cheap to me, I wrote a Forbes article entitled "You pay a very high price in the stock market for a cheery consensus." At that time skepticism and disappointment prevailed, and my point was that investors should be glad of the fact, since pessimism drives down prices to truly attractive levels. Now, however, we have a very cheery consensus. That does not necessarily mean this is the wrong time to buy stocks: Corporate America is now earning far more money than it was just a few years ago, and in the presence of lower interest rates, every dollar of earnings becomes more valuable. Today's price levels, though, have materially eroded the "margin of safety" that Ben Graham identified as the cornerstone of intelligent investing.

     My first mistake was in buying control of Berkshire. Though I knew its business - textile manufacturing - to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965, I was becoming aware that the strategy was not ideal.

     If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit.  Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original "bargain" price probably will not turn out to be such a steal after all.

     I could give you other personal examples of "bargain-purchase" folly but I'm sure you get the picture:  It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. Now, when buying companies or common stocks, we look for first-class businesses, with enduring competitive advantages, accompanied by first-class managements.

     In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen.  Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return.

The investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost.  Therefore, remember that time is the friend of the wonderful business, and the enemy of the mediocre.

How exactly do we know the value of the asset? Trust Your Instincts (Common Sense).

"Price is what you pay. Value is what you get."

Leave it to Warren Buffett to sum up the dilemma in a single pithy dichotomy. 


The world's greatest investor reminds us that the value of an asset -- whether a car, a house, or a stock -- does not necessarily have any relation to the price we pay to own it.   


Buffett's observation still leaves us with one crucial question: How exactly do we know the value of the asset?

• Benjamin Graham's classic non-answer stated that an asset is worth at least its book value, so you're safe if you pay less than that. 
• There's also a logically impeccable but not very helpful adage that "an asset is worth whatever someone will pay for it." 
• And Professor Aswath Damodaran offers this math-intensive solution: "The value of equity is obtained by discounting expected [residual] cash flows."

A more honest answer, though, is that we simply never know how much anything is worth. Not exactly, at least.



Yet in real life, we don't allow the lack of an exact answer to stop us from buying. 

• Humans need shelter, so we buy a house when the price seems fair. 
• We need cars, so we work from sticker prices and the Kelly Blue Book to pick an acceptable price for those, too.

The same goes for stocks. We shouldn't "measure with a micrometer, mark it off with chalk, then cut it with an axe." 

• We make our best guess at a fair price (intrinsic value). 
• We try to buy for significantly less (margin of safety) than our estimation. 

If we guess right more often than wrong, we make money. But where do we start?








Start with common sense

Look in places where you're more likely than not to find bargains:

Low prices: Stocks hitting the new 52-week-lows list may be "down for a reason." Still, a stock selling cheaper today than it's sold any time for the past year is more likely a good bargain than a stock selling for more than it's ever fetched before. 

Read the paper: Newspaper headlines offer another superb place to seek bargains. Remember how oil was selling for $150 a barrel last July? Remember how a few months later, it sold for less than $40? How much do you want to bet that the intrinsic values of oil majors such as ExxonMobil (NYSE: XOM) or Chevron (NYSE: CVX) tracked those movements exactly? (Hint: They didn't.) Somewhere between $40 and $150, there was value to be had in the oil majors.

Cheap valuations: Another great way to scan for bargains is to run a stock screener every once in a while. I like to look for stocks that trade for low price-to-free cash flow multiples, exhibit strong growth, and have low debt. 


The key point I want you to take away from all this is simple: Trust your instincts.

• When Zillow tells you your house has doubled in value, treat that "Zestimate" with some skepticism. 
• When Suntech Power (NYSE: STP) doubles in price on announcements of industry subsidies from China, be wary. 
• On the other hand, when stocks that have little to do with the financial crisis drop 50% in the space of a year, when stock prices don't match the news they're supposed to reflect, or when you stumble across a stock with a price that looks cheap, you might just have found a bargain.

http://www.fool.com/investing/value/2009/04/25/how-i-lost-100000-without-even-trying.aspx

There is no price low enough to make a poor quality company a good investment.

If you're in doubt about the quality of a company as an investment, abandon the study and look for another candidate.

When in doubt, throw it out.

Abandon your study and go on to another.  There is no price low enough to make a poor quality company a good investment.


The worse a company performs, the better value its stock will appear to be.

Because declining fundamentals will prompt a company's shareholders to sell, the price will decline.  This will cause all the value indicators to show that the price has become a bargain.  It's not!

When the stock is selling at a price below that for which it has customarily sold, you will want to check to see why - what current investors know that you don't.

Margin of Safety Concept in Undervalued or Bargain Securities

The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. 

• We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. 
• That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck. 
• The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments. 
• For in most such cases he has no real enthusiasm about the company’s prospects.

True, if the prospects are definitely bad the investor will prefer to avoid the security no matter how low the price. 

But the field of undervalued issues is drawn from the many concerns—perhaps a majority of the total—for which the future appears neither distinctly promising nor distinctly unpromising. 

• If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results. 
• The margin of safety will then have served its proper purpose.

Ref:  The Intelligent Investors by Benjamin Graham

CHAPTER 20  “Margin of Safety” as the Central Concept of Investment





Also read:

• Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
• Margin of Safety Concept in Conventional and Unconventional Investments
• Margin of Safety Concept in Speculation and Investment
• Margin of Safety Concept in Diversification
• Margin of Safety Concept in Undervalued or Bargain Stocks
• Margin of Safety Concept in Growth Stocks
• Margin of Safety in Good-Quality and Low-Quality Stocks.
• Margin of Safety Concept in Common Stocks
• Margin of Safety Concept in Bonds and Preferred Stocks

Market Behaviour: Unjustifiable Pessimism - Time to Find Your Best Opportunities (Gems in the Rough)

You will find your best buys when the market is unjustifiably pessimistic about a sector.

It is in such situations that one can find incredible buys among the beaten-down stocks in the sector. You do have to be patient and hold on to the stocks for a while until the crowd realized its mistakes.

If you believe the market has beaten down this sector UNJUSTIFIABLY, start looking for good buys in this sector.

Do not look for the cheapest stock; instead find the stock of a company with financial results that meet your criteria and a solid management team (QVM).

Look at the new daily lows in the financial press. Find a stock that has been beaten down for two or three years and has already taken its big fall.

Research the candidates you've found. You'll find a lot of stocks that have been beaten down JUSTIFIABLY - just move on.

But start watching those gems in the rough as you research them further to determine whether they are a good buy for you.

Related topics:

Market Behaviour: The Least You Need to Know
Market Behaviour: Crowd Impacts on Stock Prices

Market Behaviour: Can You Beat the Market?
Market Behaviour: Bull Runs
Market Behaviour: Bear Stalls
Market Behaviour: Pendulum Swings (Volatility)
Market Behaviour: Irrational Exuberance
Market Behaviour: Unjustifiable Pessimism
Market Behaviour: Control Yourself (Patience)

Avoiding Bad Stock

Avoiding Bad Stock
Most investors often fall in the simple trap of believing someone who tells them that a particular stock represents the next winning bet. However, you should be very cautious when examining the possibility of investing in such a "promising" stock.

1.  An example of a great looking stock is the one that looks absolutely healthy from the outside, but it is usually hollow and unprofitable in its core. Most investors that are attracted by these shiny stocks eventually find out that the companies that have issued them are not profitable and financially sustainable. These stocks are easily forgotten after a short period of time.

2.  Another example of a bad stock is the one that is tied to the cycles of the business. This means that its price is very vulnerable to the changing cycles of the market. If you purchase the stock at a time when its price was high (due to high demand), you will soon end up with a worthless stock because of the changed cycle of the market.

3.  Sometimes a stock may be really very profitable and a viable investment. However, you have entered the game too late at a point where the market has increased the price of the stock to a high level. No matter how good the stock may be if you buy high you will soon feel the losses.

Making the Right Investment Decision
In order to make a successful investment decision you should first of all select a company that has a reliable business. Additionally, the company should prove that it has good prospects for success in terms of growth.

Second, you should be able to find a price that coincides with the current state of the company and its future position. You should make a reasonable evaluation in order to avoid paying more than the company is really worth.

In order to determine the current and future value of the company's stock, you can refer to one or several of the many formulas for this purpose. However, you should not fully rely on them and try to develop your common sense feelings in order to pick the stocks that best meet your financial goals.

When you start the stock selection process take your time. Don't be too impatient and if a stock doesn't look very viable don't invest in it. There are plenty of other opportunities in which you can invest your hard-earned money. Analyze all the alternative investments and select the one that best meets your needs and goals.

Remember that you should try to avoid the described above bad stocks, which only look profitable but are financially hollow. Additionally, the best way not to lose your money is to invest reasonably and cautiously by analyzing every opportunity before jumping into it.

http://www.stock-market-investors.com/stock-market-advices-and-tips/avoiding-bad-stock.html

Avoid These Investment 'Bargains'

Avoid These Investment 'Bargains'
When is "such a deal" not such a great buy?

Christine Benz is Morningstar's director of personal finance, editor of Morningstar PracticalFinance, and author of the Morningstar Guide to Mutual Funds. Meet Morningstar's other investing specialists.

Like an extended warranty on a new appliance or the time-share pitch that's disguised as a "free" vacation, savvy consumers know that some deals that look good on the surface aren't all they're cracked up to be once you read the fine print. The same holds true in the investing marketplace.

A few months back, I shared some tips for unearthing a few true investment bargains. But what about those investments that seem like good deals but really aren't? I'll discuss some of them in this week's article.

Looking for Securities with a Cheap Share Price

Ford Motor and General Motors are currently trading at less than $2 and $3 per share, respectively. When storied companies like these two hit the skids, it may look tempting to gobble up their stocks in a bet that they won't go belly-up. After all, you can buy 100 shares of each for less than $500, and if they do manage to resuscitate themselves, you could stand to gain big. That's not the stupidest idea in the world--as long as you go in knowing that it's similar to a bet you might place in Vegas. If your bet works out, you're buying the drinks. If not, you could lose everything, as equity shareholders would likely lose almost everything if the two companies ended up in bankruptcy court. (For proof that gambling on near-busted companies is a risky proposition, just talk to shareholders of Fannie Mae, Freddie Mac , and American International Group

Hoarding Company Stock--Even When You've Bought It at a Discount

Many publicly traded companies give their employees the opportunity to purchase their stock at a discount to the current share price. That might seem like a good deal. But loading up on your company's stock can be dangerous, particularly if you're hoarding shares of your company at the expense of building a well-diversified portfolio. Remember: You already have a lot tied up in your company's financial health and your industry via your job, so it's a mistake to compound that effect by socking a disproportionate share of your portfolio into your employer's stock. To be on the safe side, limit employer stock to no more than 5% of your overall portfolio.

Buying a Cheap Fund, Then Paying Commissions on Small Purchases

Exchange-traded funds have recently taken off in the marketplace, in part because their expenses can be lower than mutual funds that invest in the same basket of securities. Before you venture whole-hog into ETFs, however, take a step back and think about your investment style. If you plan to make a lump-sum investment and let it ride, the ETF may well be the best bet for you. However, that's not so if you trade frequently or make small purchases at regular intervals (and dollar-cost-averaging is a great way to invest, by the way). That's because you'll pay a commission to buy and sell ETFs, and those charges could quickly erode any cost savings versus plain-vanilla mutual funds. Ditto for paying a transaction fee to buy a fund in a mutual fund supermarket or buying a front-load fund, even if its expenses are low.

http://news.morningstar.com/articlenet/article.aspx?id=265385