Where's the value found?
Lately, I’ve noticed myself getting too caught up in the indexes and stocks making dramatic moves, like MicroStrategy, for instance. I watch the market’s frenzy with a mix of wonder and disbelief.
Despite these wild fluctuations—sometimes foreseeable—, I stick to my method: hunting for undervalued stocks.
No matter the strategy you use for investment decisions, a rising market always comes with rising risks. As loyal readers know, I like to keep things simple. One straightforward way to look at stock prices is as follows:
When stock prices rise, risk increases.
When stock prices fall, risk decreases.
This assumes that all fundamentals remain unchanged. While that’s not always the case, this principle generally holds true on a daily basis.
Where’s the Value?
If rising prices mean higher risk, it makes sense to look for falling prices to reduce investment risk. Value investors often focus on companies trading near their 52-week lows.
While this can generate an interesting list, I usually prefer other approaches. For instance, I often review lists of stocks that have fallen the most over the past month, quarter, or year. Thanks to modern stock screeners, finding this information has become much easier.
Momentum vs. the Long Term
Momentum is a powerful force: cheaper stocks often become even cheaper in the short term. However, I’ve learned that while short-term momentum (six months to a year) tends to dominate, over the long term, mean reversion usually prevails—especially with negative momentum.
Looking at these lists now, you’ll find many automakers, suppliers, and industrial companies that have dropped 50% to 70% in the past 12 months.
Risk Management Starts with the Balance Sheet
As a Graham & Dodd investor, I start with the balance sheet. One of my favorite investors, Walter Schloss, did the same. The reason isn’t that the balance sheet offers the best insight into potential returns—it doesn’t. But it does provide a clearer picture of risk.
What I’ve learned from Schloss (sadly, not directly) is that one of the best ways to reduce risk is to invest in companies with low debt and strong liquidity. This is particularly relevant for stocks found on low-price lists. Many of these companies face structural problems and risk bankruptcy without sufficient capital.
When analyzing such companies, it’s essential to look for:
Low debt relative to equity.
A high current ratio (current assets divided by short-term liabilities) shows how well a company can meet its short-term obligations.
Contrarian Thinking: Herd Behavior Leads to Mistakes
When the majority of investors avoid a stock or sector, these stocks are often mispriced. A well-selected portfolio can outperform the market—some stocks will drop, but others will rise.
The logic here is that bad news is already priced in. If the negative expectations come true, it’s no surprise, so losses are relatively limited. But if there’s positive news—improved operations, sector recovery, or an unexpected boost—the upside potential can be enormous.
This allows you to build a portfolio where the risk-return ratio works in your favor. Benjamin Graham once compared this to the insurance industry: of 1,000 policies sold, some will result in losses, but with proper management, the insurer knows the overall portfolio will be profitable.
The same applies to investing: some stocks will disappoint, but the winners will more than make up for the losses. Walter Schloss followed this strategy and achieved nearly 21% annual returns over more than 40 years.
Graham/Schloss vs. Buffett: Value or Quality?
Graham, Schloss, and the younger Warren Buffett managed their portfolios quite differently from today’s quality-focused Buffett, who was heavily influenced by Charlie Munger. The key difference lies in their focus: value investors versus quality investors.
Graham and Schloss: Diversification with stocks that weren’t always the best companies.
Buffett: Investing in fewer, high-quality companies with sustainable competitive advantages.
This difference also shapes how they define their margin of safety:
Graham and Schloss: Buy cheap stocks and spread risk across a broad portfolio.
Buffett: Buy fewer stocks but focus on high-quality businesses to ensure the margin of safety.
Many of the stocks I’m currently considering or holding would appeal to the younger Buffett but less so to the current, quality-focused version. Think of companies trading well below book value but operating in challenging sectors like construction or the automotive industry.
Graham, Schloss, the young Buffett, and Templeton didn’t buy such stocks because they loved these sectors—they didn’t. They bought them because they were cheap. Their strategy was all about chances.