VALUATION begins and ends with profits. Just about everybody agrees with that. The faster a company's earnings grow and the more reliable they are, the more investors will pay for its stock (See How Much Is This Stock Worth? for more.)
When it comes to strategy, though, Wall Street is decidedly less single-minded. Everybody wants to buy low and sell high. But how low is low and how high is high?
Generally, the Street is torn between two camps: Growth and Value. Growth investors believe in buying stocks with above-average earnings growth no matter what the price. Value investors look exclusively for "bargains," or stocks that are trading at a discount to their usual valuation.
Which strategy makes the most sense? There's no right answer -- people make money both ways. But there are several reasons why we think a value approach is superior, particularly for long-term investors.
First of all, history shows that when you buy stocks that are cheap relative to others (more on that in the next lecture), your returns benefit over time. It's easy to see why. Suppose you're looking at a stock that typically trades in a P/E range between 20 and 30. If you buy it at 20 and let it move up to 29 before you sell, you clearly see a bigger profit than if you buy at 27, let it move up to 30, and then sell when it starts to head back down. Even if you ignore short-term cycles and hold it for the long term, you're better off if you buy the stock as cheaply as possible in the first place.
The danger, of course, is that the your company has problems that justify its low valuation. What if it stays at 20 and holds your money hostage. That's something growth investors rarely have to worry about. But if you choose companies that are in good financial shape and there's an explanation for why their stock is selling cheap, chances are the shares will resume their growth eventually. And if they don't budge off the bottom, you really haven't lost much. That isn't true if you mistime your exit from a volatile high-multiple stock and get caught in a downdraft.
The ideal stock, of course, will have a low P/E and a rapid rate of earnings growth. Unfortunately, such situations are rare since any whiff of growth attracts investors and boosts the price. But that doesn't mean there aren't times when a stock like Microsoft or Cisco Systems is selling at a much lower price than it should. You just have to be ready to pounce.
And that's really the point. Above all else, we believe investors should be opportunistic as they set out to build a balanced portfolio of stocks. You shouldn't miss the opportunity to own big, important companies like Microsoft or Wal-Mart. But you shouldn't pay too much for them either. The key -- and the subject of the next lecture -- is learning how to tell when it's time to buy.