Waiting For Fair Value

The “unfair value” should be taken as a base rate to which to compare the results of the “fair value” experiment.

Price-Based Value

Just to be on the safe side, I’ve also created a “price-based fair value” that has nothing to do with a company’s fundamentals.

I’ll set the “price-based fair value” of a stock as equal to the average of its price one month ago, three years ago, and five years ago, each adjusted for the growth of the sector it’s in since then. (I'm avoiding its price six months ago and one year ago because of the momentum factor.) Once again, we’ll buy stocks that are priced at one-third of their price-based fair value and sell them when their price is greater than their price-based fair value. This system disregards fundamentals altogether, simply buying stocks whose prices have fallen quite drastically.

Base Rate Results

If the success of the “fair value” measure were due entirely to mean regression, we should find the same success with the “unfair value” measure and the “price-based value” measure. But we do not. Below is a table comparing the results.

On every measure—CAGR, average holding period, return per stock, and percentage of stocks that rise to fair value—the original “fair value” method works far better than the “unfair value” or the “price-based value” method.

Conclusion

Value-based investing works. If you buy a stock at a deep discount to its fair value with a plan to sell it when its market value is more or less equal to its fair value, you will more likely than not end up realizing a decent profit. And your success will not be due solely to the law of mean regression. Stocks actually do have a fair value, no matter how difficult it might be to come up with a reasonable estimate of it. I won't say that value investing is the only method that works in the stock market. But as a portfolio management strategy, it's hard to beat buying at a discount and selling at full value.

A Few Stocks That Are Priced at a High Discount to Fair Value

Currently, quite a few stocks have market caps of less than a third of fair value, according to my seven-factor formula. But most of those are pretty tiny companies. Of companies in the S&P 1500, the following five are clearly underpriced: Brighthouse Financial (BHF), Endo (ENDP), Genworth Financial (GNW), H&R Block (HRB), and Seneca Foods (SENEA). That doesn't mean, however, that they are all good investments. If you're willing to go smaller, I would favor the following underpriced stocks for a sell-when-price-approaches-fair-value approach, though some of them may be difficult to buy in quantity due to limited liquidity: Big 5 Sporting Goods (BGFV), Ingles Markets (IMKTA), Medical Facilities (MFCSF), Mannatech (MTEX), and Summer Infant (SUMR).

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