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When it comes to picking stocks, ‘quality score’ key

I have written many times about my concerns for the many investors that have been brainwashed by decades of Warren Buffett marketers telling them value investing is the be-all and end-all of making money in stocks.
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It is not so because company valuations alone have several weaknesses. Here are some of them:

■ Value is only one element of a share price. If the bank sector can fall 56 per cent in the GFC and then recover 152 per cent (to today) then clearly there are a lot of other things at work in the stockmarket beyond ”value” because the bank sector’s value didn’t change that much, in fact some might argue it hardly changed at all.

If share prices can move that much, inflict that much pain and present that much opportunity then there are clearly many forces at work on share prices besides value and if you want to exploit that then surely you should consider the other elements that drive a share price. Value is just one rather boring one. Consider how much more money you would make if you could time fear, greed, exuberance, stocks and the market. So shouldn’t you try?

■ Value is often presented as a ”quick shot” stock view akin to the ”Target Price” and ”Recommendation” that everyone seems to live off these days. These snapshots are not the whole story but are there to dumb down the research and fulfil the commercial requisite for analysts to deliver their advisers and clients ”conclusions without the need for brains” Just like the recommendation and target price, you can put too much value on a valuation if you don’t actually understand ”why?”

■ Value is calculated using consensus earnings forecasts. Need I say more? Forecasts change and the money is made not from the valuations that depend on them but on knowing when the forecasts are wrong and the valuations are wrong. The more accurate a valuation the more useless it is. What you really want is to know when everyone is wrong. That’s much more useful.

■ A single number no matter how accurate is of little use. This year’s number, be it a PE, yield or intrinsic value overlooks the more important information, the trend. Stating one data point is meaningless, it is the trend in intrinsic value, PE or ROE that is important. It is no good saying a stock is expensive on a 50 per cent premium to intrinsic value this year because if it is going to be at a 50 per cent discount in five years’ time it’s going up.

■ The required rate of return, a key component of the intrinsic value calculation, is a very rubbery assumption. The rubbery rate of return that goes into an intrinsic value calculation is often not disclosed, is subjective, but is the crucial assumption. You can’t gloss over it because it is the core of the valuation. Tiny movements in an RRR can make a huge, literally huge, difference to a value calculation. Move your RRR on BHP by 1 per cent and the ”value” of BHP changes $5 in both directions.

If RRR is such a questionable variable then clearly there is no such thing as an ”exact” valuation because you are dealing with opinion, not fact. The only way to bring order to value is to realise value calculations are a relative calculation between stocks rather than a definitive statement of fact or a statement of what the share price should be.

■ If your time frame is shorter than value investing allows and you are financially impatient (all of us) it is not about ”what” you buy, it is about ”when” you buy. Investors who sat through the 54.5 per cent fall in the market in the financial crisis being patient then needed to earn 113 per cent to get their money back. You can tell value investors to be patient but the truth is they should have done something about it.

In the end a more reliable, enduring, and desirous judgment on a stock in a safety-first investment environment would be a ”quality score”. The quality of a company’s earnings would be a much more useful piece of information than any valuation calculation no matter how ”exact” it looks, because there is no ”exact” valuation if it is based on unreliable forecasts and a rubbery rate of return.

Marcus Padley is a stockbroker and the author of sharemarket newsletter Marcus Today. This column should not be construed as personal investment advice.

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