The biggest challenge with buying value stocks is determining when a stock is cheap. Many investors reason that if the stock is now less expensive than it used to be or less expensive than the competition, it's bound to outperform. But often, relative bargains are simply a trap.
History is bunk
A stock can be relatively cheap compared with its historical prices but still be a terrible investment. Take Nortel Networks
Even a fairly valued stock that falls dramatically may not be a good investment if the outlook for a company has significantly deteriorated. Take Novastar Financial
My stock is bigger than your stock
It is also a mistake to believe that a stock is cheap simply because it's trading at a lower multiple than its peers. Back in early 2000, Nokia
Or consider the more recent examples of Yahoo!
As a value investor, you have to look beyond relative value and take into account the growth opportunities and competitive position of the businesses as well. That's because you're buying value stocks to ensure that you have a margin of safety and a bigger upside on your investment. An overpriced stock -- even if it's a relative bargain -- will not offer either one of these benefits. Cheapness is determined not by a simple P/E ratio, but rather by analysis of the businesses in question.
The Foolish bottom line
Now, this isn't to say that relative valuation is always a bad idea, but rather that you can't just mindlessly buy relative bargains. Relative valuation can be an indicator of value, but it should go hand-in-hand with other valuation techniques and solid understanding of the fundamentals of the business.
If you're looking for help identifying stocks that are huge absolute values -- businesses trading at prices substantially less than their fair value -- our Inside Value newsletter can help. Each month, we identify and explain two promising value investments for our subscribers. And you're in luck, because this afternoon is when we release our two brand-new picks. You can read them when they're released at 4 p.m. ET by joining our service free for 30 days. Just click here for more information. There is no obligation to subscribe.
Fool contributor Richard Gibbons has a relatively weak stomach and a relatively strong odor. He does not have a position any of the stocks discussed in this article. Yahoo! is a Motley Fool Stock Advisor recommendation. The Motley Fool has a hauntingly familiar disclosure policy.