Few strategies make more sense than value investing. The idea that you should seek to pay less than the intrinsic value of a given stock seems like an obvious way to win at investing, as even share-price discounts from an irrational market should eventually correct themselves. But if you want to use value investing in 2014 to produce big profits, you'll need to avoid these three common mistakes.
1. Looking at a stock's raw share price
Many beginning value investors look at a stock's price as being indicative of its value. They'll consider companies with shares for $5 or less to be "cheap" and therefore solid value candidates. Stocks with share prices measured in the hundreds or thousands of dollars, on the other hand, look "expensive" -- and therefore not worthy of notice.
But share price has little to do with value. For instance, MasterCard (NYSE:MA) announced earlier this week that it will split its shares 10-for-1 in early January 2014, turning its $700 share price into a $70 share price. But that doesn't represent a 90%-off sale going for value investors in 2014, as the company will now have 10 times as many shares outstanding. Similarly, Alcoa (NYSE:AA) has a share price of just more than $9, but it's a member of the S&P 500 Index with a market capitalization of more than $10 billion, dwarfing thousands of stocks with much higher per-share prices.
2. Paying too much attention to earnings multiples
Even expert value investors often focus only on a stock's price-to-earnings ratio in assessing value. That often leads them to stocks with poor growth prospects, including perpetual slow-growers and cyclical companies facing downturns. Those stocks won't always be your best prospects.
For instance, in June, gold-mining giant Goldcorp (NYSE:GG) traded at just more than 12 times trailing earnings, marking its lowest valuation since the financial crisis. For value investors who merely looked at trailing earnings, the plunge seemed like a buying opportunity. But the drop in gold prices that caused Goldcorp's shares to drop also resulted in its profit turning into a loss.
At the other end of the spectrum, some stocks have incredibly high earnings multiples but also have the growth prospects to back them up. Priceline (NASDAQ:BKNG) traded above 50 times trailing earnings in mid-2011, with the stock having soared from around $70 per share during the lows of the financial crisis to more than $500 per share. Yet since then, the online travel giant's earnings have almost tripled, leaving room for Priceline's stock to rise to almost $1,200, more than doubling. With next year's growth prospects still looking strong, ignoring growth would be a huge mistake in your value investing in 2014.
3. Assuming that certain industries are inherently "value" industries
Related to the two points above is the fact that in assessing changing conditions, value investors in 2014 will have to go beyond preconceived notions of which industries will have the best value stocks. Traditionally, value investors have turned to slow-growth sectors like consumer staples for value. Yet the demand for more conservative dividend-paying stocks has pushed valuations in consumer stocks well above their typical levels, making those stocks much less viable value plays.
By contrast, the tech sector, once seen purely as a growth play, arguably has some better values. Growth rates have fallen considerably, but many stalwarts in the industry carry single-digit or low-double-digit earnings multiples, leaving them reasonably valued even for more modest future growth. Moreover, if their turnaround efforts take off, the low share prices will look even more attractive in hindsight. For instance, Hewlett-Packard (NYSE:HPQ) still trades at just 10 times trailing earnings, even though the stock has nearly doubled in 2013. If efforts from CEO Meg Whitman succeed in making HP less dependent on hardware and more exposed to higher-margin business, HP stock could climb much further.
Be smart about value
Value investing in 2014 promises to be challenging, given the big advances in the stock market lately. But by avoiding these three mistakes, you'll go a long way toward improving your value-investing results both next year and well into the future.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends MasterCard and Priceline.com. The Motley Fool owns shares of MasterCard and Priceline.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.