Investing is all about predicting the future. When you decide to buy stock, you're essentially saying that the shares you're purchasing are worth more to you than the cash you're handing over to buy them. At the time you buy them, of course, those shares are priced at exactly what you paid, so what you're really doing is predicting that in the future, those shares will be worth more.
The trouble is that for you to be able to buy those shares, someone else had to be willing to sell them to you -- at the same price you paid. That seller looked at the same company you did, and came to the opposite conclusion -- that the shares were worth less than they sold them to you for, and that cash was preferable to hold.
Who's right, and who will win?
In all probability, you're likely up against a rapid-fire, data-crunching computer program. Those high frequency traders actually trade a majority of the volume in the market, especially during periods of volatility. And those programs are in it to win it -- with trading profits measured in the billions, annually, they're there to capitalize on any inefficiency in a stock's price, no matter how small.
Their profits are made from money other investors leave on the table. That's money that's generally not accessible to us mere mortals without ultra-fast network connections, processing power, and sophisticated trading algorithms. Frankly, unless you're already filthy rich and can afford the incredible technological investment, it's not worth your effort to try to beat those machines at their own game.
While those machines are ultra-efficient and effective at what they do, there's one area they're vulnerable to you. And that area is implied by their very name -- high frequency traders. They're not interested in holding onto the shares they trade or owning the companies represented by those shares; they only care about getting in, scraping off their profit, and then getting out.
Your edge over those computers
Where you have the advantage is if you treat those shares you're buying as what they really are -- fractional ownership stakes in a company and the business it operates. While the high frequency traders measure time in microseconds, companies generally update their financial conditions quarterly. Indeed, it may take years for a change in a business's operating strategy to translate into improved profits.
When trade times are measured in microseconds, but business value is generated over years, there's a very real potential for a huge gap to open between a stock's price and a company's value. It's by looking for and exploiting those gaps -- and then waiting for the short-sighted computers to catch up with the long-term reality -- that you have an edge over today's high-tech traders.
One straightforward way to find such opportunities is to look for profitable companies that the market has discarded as being worth more dead than alive. As absurd as that might sound on the surface, in today's right now focused market, you can find a few surprises. Take a look at some of what the market and its microsecond traders served up at the end of last year, for instance:
Price to Tangible Book Value
Trailing Earnings (in millions)
Forward P/E Ratio
Long-Term Estimated Growth Rate
Royal Caribbean Cruises
Source: S&P Capital IQ, as of Dec. 28.
Every single one of those companies:
- Is profitable and expected to continue to be profitable,
- Is estimated to actually grow its business in the future, and
- Has a debt-to-equity ratio less than two, which indicates it isn't outrageously over-indebted.
Yet they all trade below their tangible book values. That measure is a rough estimate of what the companies would be worth if they simply stopped operating, sold off all their assets at book value, paid off their debts, and distributed what was left to their shareholders. In essence, if book value fairly represents the value of those assets -- which is often a big "if "-- then you're paying a bargain price for the company's assets, and getting a profitable business, for free.
No instant gratification
Of course, it may take awhile for the market to wake up to that fact, especially when there are real issues affecting the company. Toyota, for instance, seemed to be in Mother Nature's crosshairs this year, between the Japanese earthquake and resulting nuclear meltdown and the massive flooding in Thailand messing up its supply chain. They're real problems affecting Toyota's real business, but not even that nuclear meltdown turned into a huge, permanent, and total loss to Toyota's business.
Over time, a good business will likely prevail and reward the shareholders who bought it at a bargain price. It's thanks to that long-term perspective and ability to consider time frames measured in quarters and years rather than microseconds that I feel confident enough in each of these companies to make CAPScalls in favor of them. I've put my own CAPS All-Star rating on the line by handing out green thumbs to their shares in Motley Fool CAPS.