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Volatility Exposes Value

Written by Jason Williams
Posted December 13, 2018 at 7:00PM

It’s common to hear people say that traders love volatility. But judging from the traders I follow on Twitter, they’re not having a great time in this market.

The truth is, nobody loves volatility. It makes our jobs harder. It makes investing harder. It’s just not as fun as the roller-coaster ride it looks like.

We’d all much prefer easy trades. If the market is steadily heading up, you go long. If it’s going down, you trade short or buy puts.

If it’s all over the place, you’ve got to work a lot harder to figure out where to put your money and what direction to bet on.

But volatility does a couple of good things for us, too.

It shakes out some of the gamblers. And it reminds everyone that there’s always risk involved with investments.

But perhaps the best gift volatility gives us is the chance to take advantage of relative value.

What Is Relative Value?

A week or so ago, my colleague Briton Ryle wrote about relative strength in a down or sideways market. He advised you to look for companies that aren't suffering the downturn as badly as their peers.

He gave a few companies he sees as relatively strong and ready to break out when the market settles down. They’ve pretty much all outperformed since.

Relative strength is going to reward you when you find it. But it’s not the only thing you should be looking for in troubled markets.

This is when you really need to be looking for relative value as well. And you'll find that many of the stocks with the most relative value also have the most relative strength, too.

But what is relative value? And how do you find it?

First off, let’s define the term.

Relative value is defined by Investopedia as “a method of determining an asset’s value that takes into account the value of similar assets.”

That way of thinking about value is a little different from how most folks might. Typically, we think of absolute value — the intrinsic value of any asset.

But that can lead us down a dark path, especially with investments. If we just look at the company by itself, we don’t get a real picture of what it’s worth.

If we look at a company with a very low price-to-sales ratio and think it’s valuable, we might be surprised when we find out that its P/S is actually high when compared with similar investments.

You’ve got to look at a company’s intrinsic value. But you can’t forget about relativity. After all, it’s perspective that controls the rallies.

So, when we’re looking at a stock, we need to compare it to other stocks in the same industry. And we need to use measures that are easily comparable.

You Need Value to Find Value

The first thing we do when looking into relative value is establish a basis — a market value.

In the case of stocks, that’s usually the market capitalization or the share price.

After we get our market value as a basis, we start to take that value and see how it stacks up against other operating metrics like sales, net income, or earnings before interest and taxes (EBIT).

So we’ll look at the price-to-sales (PS) ratio. And we’ll check the price-to-earnings (PE) ratio. We might even look at the value-to-EBIT ratio just to get a really good picture.

Then, finally, we take those ratios and compare them to the same ones across multiple peers.

Since we’ve converted the market value into a ratio, we can now compare large companies to smaller ones, too.

Where’s the Beef Value?

So, now you know how to find companies with relative value. But where should you start looking?

A good place to start is the industry-specific indices and exchange-traded funds (ETFs).

Since they’re set up to track a particular industry, they’ll help you get a big-picture view of what you should expect to see when you look at the individual components.

If you’re looking for relative value in technology, you should be looking at the tech-heavy Nasdaq index. Or you should look at the components of Technology Select Sector SPDR Fund (XLK).

If you’re more of an energy investor and you want to take advantage of the drop in oil prices before more OPEC nations drop out, look at the Dow Jones U.S. Oil & Gas Total Stock Market Index. Or take a look at one of the many ETFs that track this market.

The Energy Select Sector SPDR Fund is a good place to start here, too.

You can use a screener like the one I use in this article about free financial resources on the web, too. Just set the industry, and filter your way down to the most (relatively) valuable stocks.

Throw Me a Friggin’ Bone, Here

I’ve explained how to do it, but the best way to learn is doing it yourself. Someone once shared a Spanish saying with me that really exemplified this.

Bear with me as I paraphrase:

“What I hear, I remember. What I write, I learn. What I do, I master.”

It’s a lot prettier in Spanish. But the message is the same in every language. The only way to truly master something is by doing it.

So, let’s do an example together here before you get to work with real money:

I happen to be a fan of Microsoft. It’s a great company, and I really like what it’s doing with the conversion to subscription-based software.

It’s been beating the heck out of the tech sector all year. MSFT shares are up nearly 30% this year, while the XLK is barely breaking even.

So let’s see if Microsoft, even after that outperformance, is a valuable stock relative to its peers...

I’m going to use the screener I recommended. I set the sector and industry to those into which MSFT falls. I also limited it to stocks that trade on U.S. exchanges. And to cut down a little more, I limited the size to get the tiny development-stage companies out of there.

That’s it. Just four filters.

Now, I’ve got about 30-odd companies to compare so I can get a really good look at how MSFT stacks up...

If you were doing this by hand, you’d have to go and find the earnings, revenues, market capitalization, etc. And then you’d have to crunch the numbers yourself or in your own spreadsheet.

But this screener makes it even easier. Which is nice, since, as I said, we like easy trades.

On the “Valuation” tab, you can see the P/E, P/S, and many other valuation ratios of all of the companies in your search.

You’ll see that Microsoft, even after its outperformance, still has a lower PE than all but four other companies. So, from a price-to-earnings standpoint, MSFT is still relatively undervalued compared to its peers.

If you want to get really fancy, you can break down the XLK ETF into its components and see how Microsoft stacks up against the other top holdings:

Company

Market Cap

Sales

Earnings

P/S

P/E

Microsoft

$839.00

$114.91

$18.82

7.30

44.58

Apple

$810.66

$265.60

$59.53

3.05

13.62

Visa

$302.18

$20.61

$9.94

14.66

30.40

Intel

$220.26

$69.24

$15.17

3.18

14.52

Cisco

$213.24

$50.27

$1.27

4.24

167.91

Mastercard

$203.87

$14.46

$5.19

14.10

39.28

Oracle

$178.27

$39.92

$3.95

4.47

45.13

Adobe

$120.62

$8.57

$2.41

14.08

50.05

IBM

$109.62

$80.37

$5.72

1.36

19.16

Broadcom

$105.92

$20.25

$11.68

5.23

9.07

 

Average

7.17

43.37

As you can see, this is most certainly no longer an easy trade. I went the extra mile and put a spreadsheet together.

And that sheet tells me there’s better relative value in the XLK Technology ETF...

IBM is way undervalued when you look at its sales over the past 12 months.

And Broadcom is looking cheap as far as earnings are concerned.

Microsoft isn’t screaming sell, though. It’s running right about average as far as P/S and P/E go. And it’s still showing relative strength, too.

So it looks like I’ll be holding MSFT and finding my relative value elsewhere.

Go Forth and Prosper

There you go. You’ve got all the tools you need to go hunting for value even in the toughest markets.

Now, go find yourself some stocks that are getting sold just because everything else is getting sold. Go find the babies getting thrown out with the bathwater. Go get the treasures this choppy tide is washing up on shore.

Whatever metaphor you use, get out there and take advantage of everyone else’s fear-driven mistakes.

I’ll be back next week with some more actionable advice. But I’ll also have an opportunity for you to join me, the members of my investing community, and a small group of elite investors who’ll be cashing in on nearly every medical marijuana sale made in 2019.

I’ll make sure you get all the details next Friday. So keep an eye out.

To your wealth,

jason-williams-signature-transparent

Jason Williams

follow basic@TheReal_JayDubs

After graduating Cum Laude in finance and economics, Jason analyzed complex projects and budgets for the U.S. Army. Then, at Morgan Stanley, he led the assistants' team for the North American repo sales desk, responsible for hundreds of multibillion-dollar trades every day. Jason is the assistant editor for The Wealth Advisory income stock newsletter. He also contributes regularly to Wealth Daily. To learn more about Jason, click here.

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