The Importance of Fair Value

Most articles I write deal with either broad market trends or specific stock ideas. This one will do neither. Instead, I will focus on the importance of maintaining fair value estimates and basing our trading decisions upon them, thereby laying the foundation for approaching future trading opportunities.

Many investors seek to understand why stocks perform the way they do. In their minds, good news pushes prices higher and bad news will take stocks lower. Such a linear view of cause and effect dominates our everyday lives, so it's logical that investors would try to apply it to investing. However, the markets are extremely complex and rarely can be explained by such a straightforward approach. Therefore, instead of attempting to understand every wiggle in a stock's price, we should prepare to react to the unknown.

As an example, consider one of our prior portfolio investments my weekly newsletter EPIC Insights- Arkansas Best (ABFS). ABFS is a trucking company whose business is extremely sensitive to the overall economy. When economic growth occurs, companies ship more items, and ABFS's business improves. However, when the economy slows, ABFS's business declines dramatically.

Such sensitivity makes valuing the company difficult. As with most cyclical businesses, in good times ABFS appears cheap because high earnings make the shares trade at low Price/Earnings (PE) multiples. Conversely, when business is poor, the shares look extremely expensive based upon traditional metrics. For this reason, I use a blend of approaches that allows for the calculation of fair value over an entire business cycle. This method enables me to eliminate emotion from my decision and base investment choices on the strength of the business as opposed to economic conditions at a particular point in time. When the shares trade at a discount to fair value we buy, and when they reach fair value we sell.

In the November 8 issue I recommended buying ABFS at $24.09. For nearly a month, the price did not move. Then a rally pushed the shares above $31, and in the December 20 newsletter I recommended exiting the position. Having earned a 30% return in six weeks, many would have expected that company-specific news had triggered the rally, but they would have been wrong. The newswire for ABFS shows that nothing material was reported during that period. Instead, we created an opportunity by buying the shares below fair value.  All we had to do was wait for the market to recognize this opportunity and bid the price higher.

As markets have sold off recently, it is important to remember the need to employ fair value to trigger our investment decisions. Amazon.com, at $121, is less expensive now than the $145 you would have paid in early December, but is still far from cheap. As drops in price create uncertainty, we must avoid buying stocks simply because they have fallen lower. Following a discipline of buying only when a company is trading below its fair value target will allow us to prosper when markets stabilize and prevent us from stepping into a stock that has further room to fall.