As the late Benjamin Graham, father of value investing, pointed out to his readers, past performance is useful in calculating the value of a stock, bond, mutual fund, or other asset only so far as it is indicative of what is to come in the future. Often, the very best time to invest in a particular area is when it has suffered from horrific industry trends over the recent past. Take the oil sector, for example. In the late 1990s, black gold was trading at $10 a barrel and very few analysts saw an end to the energy sectors woes. Yet, over the past six years, an investor in refiners such as Valero or an integrated giant such as Exxon Mobile have experienced wonderful returns.
How can you help ensure you arent guilty of jumping into a hot sector? Ask yourself the following questions.
- What makes me think the earnings of this company will be materially higher in the future than they are at the present time?
- What are the risks to my hypothesis of higher earnings? How likely is it that these theoretical risks will become actual realities?
- What were the original causes of the companys underperformance? If it was in any way linked to aggressive accounting, what makes you sure that the situation has been permanently resolved and integrity restored to the firm? If it was an industry specific problem, what makes you think that the economics going forward will be different? A temporary supply and demand situation? Lower input costs?
- Has this particular sector, industry, or stock experienced a rapid increase in price in recent history? Knowing the principle that price is paramount, does this still make the investment attractive? Have the prospects for better earnings already been priced into the security?