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I'll use a metaphor to explain this one..
1. Buyer - Say your buying a car. You want the car to run good, have a good engine, no scratches, low mileage, good quality, good tires, etc. You also want to buy the car for the lowest possible price.
2. Seller - The dealer selling the car is trying to sell the car for as high a price as possible. He will sell high if he knows you will buy high.
The investing philosophy I follow (Value Investing) says the investor should only buy companies he knows are fundamentally sound, while also being undervalued. Now what is being under/over-valued?
Before going to the dealership, you do your homework on the car. You searched several models of cars, but found that a Bentley was the best quality car. Usually though, because of the high quality of the car, the free market prices it expensively at say $350k per car. Human psychology shows us that the market is not always correct in its valuations, so we have periods of over-valuation, and under-valuation, which are fixed only by market corrections to the right price.
Going back to our Bentley, assume few people are buying them for whatever reason. The price drops to $250k per car because fewer people want to buy it. This is popularly called a "SALE" or bargain. This is where Value comes into the investment picture.
Knowing the car is really worth $350k, you buy it from the dealer for $250k, a discount. Assume that eventually, people start buying Bentleys again for some good reason. The market recognizes buyer sentiment and prices go up again, and so now you are able to sell your Bentley for a higher price. The GREAT thing about it all is you already knew beforehand the true price of the car was $350k, when it was still selling for $250k. The same thing happens in the stock market.
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When looking for a potential stock to buy, you want to look at 3 things in this order.
1. Quality
2. Valuation
3. Trend
1. Quality - As with buying a car, you want your stock to have quality. You want to be buying Bentley's, not Datsuns (sucky car). Are they profitable? Are they increasing profit margins? Are they growing quarterly revenue relative to last year? Do they have an economic moat (Brand name, age, etc.)? In my research, I find that for every 100 random stocks looked at, less than 15% are of good quality, according to my specifications (which are high). Why invest in a company that sucks? Researching the company's performance should inform you to the quality. Look at yourself as a gold-digger sifting the riverbed for gold nuggets out lots of dirt and rocks.
2. Valuation - Ok, so you have a company stock you think is of great quality, a Bentley so to say, what next? The stock price. Realize why stock prices move up and down is because of 'supply and demand'.
Take TransGlobe Energy Corp. (TGA) as an example...
I began watching this stock in mid-March. I knew the small company was good quality by looking at the fundamentals. They were profitable for at least 7 years, repeatedly beating their own records, etc., etc. It's good quality. So now, I'm going to look at the valuation. The stock was trading in the $3.90's most of March, down at least 30% from its high back in December. By using a set of algorithms based on revenue from the past 5 years, I valued the TGA stock at $5.71 which was more than 30% above the current price. Whatever reasons the stock went down were alleviated by the inherent quality of the company which did not change even though their stock tanked in the first months of 2007. If I know the company is of very excellent quality, and their stock is trading at lows evidenced by the stock price not going below $3.80 (trend-following) and having a valuation of more than 30% higher the current price, I will surely BUY BUY BUY.
Buying Bentley worth $350k for $250k = Buying TransGlobe (TGA) worth $5.71 but trading at $3.93.
As the chart above shows, I was correct in my valuations. I bought TGA at 3.93 and 3.94 in real life, and am up on my investment 25-30%.
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