Have you heard about value investing? Well, it is one of the most popular and result-driven investment strategies for investors all across the globe. In this straightforward guide, we will enlighten you about value investing. So, settle down and read!
Value Investing: Introduction and key terms
When you plan to invest, you intend to generate enough returns out of it. To generate sustainable profits, investors adopt a plethora of strategies to achieve the desired goals. One such strategy is value investing.
What Is Value Investing?
Value investing is one of the most successful investing strategies whereby those stocks are chosen that are traded at a price lower than their intrinsic value. This process of picking the stocks and buying them with the possible margin of safety is known as value investing. Similar to any capital-profits focused strategy, value investing uses the same idea of ‘buying at lower price’ and ‘selling at a higher price’.
Terminologies Related To Value Investing
When it comes to value investing, there are some important terms that you need to know in order to understand it well. Here are some key concepts and terms of value investing:
Generally, the market value of the stocks is influenced by several external factors such as unemployment, GDP, economy, pending legislation, geopolitics, or presidential tweets, which are not in control of the company. But, every asset has a value that is not influenced by any external factors. This is intrinsic value.
In the intrinsic value, the influence of such external factors is eliminated and it emphasizes more on the fundamentals, thus valuing a company on its own merits. The intrinsic value is determined by internal factors such as management and brand strength in the marketplace. Value investing is the real worth of a stock, which gives us the reason why it is considered as the fundamental value.
Intrinsic value is calculated through various methods such as dividend discount model, discounted cash flow analysis, etc. The important reason for calculating intrinsic value is to identify under-valued stocks.
For examples, if you calculate the intrinsic value of $400 for a stock, and it is trading in the market at $300, then it shows that the stock is trading at a low rate. Hence, you will have a good opportunity for value investors.
Margin Of Safety
When the market price of a security is significantly below its intrinsic value, the difference is known as the Margin Of Safety. A higher margin of safety is better because it cushions you against poorly made decisions or market downturns.
Discounted Cash Flow (DCF)
It is a valuation method that is used to estimate the value of an investment based on its future cash flows. In simple terms, DCF figures out the value of an investment based on how much money it will generate in the future.
Dividend Discount Model (DDM)
It is a quantitative method used in valuing a company’s stock price. It is based on the theory that ‘stock is worth the sum of all of its future dividend payments, discounted back to their present value.’ In other words, it is used to value stocks based on the net present value of future dividends.”
General Characteristics of Value Investors
Here are a few characteristics that make value investors different from regular investors.
Value Investors are Lazy
The prime reason why value investors often look like lazy is because they rely on deep thinking. Most of the time, value investors are doing absolutely nothing. But in reality, they’re contemplating. They are not always engaged in buying stocks all the time. Instead, they are involved in reading, sleeping, doing calculations, and mathematics.
Value investors generally do not invest in stocks with a mentality like what others do. Instead, these investors focus on buying those stocks which others are selling. Hence they can get them at great cost than others. When a lot of other investors are relying on buying stocks for day trading, value investors, on the other hand, purchase them with intentions of holding for a lifetime.
Value investors generally showcase two key skills:
- They easily read and understand financial statements.
- They have profound knowledge of evaluating the intrinsic value.
These two qualities (when combined) make value investors exceptionally unique and better in the realm of stock investing.
Blue Chip Bias
Did you know? Most value investors have a strong affinity for blue-chip companies and the reason behind this is that these are valuable stocks of the market. Value investors target to collect only blue-chip stocks at a discount.
Principles of Value Investing
Some of the world’s most successful investors such as Warren Buffett and Benjamin Graham have used value investing approach to generate market-beating returns. This truly indicates how value investing has built a lot of fortunes. If you desire for worthy value investment, then these key principles will keep you in every aspect of it.
Value Investing And Speculation Are Not The Same
Widely considered as the founding father of value investing, Benjamin Graham has given his words to the investors to treat ‘value investing’ different from ‘speculation’. In his book The Intelligent Investor, he puts his views clearly regarding this:
“An investment operation is one which upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
There are several key ideas embedded in these two sentences, and the biggest one is that value investors are not focusing on the “next big thing” i.e. a company that might become great over time. According to Graham, if there is an investment case for a company that includes various assumptions that could happen in the future, but it necessarily won’t happen– then it’s speculative.
Therefore, in Graham’s point of view, investors should look for companies that have the real possibility of attaining greater value. Mostly, investors don’t do so. They buy companies at substantial discounts according to their current values, thus ignoring the fact that the company may not prosper in the future.
Value Investing Relies On The Intrinsic Value
The entire process of value investing is dependent on intrinsic value. The value investor will first determine the intrinsic value of the company from various fundamentals. The process of calculation and the value results differ from investor to investor. Some investors will put more emphasis on future cash flows, whereas, some will only consider the financial situation. The decision of the calculation method or the process is in the hands of the investor’s investment style and the period of holding.
The stock price of a company vividly reflects all the available information about the company. Whether it’s due to some misfortunes of a company or a market-wide stock selling, there will certainly be times when the stocks of great companies will be discounted. Value investors always attempt to buy such stocks at such times. Then, they hold those stocks until their prices rise and generate maximum returns out of them.
Margin Of Safety Is Important For Value Investors
As already mentioned above that the difference between the current market price of a stock and its intrinsic value is known as the Margin Of Safety. One of the most important keys to value investing is to choose stocks with a good margin of safety.
Warren Buffett rightly said, “The three most important words in investing are the margin of safety.” But, how will you find the companies with a good margin of safety? Well, there are several ways. The most popular and approximate method involves finding out companies that seem like ‘promising value investments’ by using several metrics such as P/E and PEG ratios. We will discuss them later in this post.
Another metric that can assist in identifying such companies is the Price-To-Book ratio, where “book” is “book value” of the company. But, you need to be careful with the Price-To-Book ratio because it doesn’t work as an absolute measure. It is quite possible that two very different companies can have different Price-To-Book ratios, but they both may be fully identical in value. The best way to get the most accurate ‘margin of safety’ is to understand the difference between value and price. While price is only what you pay for something, the value is what you get out of something.
The margin of safety is the key principle in value investing as it insulates your industry from shocks and it also depicts the potential upside of the investment.
Don’t Think In Terms Of Weeks Or Months, Think In Years Or Decades
Value investing is not a quick-fix method to gain profits out of the stocks. It is a time-consuming strategy that requires a great deal of patience. Sometimes, it can take years or decades to see your stocks rising in value, which is certainly not an exciting process for those who desire to earn big returns quickly.
Warren Buffett aptly said, “The stock market is a device for transferring money from the impatient to the patient”. Hence, value investing is not for those who don’t have enough patience or time.
If you are vouching on value investing, you’ll have to show patience. Even if it is taking several years, you have to be patient and calm. The general principle is that value investing is usually efficient over the long run and the stock’s price will eventually reflect the company’s genuine value.
If you have bought a stock at a discount, you should wait for the right time. Here, right time refers to a phase when the price of stocks rises somewhere closer to its intrinsic value. Having the patience to see all these things happenings is one of the most important keys to success as a value investor.
Value Investing Demands A Contrarian Mindset
If you are the kind of investor that prefers to go with the flow, then value investing is certainly not for you. As described in the definition, value investing entails to looking for undervalued stocks and seeking investment opportunities that are overlooked by other investors. Hence, you need to carry out proper research and find stocks that are cheaper than their intrinsic values. This requires a broader vision and sound mind because you need to take into account each aspect of it.
For example, starters usually know that a low P/E ratio is a good indicator of a company for value investing. Now, consider XYZ Motor Company, whose P/E ratio is around 5.8. We know that it is low for a global automaker. So, is XYZ worth buying? Probably your answer will be ‘No’.
Now consider the case that after closely monitoring XYZ, you notice that the company has a big cash hoard, low debt, better technology than others, future-minded management, and a credible as well as efficient plan to boost profits and reduce costs over the next few years. So, what do you think about value investing for XYZ now? Don’t you think it is worth investing?
This example clearly shows that metrics can sometimes mislead investors. The main point here is that for successful value investment, one needs to take the options that are contrary to the conversational wisdom or even to the opinions of the experts. Being the contrary, it is not always easy. Going against all the odds and the advice given by the highly paid professionals can be daunting sometimes. However, this most daunting investment can turn out to be the best in generating extraordinary revenues.
Your First Priority Is Avoiding Losses
Value investors need to avoid losses and it should be their priority. If the value drops by 30% and then grows by 30%, then you have lost money. Moreover, you need a large number of returns to meet your goals over time. This might force you to take larger risks than before, thus increasing the probability of more losses.
Therefore, to be a successful value investor, you need to mitigate the risk of big losses. You can do so by investing in stocks available at a discounted rate. This may not always provide you with market-beating growth, but if you can minimize the losses, then you will be able to meet your investing goals over time.
Know Everything About What You Own And Why You Own It
If you think value investing is only about buying and selling the stock at the right time and right price, then you are completely wrong. It is certainly not a passive strategy. To be a successful investor, you need to know everything about the companies that you are owning and why you are owning them. Several questions need to be asked, such as:
- What does the company do?
- Who are its competitors?
- Why is it selling its stock at a discount?
- Why do you think its stock price will rise over time?
- How much return do you expect from the investment?
All these things are really important. But, it is also important to stay up to date on various major developments that are affecting the company. This is crucial to correctly find the answers to the questions similar to and as mentioned above. At the minimum level, you can read the annual report of the company and keep eyes on the latest news regarding the company. This is important to identify the changing situations and to re-evaluate: Is there any good reason left to still own this stock? If the changes can lower the intrinsic value, then you should reconsider your decisions and actions.
Process of Value Investing
Understanding the process of value investing could be a cakewalk. But things get tangled a bit when it comes to its implementation. To make the implementation easier, investors should focus on building their “circle of competence.” Before heading to the circle of competence, let’s discuss the process of value investing first.
Value investing is all about choosing blue-chip stocks at a discounted price. They represent some of the top corporate giants, MNCs, and established companies that have a long history trail.
Example: My stock analysis worksheet does not accept a stock that includes financial data of less than 10 years. Warren Buffett, the best investor of all time, considers the last 15 years data of a company to estimate its intrinsic value.
To estimate the financial health of a company, 10 years of financial data related to company’s stock should be checked. The main idea behind this is to shortlist those stocks which are fundamentally strong. Value investors would choose to invest in only those companies which are fundamental powerhouses.
Irrespective of the year of establishment of a company, value investors will not take any risk until they calculate the intrinsic value. To ensure that the calculation is correct, they will also apply a suitable margin of safety. After paying the particular margin of safety, they compare the current price with intrinsic value to check if the stocks are undervalued or overvalued.
Principles of Value Investing and how to get started
The following are the core principles of value investing to know.
Do your research
Before buying any stock, you must analyze and understand the company you are investing in. As a matter of fact, try to focus on the following things about the company:
- Its financial structure
- The team that manages it (the CEO, CFO, etc.)
- Its long-term plans
- Its business principles
Value investing emphasizes on organizations that regularly pay their dividends. The mature and profitable companies often pay part of their profits back to their investors. This portion of the profit is known as a dividend. Experienced and smart investors even check company’s short-term earnings. For them, popularity doesn’t matter that much.
Have you ever heard this marketing philosophy- “Don’t put all your eggs in one basket”? It means that you should not invest at a single place, but you should diversify your investment portfolio. The same theory applies to value investing, as well.
Remember that all smart investors don’t rely on a single investment; instead, they have many different types of investments in their portfolios. So, if one investment is going down, it is balanced by other investments that are doing well. This protects the investors from serious losses.
Look for safe and steady returns
It is certainly difficult for new investors to grasp this principle. There’s no denying that everybody wants to make money fast. But let’s be honest and think why there are so many “5 Best Stocks for…” articles out there?
Many of us are looking to put in the time and effort to get safe, steady returns. You might be able to find stocks like that, but the fact that they won’t last forever. An intelligent investor will be happy with low-risk, consistent returns on their investments, instead of seeking immediate and market-beating returns.
Hence, you need to find stocks that can perfectly meet your personal needs. Make sure you don’t try to beat the portfolios of those who are doing this just for their essentials.
How to Get Started?
So have you made your mind to go for value investing? Pondering how to get started and choose the right stocks? But the question, where should you start?
If you are a defensive investor, you must focus on
- Minimizing potential risk as often as possible
- Adopting a passive approach to managing portfolio
- Diversifying by investing in high-grade bonds and blue-chip stocks.
Enterprising Investors are usually focused on
- Managing investments
- Willing to take risks on fresh organizations to get higher returns
- Placing a heavier weight on stocks
If you follow the rules of value investing, you can be an intelligent investor. Once you’ve decided how you want to invest, you must start looking for stocks. You should start your research, once you find some stocks you like. Once you’re done with your research, you can invest. However, you must invest what you’re comfortable losing. Remember, there are no guarantees in investing—even value investing.
Value investing: Pros & Cons
Advantages of Value Investing
Here are the advantages of value investing;
- With value investing, you are looking at a low risk-high reward scenario, ultimately reducing the risks associated with it. However, the returns can be staggering, when the stock rises toward its intrinsic value.
- As value investing focuses on fundamentals, investors need not be concerned about the day-to-day fluctuations in stock prices.
- Normal investing is influenced by emotional decisions that can lead to errors while making a decision related to the investment. Emotional decisions are based on gut feeling or general market conditions. However, when it comes to value investing, you’ll focus on shares of companies capable of delivering outstanding returns and strong growth potential.
- As reinvestment of returns and dividends will grow your investments appreciably, value investing also takes advantage of the power of compounding.
- Since value investment comes with a longer-term horizon, you need to pay a lower tax rate on your investment income. You also pay less by way of fees and commission by the same token. You do not need to transact frequently but employ a buy-and-hold strategy.
Disadvantages of Value Investing
Here’s the list of disadvantages of value investment you must know;
- For a good return investment, extensive time and effort are required in research.
- The underperformance of the stock may continue for a longer period that could hamper an investor.
- Calling a bottom is a harsh proposition that makes it difficult for finding out the right entry point.
- Liquidity is more or less connected with value buys, given their depressed valuation.
- It is not easy to achieve diversification with value buys as it could expose an investor to significant risks.
Some Common Events Indicating a Good Purchase
You need a way to filter out most of the undesirables, assuming you don’t have the computing power or time to sift through the tens of thousands of stocks available. Below we will discuss a few scenarios that would help you to check whether the purchase is worthy or not.
The value investing investor, as discussed above, comes with multiple traits of the contrarian. Equipped with this knowledge, you must check that steep increases in a price are cause for concern.
If a stock is on fire, value investing investors stay far away. When a stock is in freefall, on the other hand, for some minor infraction, it may be a signal to choose a cheap price. Make sure you aren’t missing something in your fundamental analysis if it blasts through your margin of safety point. It’s also important for a value investing investor to check the drop as a buying opportunity. For that, you can check herd behavior. You should analyze the financials of the company, whether positive or negative, and do some more research if you see big movements on news.
You can integrate the big-movements-on-news criterion, if you are from a technical background, with a portfolio of financial ratios. This would help eliminate the menial work of finding the stocks. You still need to do analysis, though; you won’t have to sift through financial statements, news reports, and press releases.
Unknown or unnoticed stocks are usually the small caps and foreign stocks. This is where you can outshine others.
If you have in-depth knowledge about the niche market for new technology and found a company that produces the tech with solid financials, don’t wait for it, just grab the stock. If you expect the technology to take off soon, value investing is a long-term game.
Foreign stocks are a good place to look apart from other small-cap companies that have gone so far unnoticed. One of the top Korean-giant like Samsung does not fit the “unnoticed” criteria. But a tiny Korean tech firm, for example, is an ideal option because any news of it is likely still in Korean only. That’s the reason, the financial world hasn’t heard of it yet.
Speaking of another scenario, if you speak a language that has small numbers of native speakers, looking at local companies in the language could be an incredibly beneficial way to find companies that are undervalued.
You can probably choose the stock well below your calculated intrinsic value if you include future revenue and you expect their product to take off. Since future cash flows can be comparatively huge for incomprehensible stocks, value investors have great opportunities to diverge significantly from each other in intrinsic value calculations.
Always keep this in mind that insiders have more information than you. Insiders are free to buy and sell their stock with good faith while there are laws against insider trading. Let’s take an example to understand.
The SEC requires all insider trades to be reported within two business days if you are investing in the United States. If you see insiders and large shareholders buying more, it is a great indication as their sale is not necessarily bad.
The changes may be easier to identify in the stock if you know a company’s market is cyclical.
However, if everyone knows the company moves up and down with cycles, then no matter how good you are, there won’t be any opportunity for you.
If the market expects a cycle to start or end at a particular time and it doesn’t, it will likely exaggerate to the missed cycle and then you would have the opportunity to take advantage of it.
Some Successful value investing investors
If you’ve been wondering- Does value investing work? Then, the answer is- it all boils down to the individual’s ability to correctly price a stock. In theory, it surely makes sense. In a real-life scenario, it may be difficult to implement but it does make sense, too.
There’s no denying the fact that most famous investors have implemented value investing to their advantage. Let’s have a look at some of them:
Who doesn’t know Warren Buffet!! He is probably the most well-known investor today. The man is among the richest people of the world and the credit goes to his investment antics. He is known for his ‘words of wisdom’ for the investors. In fact, many investors follow his trail to succeed. His investment approach is all about value investing.
For those who don’t know, he is the man who suggests that value investors should know the industry they intend to enter. Yes, you need to understand what you don’t know because what you don’t know, can hurt you.
For projecting future cash flows and easier returns, Buffett advises to consider historical consistency. This also indicates stability, meaning your stock won’t be wildly fluctuating but there are chances that it would be slowly building to its intrinsic value. Historical consistency, on the other hand, also eliminates new offers that can ultimately result in growth stocks and overpricing.
He is better known as the “father of value investing” while not as well-known as Buffett outside the financial world today. Graham was the one who came up with the ideas of intrinsic value and he wrote the book (the original one) on value investing.
His approach stresses the implementation of the margin of safety associated to diversify. This totally makes sense as Benjamin Graham looked for low-risk companies, not the high-risk ones. Furthermore, he stresses on the diversification as he believes that diversification can lower the risk. This is certainly true as in the case of diversified stocks, poor performing stocks are balanced with the high-performing ones.
By following this investment approach, you won’t lose your entire investment if management closes the shop tomorrow. Companies that are paying dividends (some extra income) would be there for you.
Warren Buffett was the man who pushed Charlie Munger to have a long-term outlook rather than just considering the current value of stocks while making the decision. Munger worked with Buffett at Berkshire Hathaway, where he received these valuable tips. He followed this tip and succeeded. That’s the reason he has become a notable name in the field of investment.
Interestingly, he thinks three companies make a diversified portfolio. He strongly encourages “elementary worldly wisdom”, and thinks three companies are sufficient to create a diversified portfolio that encourages one to have more than one model. This allows one to adapt to the situation, not force the situation into a single, perhaps unrelated, model.
Klarman is the founder of the Baupost Group, and he believes in a long-term approach. He often holds large amounts of cash, which indicates he does not want his money to be fully invested all the time. This could be interesting for those who are generally consistent and looking for good bargains. As the main indicator in his picks, he uses liquidation value. And the surprising thing is that even though he is US-based, he is not beholden to US stocks.
Schloss has many of the same strategies as the others and is referred to as another titan of value investing. Talking about his approach, he usually looks for low debt security and suggests to be patient. He says, “doesn’t sell on bad news, or buy near a low of the past few years just when you’re immediately upon hitting your target.”
As the key indicator rather than earnings, one major tip that he suggests may not apply to everyone is to use ‘assets’. He says that assets tend to change slowly but earnings can change quickly.
One of most powerful Walter Schloss’s tips is to “listen to the people you respect” and he even mentioned this in his 16 Golden Rules for Investing.
If you regard someone as a good investor or an intelligent investor, his/her opinion is useful. This would help you to measure your position and even test your theories and ideas with the person’s thoughts. What could be the right way to meet some of those people? You can meet along with investors at an event (you can arrange) and then discuss value investing ideas.
Remember that investing is never simple and straightforward. However, value investing is one such method that can allow you to leverage huge ROI, provided you are patient. When it comes to value investing, it requires patience and a lot of confidence because you are often investing and you must follow the latest trends, as well.
Secondly, value investing is not for everyone. You may waver just when you need to stay strong the most. This would result in selling at the wrong point and you could end up bearing loss. Keep this in mind that deep value investing is for even fewer people. And the best part about this is that it is cheap, but the contrarian viewpoint is difficult especially when all the trends, analysis, media, coverage are against you.
Then again, you would be ordinary if you did what everyone else does. If you want to make money in the market, you must think better and unique than others.
The main tenets of value investing include solid earnings, low debt, profitability, a consistent history, and little support from the market. Because the latter is hyped and too well-known, an unloved stock trumps a loved stock.
All of the tenets are quite flexible; otherwise, they wouldn’t be able to stand the test of time. As they are built on services or significant branding, using assets as the main key might exclude large parts of some industries. To expand intrinsic value derived from assets by using future earnings is fine. But you must ensure that the future earnings do not shade the financials picture.