Value investing is the art of buying stocks which trade at a significant discount to their intrinsic value. Value investors achieve this by looking for companies on cheap valuation metrics, typically low multiples of their profits or assets, for reasons which are not justified over the longer term. This approach requires a contrarian mindset and a long term investment horizon. Over the last 100 years a value investment strategy has a consistent history of outperforming index returns across multiple equity markets.
Value investing seeks to exploit the irrational behavior of emotional investors. Emotion is a constant feature of investment markets through time and whilst the companies available to stock market investors change from decade to decade, the human nature of the investors themselves doesn’t. Fear and greed remain ever present and frequently lead to poor investment decisions based on perception and emotion rather than reality. Periodically these miss pricings can become extreme (the tech bubble of the 1990s or, conversely, the great depression of the 1930s), however, they exist to a greater or lesser extent in most markets. This creates an opportunity for dispassionate, long term value investors. Though this concept seems simple, sensible and, hopefully, appealing, it is much easier to say than do in practice.
Value investing is not always in favour and does not always outperform over shorter time periods. In the short term the market is a voting machine, whilst over the longer term it tends to be a weighing machine. Over the last 100 years there have been many periods where buying cheap stocks has not been a short term vote winner and other investments have been the darlings of the day. These periods may last for some years during which time value investors are made to look foolish and are dismissed as being out of touch. This is psychologically arduous for both fund managers and their clients alike and requires a balance of humility and fortitude. However, the long term results from this approach are extremely attractive seldom are the best things easy.
- What Is Value Investing?
Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Value investors actively ferret out stocks they think the stock market is underestimating. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond to a company's long-term fundamentals. The overreaction offers an opportunity to profit by buying stocks at discounted prices on sale.
Warren Buffett is probably the best-known value investor today, but there are many others, including Benjamin Graham (Buffett's professor and mentor), David Dodd, Charlie Munger, Christopher Browne (another Graham student), and billionaire hedge-fund manager, Seth Klarman.
- How Value Investing Work ?
The basic concept behind everyday value investing is straightforward: If you know the true value of something, you can save a lot of money when you buy it on sale. Most folks would agree that whether you buy a new TV on sale, or at full price, you’re getting the same TV with the same screen size and picture quality.
Stocks work in a similar manner, meaning the company’s stock price can change even when the company’s value or valuation has remained the same. Stocks, like TVs, go through periods of higher and lower demand leading to price fluctuationsbut that doesn't change what you’re getting for your money.
Just like savvy shoppers would argue that it makes no sense to pay full price for a TV since TVs go on sale several times a year, savvy value investors believe stocks work the same way. Of course, unlike TVs, stocks won't go on sale at predictable times of the year such as Black Friday, and their sale prices won’t be advertised.
Value investing is the process of doing detective work to find these secret sales on stocks and buying them at a discount compared to how the market values them. In return for buying and holding these value stocks for the long term, investors can be rewarded handsomely.
- Value Investing Strategies
The key to buying an undervalued stock is to thoroughly research the company and make common-sense decisions. Value investor Christopher H. Browne recommends asking if a company is likely to increase its revenue via the following methods:
- Raising prices on products
- Increasing sales figures
- Decreasing expenses
- Selling off or closing down unprofitable divisions
Browne also suggests studying a company's competitors to evaluate its future growth prospects. But the answers to all of these questions tend to be speculative, without any real supportive numerical data. Simply put: There are no quantitative software programs yet available to help achieve these answers, which makes value stock investing somewhat of a grand guessing game. For this reason, Warren Buffett recommends investing only in industries you have personally worked in, or whose consumer goods you are familiar with, like cars, clothes, appliances, and food.
One thing investors can do is choose the stocks of companies that sell high-demand products and services. While it's difficult to predict when innovative new products will capture market share, it's easy to gauge how long a company has been in business and study how it has adapted to challenges over time.
- Margin of Safety
Value investors require some room for error in their estimation of value, and they often set their own "margin of safety," based on their particular risk tolerance. The margin of safety principle, one of the keys to successful value investing, is based on the premise that buying stocks at bargain prices gives you a better chance at earning a profit later when you sell them. The margin of safety also makes you less likely to lose money if the stock doesn’t perform as you had expected.
Value investors use the same sort of reasoning. If a stock is worth $100 and you buy it for $66, you’ll make a profit of $34 simply by waiting for the stock’s price to rise to the $100 true value. On top of that, the company might grow and become more valuable, giving you a chance to make even more money. If the stock’s price rises to $110, you’ll make $44 since you bought the stock on sale. If you had purchased it at its full price of $100, you would only make a $10 profit.
- Value Investing Requires Diligence and Patience
Estimating the true intrinsic value of a stock involves some financial analysis but also involves a fair amount of subjectivity meaning at times, it can be more of an art than a science. Two different investors can analyze the exact same valuation data on a company and arrive at different decisions.
Some investors, who look only at existing financials, don't put much faith in estimating future growth. Other value investors focus primarily on a company's future growth potential and estimated cash flows. And some do both: Noted value investment gurus Warren Buffett and Peter Lynch, who ran Fidelity Investment's Magellan Fund for several years are both known for analyzing financial statements and looking at valuation multiples, in order to identify cases where the market has mispriced stocks.
Despite different approaches, the underlying logic of value investing is to purchase assets for less than they are currently worth, hold them for the long-term, and profit when they return to the intrinsic value or above. Instead, you may have to wait years before your stock investments pay off, and you will occasionally lose money. The good news is that, for most investors, long-term capital gains are taxed at a lower rate than short-term investment gains.
Like all investment strategies, you must have the patience and diligence to stick with your investment philosophy. Some stocks you might want to buy because the fundamentals are sound, but you’ll have to wait if it’s overpriced. You’ll want to buy the stock that is most attractively priced at that moment, and if no stocks meet your criteria, you'll have to sit and wait and let your cash sit idle until an opportunity arises.
- Market Moves and Herd Mentality
Sometimes people invest irrationally based on psychological biases rather than market fundamentals. When a specific stock’s price is rising or when the overall market is rising, they buy. They see that if they had invested 12 weeks ago, they could have earned 15% by now, and they develop a fear of missing out.
Conversely, when a stock’s price is falling or when the overall market is declining, loss aversion compels people to sell their stocks. So instead of keeping their losses on paper and waiting for the market to change directions, they accept a certain loss by selling. Such investor behavior is so widespread that it affects the prices of individual stocks, exacerbating both upward and downward market movements creating excessive moves.
- Cyclicality
Cyclicality is defined as the fluctuations that affect a business. Companies are not immune to ups and downs in the economic cycle, whether that's seasonality and the time of year, or consumer attitudes and moods. All of this can affect profit levels and the price of a company's stock, but it doesn't affect the company's value in the long term.
- Analyze Earnings Reports
At some point, value investors have to look at a company's financials to see how its performing and compare it to industry peers.
Financial reports present a company’s annual and quarterly performance results. The annual report is SEC form 10-K, and the quarterly report is SEC form 10-Q. Companies are required to file these reports with the Securities and Exchange Commission (SEC). You can find them on the SEC website or the company’s investor relations page on their website.
You can learn a lot from a company’s annual report. It will explain the products and services offered as well as where the company is heading.
- Analyze Financial Statements
A company’s balance sheet provides a big picture of the company’s financial condition. The balance sheet consists of two sections, one listing the company’s assets and another listing its liabilities and equity. The assets section is broken down into a company’s cash and cash equivalents; investments; accounts receivable or money owed from customers, inventories, and fixed assets such as plant and equipment.
The liabilities section lists the company’s accounts payable or money owed, accrued liabilities, short-term debt, and long-term debt. The shareholders’ equity section reflects how much money is invested in the company, how many shares are outstanding, and how much the company has in retained earnings. Retained earnings is a type of savings account that holds the cumulative profits from the company. Retained earnings are used to pay dividends, for example, and are considered a sign of a healthy, profitable company.
The income statement tells you how much revenue is being generated, the company's expenses, and profits. Looking at the annual income statement rather than a quarterly statement will give you a better idea of the company’s overall position since many companies experience fluctuations in sales volume during the year.
- Couch Potato Value Investing
It is possible to become a value investor without ever reading a 10-K. Couch potato investing is a passive strategy of buying and holding a few investing vehicles for which someone else has already done the investment analysis i.e., mutual funds or exchange-traded funds. In the case of value investing, those funds would be those that follow the value strategy and buy value stocks or track the moves of high profile value investors, like Warren Buffett.
Investors can buy shares of his holding company, Berkshire Hathaway, which owns or has an interest in dozens of companies the Oracle of Omaha has researched and evaluated.
- Risks with Value Investing
As with any investment strategy, there's the risk of loss with value investing despite it being a low-to-medium-risk strategy. Below we highlight a few of those risks and why losses can occur.
- The Figures are Important
Many investors use financial statements when they make value investing decisions. So if you rely on your own analysis, make sure you have the most updated information and that your calculations are accurate. If not, you may end up making a poor investment or miss out on a great one. If you aren’t yet confident in your ability to read and analyze financial statements and reports, keep studying these subjects and don’t place any trades until you’re truly ready.
One strategy is to read the footnotes. These are the notes in Form 10-K or Form 10-Q that explain a company’s financial statements in greater detail. The notes follow the statements and explain the company’s accounting methods and elaborate on reported results. If the footnotes are unintelligible or the information they present seems unreasonable, you’ll have a better idea of whether to pass on the stock.
- Extraordinary Gains or Losses
There are some incidents that may show up on a company's income statement that should be considered exceptions or extraordinary. These are generally beyond the company's control and are called extraordinary item gain or extraordinary item loss. Some examples include lawsuits, restructuring, or even a natural disaster. If you exclude these from your analysis, you can probably get a sense of the company's future performance.
However, think critically about these items, and use your judgment. If a company has a pattern of reporting the same extraordinary item year after year, it might not be too extraordinary. Also, if there are unexpected losses year after year, this can be a sign that the company is having financial problems. Extraordinary items are supposed to be unusual and nonrecurring. Also, beware of a pattern of write-offs.
- Ignoring Ratio Analysis Flaws
Earlier sections of this tutorial have discussed the calculation of various financial ratios that help investors diagnose a company’s financial health. There isn't just one way to determine financial ratios, which can be fairly problematic. The following can affect how the ratios can be interpreted:
- Ratios can be determined using before-tax or after-tax numbers.
- Some ratios don't give accurate results but lead to estimations.
Depending on how the term earnings are defined, a company's earnings per share (EPS) may differ.
Comparing different companies by their ratios even if the ratios are the same may be difficult since companies have different accounting practices.
- What Is an Example of Value Investing?
Common sense and fundamental analysis underlie many of the principles of value investing. The margin of safety, which is the discount that a stock trades at compared to its intrinsic value, is one leading principle. Fundamental metrics, such as the price-to-earnings (PE) ratio, for example, illustrate company earnings in relation to their price. A value investor may invest in a company with a low PE ratio because it provides one barometer for determining if a company is undervalued or overvalued.
- What Are Common Value Investing Metrics?
Along with analyzing a company’s price-to-earnings ratio, which can illustrate how expensive a company is in relation to its earnings, common metrics include the price-to-book ratio, which compares a company’s share price to its book value (P/BV) per share.
Importantly, this highlights the difference between a company’s book value and its market value. A B/V of would indicate that a company’s market value is trading at its book value. Free cash flow (FCF) is another, which shows the cash that a company has on hand after expenses and capital expenditures are accounted for. Finally, the debt-to-equity ratio (D/E) looks at the extent to which a company’s assets are financed by debt.
- Buying Overvalued Stock
Overpaying for a stock is one of the main risks for value investors. You can risk losing part or all of your money if you overpay. The same goes if you buy a stock close to its fair market value. Buying a stock that's undervalued means your risk of losing money is reduced, even when the company doesn't do well.
Recall that one of the fundamental principles of value investing is to build a margin of safety into all your investments. This means purchasing stocks at a price of around two-thirds or less of their intrinsic value. Value investors want to risk as little capital as possible in potentially overvalued assets, so they try not to overpay for investments.
- Not Diversifying
Conventional investment wisdom says that investing in individual stocks can be a high-risk strategy. Instead, we are taught to invest in multiple stocks or stock indexes so that we have exposure to a wide variety of companies and economic sectors. However, some value investors believe that you can have a diversified portfolio even if you only own a small number of stocks, as long as you choose stocks that represent different industries and different sectors of the economy. Value investor and investment manager Christopher H. Browne recommends owning a minimum of 10 stocks in his “Little Book of Value Investing.”According to Benjamin Graham, a famous value investor, you should look at choosing 10 to 30 stocks if you want to diversify your holdings.
Another set of experts, though, say differently. If you want to get big returns, try choosing just a few stocks, according to the authors of the second edition of “Value Investing for Dummies.” They say having more stocks in your portfolio will probably lead to an average return. Of course, this advice assumes that you are great at choosing winners, which may not be the case, particularly if you are a value-investing novice.