Value investing strategy | Become a value investor
“Price is what you pay, value is what you get”
These are the words of Warren Buffett, CEO of Berkshire Hathaway, also one of the world’s richest men, and more importantly, one of the most successful value investors in the world.
As Berkshire Hathaway’s most recent annual shareholder letter shows, between 1965 and 2020, Berkshire Hathaway’s average annual gain was 20%, which was nearly double the 10.2% average annual total return (i.e., including dividends) of the benchmark S&P 500 over the same period. Over this time span, Berkshire Hathaway’s stock has nearly outperformed the S&P 500 by an aggregate of 2,800,000%, courtesy of Warren Buffett – the value investor.
What is value investing?
Now that we know how successful value investing can be, let’s look at what exactly value investing is.
Value investing is an investment approach where investors look at the intrinsic value of the stock rather than the share price, to determine potential investments. The intrinsic value or true value of the company is determined by using various metrics that include the financials; revenue, earnings, cash flow and profits, and business fundamentals; brand, business model, competitive advantage, and target market.
A value stock is a stock that trades for less than its intrinsic value, and value investing, as a whole, is about finding those value stocks and investing in them for good long-term returns.
How value investing works?
It’s quite simple – imagine you are buying a car. Whether you buy the car at full price or at a discount during a sale, does not make any difference to the car – the car will have the same features and performance. However, if you buy it on sale, you will save a lot of money, than if you buy at full price.
The same goes with stocks; if you understand the true value of a stock, you can save a lot of money when you buy it at a discount. And in the stock market, stock price movements occur, but that does not change the value of the company. Just like the car going through periods of increased demand often resulting in a higher price, does not change what you’re getting for your money.
Value investing uses the same principle; investors learn the intrinsic value of a stock, and see if it is overpriced or undervalued, and accordingly, they wait for market fluctuations for a discount. When the stock price is well below its intrinsic value, they buy the stock, thereby saving money, and increasing the potential returns.
How is value investing different from other methods of investing?
There are a lot of differences between value investing and other investing methods, the primary one would be how investors approach a stock. Value investors are more concerned with the underlying company and its business fundamentals; earnings, cash flow, etc. rather than the current stock price or the factors that affect the price. Because value investing is based on the belief that stock prices are the perceived value of stocks that mostly depends on supply and demand from investors, and often, not an accurate reflection of the value of the underlying company. They also believe that the market reacts to each and every news about a stock, hence most stocks are either overvalued or undervalued.
Value investing also has a long-term outlook. Value investors are buy-and-hold investors who are with the company for the long term. Unlike other investors who might sell their shares within a year or two, value investors believe in the long-term capital gains and are willing to hold on to their investments, as long as possible.
Comparing with growth investing, which is more about finding stocks that produced more than average returns in the past, value investing is more about the future of the stocks. Growth stocks are generally overpriced, whereas value investors look for undervalued stocks at a discount.
Who are some successful value investors?
Even if you’ve been living under a rock, chances are you have heard about the Oracle of Omaha. Warren Buffett is the most famous and arguably the most successful value investor ever. He is currently worth $97.3 billion (as of 16 March 2021). He is the chairman and the largest shareholder of Berkshire Hathaway (30.71% of the aggregate voting power and 16.45% of the economic interest), which owns more than 60 companies, including insurer Geico, battery maker Duracell and restaurant chain Dairy Queen. Berkshire Hathaway also owns significant portions of Apple (5.4%) and Coca-Cola (6.2%).
He might not be as famous as Warren Buffet, but we can’t talk about value investing without talking about Ben Graham. He is known as the ‘father of value investing’. He wrote the book The Intelligent Investor which according to Warren Buffett is ‘the best book about investing ever written’. He was Buffett’s mentor and one of the most influential figures in Buffett’s success.
Peter Lynch is a mutual fund manager and a value investor. Peter Lynch was the manager of Magellan Fund at Fidelity Investments. Between 1977 and 1990, Lynch averaged a 29.2% annual return, consistently more than double the S&P 500 stock market index and making it the best-performing mutual fund in the world. During his 13-year tenure, assets under management increased from $18 million to $14 billion. He is the author of One up on Wall Street.
What are the principles of value investing?
Value investing follows a set of principles that makes it different from other investing strategies.
As per value investing strategies, stocks are either undervalued or overpriced, that more often than not, a stock price does not reflect the intrinsic value of the stock. One of the most important principles of value investing is understanding the intrinsic value of a stock. Value investors use fundamental analysis where an investor studies various metrics to determine the intrinsic value of the stock. The metrics include financials; revenue, earnings, and cash flow and fundamentals; company brand, market share, competitive advantage.
Margin of safety
Even though value investors are looking for undervalued stocks, they consider the possibility of an error in the valuation of the stock. Hence, they leave some room for error i.e margin of safety. This is an important value strategy. It is based upon the fact, you have a better chance of earning a profit if you buy a stock at a discounted price, rather than the full price.
For example, consider a stock that is worth $100, but currently trades for $80. If you buy that stock at $60, you will have a profit of $40 just by waiting for the stock to reach its actual value. Moreover, if the company grows and the stock price goes up to $120, you’ll have a profit of $60. However, if you had bought the stock at $100, you would only have $20 as profit. The margin of safety is to ensure that, even if your valuations are incorrect, the chances of losing money are less, since you bought the stock at a lower price.
Markets are not efficient
Value investors believe that the stock market does not take all aspects into account and that the stock price is not an accurate representation of the value of the company, it may either be overpriced or undervalued. Value investors understand that the price of a stock depends on various factors other than the underlying company’s fundamentals, which include supply and demand from investors and traders in the market, who might be under the influence of short-term news and events.
For example, investors might be hyped about an upcoming technology so they are buying a lot of shares that might skyrocket the stock price. Or they might be worried about the change in the state administration, which they believe would affect the economy, and investors sell shares that decrease stock prices.
Long term gains
Another important principle of value investing is the long-term outlook. Value investors are buy-and-hold investors who are looking to hold the investments for at least 5-10 years. There is no instant gratification when it comes to value investing. Value investors are willing to hold on to their investments through the downturns and market corrections, because they believe that, in the long run, the market will rise in value, and they will be rewarded with exponential capital gains. To quote Warren Buffet – “our favorite holding period is forever”.
What are the strategies for Value investing?
While value investing has evolved through the years, these investment strategies remain at the heart of value investing.
Avoid herd mentality
Value investors don’t go with the crowd. In fact, value investing advocates quite the opposite. So value investors mostly buy or hold when everyone is selling and sell or stand back when everyone is buying. The reason being, value investors understand that short-term fluctuations don’t necessarily affect the long-term earnings of a stock. But whereas other investors often act based on the latest news on the stock, which most likely won’t have an effect in the long term.
Also, value investors do not buy the ‘hot’ stocks. They understand that if it is ‘hot’ it is already overpriced. Instead, they look for quality companies whose products they’ve personally used, or companies they are quite familiar with. If those stocks are overpriced, they’ll buy it during one of the market fluctuations, while making sure that the fundamentals are strong and it has great potential for growth.
Value investing is all about the intrinsic value of a stock. To find the value, investors analyze the fundamentals of the stock. It includes going through the financial and corporate performance of the underlying company. Value investors will look at the financials, and business fundamentals.
Studying the financial statements of the company is a great way to understand the intrinsic value of the stock. Income statements, balance sheets, and earnings statements contain all the information you need to know about the current financial position of the company. These are some of the metrics value investors look at:
- Price-to-earnings (P/E) ratio is the ratio of the company’s share price to its earnings per share (EPS). For example, if a company trades at $50 per share, and EPS is $5, then its P/E ratio is 10. Value investors generally look for companies with P/E ratios in the bottom 10% of their sector.
- Price-to-book (P/B) ratio is the ratio of a company’s share price to its book value – which is the total value of all assets of the company. Typically, a ratio less than one is ideal. Because if the stock price is lower than the book value of the company, the stock might be undervalued.
- Free cash flow is the cash left after paying for all the expenses including operating expenses and capital expenditures – which are used to purchase, maintain, or upgrade physical assets. If a company is generating free cash flow, it means the company has plenty of cash to invest in future business, pay off debts, or pay dividends to shareholders.
Value investing also advocates looking at fundamentals of company business such as; the industry the company is in – whether it is an established industry or a growing industry with huge potential; the business model – do they have multiple sources of revenue, or do they have recurring revenue; competitive advantage – what makes them different from their peers, do they have intangible assets that make them unique; management; does the management has an impressive track record, etc.
Looking at these aspects of the company will give you more insight into the potential gains of the stock. For example, if the company has patents for the latest technology, that is a major advantage, which you won’t find in the financials of the stock.
Looking for unglamorous stocks
Like I mentioned before, value investors do not go with crowds – they go the other way. For that reason, value investors also look at industries that might not be ‘hot’. They look at unglamorous stocks because the objective is to find undervalued stocks with potential, regardless of the industry. These stocks might not be very popular among investors, as media and analysts rarely cover such stocks. Waste Management (WM) is an example of an unglamorous stock.
Insider buying and selling
Insiders are the company’s directors and senior executives who have significant knowledge about the future of the company, more than any analysts or media. If they’re buying stocks of their company with their own money, it is often considered a good sign, as it shows that they have good faith in the future of the company. Alternatively, if they’re selling their holdings, that doesn’t necessarily mean the company is going down – it might be a case of the shareholder needing some money. However, if there are mass selloffs, it might be good to take a second look at the fundamentals of the company.
Ignoring the analysts and media
Another strategy used by value investors is not paying attention to what media and analysts say. The media seems to prefer bad news, as it appeals to the audience more than good news. So they often inflate small issues to a potential market crash. Value investors believe that this hype news won’t have any long-term consequences, and making decisions based on such news, often result in a loss of money.
Value investors also understand that analysts don’t have a great reputation when it comes to predicting the future. While they may use analysts’ estimations from time to time to measure the performance, they don’t make any investment decisions based on analysts’ opinions.
How to start with value investing?
Value investing requires time and effort. Finding value stocks from the thousands of stocks listed in the market is not easy. Here are some ways you can start;
Use a stock screener
Stock screeners use various criteria to find certain stocks. The screener filters all the listed stocks, to find specific stocks according to the set criteria. It allows you to limit your research to stocks that meet your unique parameters. Generally, to find value stocks investors use parameters such as P/E ratio, P/B ratio, EPS growth. Once they narrow their search down to a couple of undervalued stocks, they start their due diligence on each one.
Some of the best screeners include Yahoo! Finance, StockFetcher, Chart Mill, Zacks, Stock Rover, Google Finance, and FinViz.
Read annual and quarterly reports
One of the best ways to understand the business of a company is by reading the quarterly or annual report. All the companies listed on the stock market are required to submit quarterly and annual reports that have all the information regarding the happening surrounding the company in the specific reporting period – a quarter or a year. These reports will include all the facts – the financial and corporate performance, the risk and threats, lawsuits faced by the company – everything you need to know.
This would be the most credible and authentic information available about a company in the stock market. Annual reports are generally preferred over quarterly reports, as sometimes companies face fluctuations in their revenue during certain periods in the year.
Focus on long term growth
This is a value investing strategy that is applicable to most investment methods. With value investing, it is all about the long-term perspective. It’s important to keep that in mind at all times. Educate yourselves on how the market works, and what is important and what is not. This will help you in riding through the short-term fluctuations and keep your focus on the long term. As the old saying goes, ‘time in the market beats timing the market’, if you take actions based on the volatile nature of the market, you’ll most likely lose out on capital gains in the long term. When you choose value investing, be ready to hold the stocks for at least 5-10 years.
Emotions play a significant role in the value investing strategy. Keeping your emotions in check is key in sailing through the short downturns in the market. Read how you can effectively manage your emotions.
Learn, invest and repeat
As I have mentioned, value investing involves a lot of research and this is just enough to get started. One of the best ways to learn more about value investing is to read books such as The Intelligent Investor by Benjamin Graham, or One up on Wall Street by Peter Lynch. Also, we have launched a mentorship program to help value investors find undervalued stocks and guide investors through their investing journey. Our program Capital Gains Multiplier (CGM) is closed for entry as of now, as the spots have been filled. However, you can join our email list to get notified when it is open again.
Also, if you would like an easy guide to value investing check out our Amazon bestseller The Beginners guide to Value investing.
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