Value investing is all about finding stocks trading at a discount to their intrinsic value. Investors have used this strategy for decades to find outsized returns; the very best have outperformed the market with this strategy.
In a 90 year long study done by Merrill Lynch, it was determined that value stocks returned an average of 17% a year, well over the average for growth stocks at 12.6%.
At its core– value investing is buy low, sell high.
Some of the most successful fund managers have had public track records equaling 17% or more a year for decades using the value investing strategy to find stocks trading at a discount to their intrinsic value.
Popular value investors with great past successes include:
- Warren Buffett
- Benjmain Graham
- Seth Klarman
- Joel Greenblatt
- Peter Lynch
- John Templeton
- Bill Ackman
- David Einhorn
- Carl Icahn
Resources to Learning Value Investing Principles
–Analyzing Annual Reports (10-k’s)
–Understanding Fundamental Analysis
—Margin of Safety is the Central Concept
–Estimating Intrinsic Value using a DCF Model
Value Investors Understand That…
–The market is emotional, swings between bull and bear markets
–This strategy isn’t a panacea, so diversification is key
—Dividend income and dollar cost averaging prevent speculation
[This is a joint contribution from Andrew Sather and Vinayak Maheswaran]
In a nutshell, value investing is about buying undervalued stocks of strong companies and holding them over a long period of time. Patient, diligent investors have seen a lot of success with value investing. When you have gathered a considerable amount of information on the company you’re investing in, it reduces risk and gives a lot more understanding.
After performing a lot of fundamental analysis, you decide to purchase stock in a company. Investors can estimate intrinsic value using the commonly accepted Discounted Cash Flow (DCF) model.
Some value investors prefer using relative valuation metrics like the price-to-earnings ratio (P/E), price-to-book ratio (P/B), price to sales (P/S), price to free cash flow (P/FCF) and the price/earnings to growth ratio (PEG).
Three principles to stick by
- Do your research
Take the time to analyze the company you are considering to be a good investment. You should know the company’s long-term plans, business principles, financial structure and the management team.
Find out if the company pays consistent dividends as value investors often focus on these stocks. If the company is popular in the media, it may be a good company to ignore. Value investors tend to avoid media darlings and are always looking past the short-term earnings of a company. It is the hard-to-find stocks that don’t get press which whet the appetite of a value investor. Carefully study the company and try to think about if it can outperform for decades.
- Diversify
Value investors put together a portfolio with investments in different companies. This will protect the portfolio holder from serious losses down the road. Benjamin Graham advises that investors should have a portfolio of 30 stocks. A large number of top-performing stocks in a portfolio means that it can approximate the performance. A large portfolio is great additionally because it negates volatility. Value investors decide the diversification strategy based on the goals they have in front of them.
Exercise a lot of patience when making investments. Waiting for the right time to buy is crucial. When opportunities emerge, the best prepared are patient investors. When there is market turbulence, stocks of great companies start trading at cheap valuations. One thing that is important is to always get out of a stock investment when the stock becomes overvalued or there is some other trouble on the horizon.
- Look for safe and steady returns
Hot stocks are best left for the media. Don’t take the chance and buy into the hype as it will already be too late to buy. If we put in the time into reading and identifying stocks, then we can get safe, steady returns. Good investors are happy with consistency. If the investments are low-risk and produce consistent returns on a regular basis, then it is safe to say that a healthy mix of stocks has been purchased.
Buy companies at bargain prices. The essence of value investing is to buy companies cheap, trading at a discount to their intrinsic value. Earnings per share is not something to pore over. The best companies to buy have high operating margins, low debt and a healthy return on equity. During the past 10 years, companies should have a consistent operating history and generate lots of cash.
Learning from the best investors – Warren Buffett
There are plenty of things to learn from the Oracle of Omaha. Firstly, stick with what you know. When you stay within your circle of confidence, you are doing something that Warren Buffett has done a lot of. Avoid investing in a company if you don’t know how it makes money or what it does.
Secondly, invest in companies with competitive advantages. Buffett calls this an “economic moat” which provides a company with protection from its competition or barriers. Some examples of these economic moats are high capital costs for competitors to enter a business, patent protection and a strong brand identity. For example, American Express has been a wonderful investment for Buffett with its strong brand and wide network effects.
Thirdly, look for companies that are operated by honest and competent people. A great CEO is a big asset for an enterprise. Seek to answer this question: what would happen if the company’s CEO or founder left? This referred to as key man or key woman risk. Also, look painstakingly to see if the company or any of its management has gotten involved in fraud at any given time.
Fourthly and finally, if the company has an attractive price then it is time to buy. When the stock is reasonably priced and the intrinsic value is less than the stock price, it is a good time to buy. The stock should be trading at a discount, or close to its fair value.
Finding an Advantage as a Value Investor
- Buy when everyone wants to sell and sell when everyone wants to buy
Basically, do the opposite of what everyone else is doing. You will have an edge against other market participants if you buy cheap and sell dear. The investment strategy that you have differs from the people you buy and sell to. You are able to sell when the market peaks and buy at the trough. For example, in the late 1990s if you refused to jump on the technology bandwagon, you would have been one of the few investors left unscathed. It took some time for the bubble to pop for the value investors who got a lot of flak for not joining in to finally be vindicated.
- Think Long term
Keep in mind that bull markets can last for many, many years. If you research the facts regarding a stock and have reason to believe that it will rebound then you should go ahead and buy it. This is even if the stock has suffered because of poor performance, bad publicity or economic downturns. When looking at your current portfolio, weight it with the long term in mind. Very few professional investors have the capacity to strategize over the long term, so you have a competitive edge just by doing this. The prices of individual securities tend to mean revert over time.
- Avoid the mainstream media
The only reason to be watching the news or paying attention to the newspapers, in our opinion, is just to become informed about business and secular trends, or gain additional information about the companies you are interest in. Market news impacts prices in the sub-seconds after it releases to a Bloomberg Terminal, so tomorrow’s front page or tonight’s newsflash can’t help the average investor. A good investor will not pay attention to the news because they have already done the hard fundamental analysis to convince them of a stock’s potential.
- Short-Term Loss Aversion
Investors with long-term horizons should not care about gains and losses over the short-term. Remember that a loss is only a loss if you sell, and you should sell if you have determined that a business has fundamentally changed, not because you are unhappy with a stock’s price performance.
- Be wary of hyped investments
As you shun market trends, don’t go jumping into a hot stock. The gains have already come and gone in the case of a hyped investment. The underlying logic is pretty simple. When a lot of investors are actively buying shares of a company, it is very soon going to be overbought and will not reflect the real cash generating value of the company. Inevitably, overbought companies will be covered on the news and the share prices will fall. Don’t chase after gains you have missed, as a correction is likely to occur and this will predictably result in a loss.
- Look for undervalued stocks
You shouldn’t go wrong if you look for underdogs. These are healthy stocks that investors have abandoned in order to hop on ‘the next big thing.’ Get into a position before everyone else notices that the stock(s) is a strong play. Otherwise everyone will be busy buying up shares and the price will be driven up. As you research the company, you should see good return on capital, efficient processes, a solid management team and innovative products. Companies that have these fundamentals can go through downturns often unscathed and weather unpopularity with investors.
- Patience and Persistence
Value investing is all about making profits over the long run. If you are patient and hold on to your stocks, you will see your net worth go up over time. Slow and steady wins the race here. One final thing to say is that the path to an outstanding stock portfolio is littered with mistakes, so don’t be afraid to make some along the way. When you go against the crowd, it brings up opportunities to make money. Let’s leave you here with a word of wisdom from Buffett: “be fearful when others are greedy and greedy when others are fearful”.
Books to read
Value investing was a concept that was established by Benjamin Graham and David Dodd who were professors at Columbia Business School. The following two books are a great introduction to value investing. The Intelligent Investor by Benjamin Graham is a book that many value investors read cover to cover. It has all the information necessary for a value investor to succeed in the markets.
The 1934 book Security Analysis by David Dodd and Benjamin Graham is another work that galvanized value investing. It is considered to be the longest running investment text ever published. The book was written after the Wall Street Crash of 1929 that almost wiped out Graham. It has some very important pointers for value investing students to take note of.
Other great value themed books:
—What Works on Wall Street by James O’Shaughnessy
—Margin of Safety by Seth Klarman
—The Little Book that Beats the Market by Joel Greenblatt
—The Manual of Ideas by John Mihaljevic
—Value Trap Indicator by Andrew Sather
—Beating the Street by Peter Lynch
—One Up on Wall Street by Peter Lynch
—Irrational Exuberance by Robert Shiller
—The Dhando Investor by Monish Pabrai
—The Warren Buffett Way by Robert Hagstrom
—Value Investing by Bruce Greenwald
Why Value Investing Will Always Thrive
The very essence of value investing is contrarian. It’s buy low, sell high. It involves buying companies out of favor with the market. It means getting great deals on stocks. And it will always work.
The reason why value investing works is because of its essence. The reason why there are profit opportunities in the market is because there is an obvious herd mentality. If this mentality exists, then do you think you’d profit more by following it or opposing it?
I hope it’s obvious to you that profits are made by going against the herd. You don’t make money if you are late to a trend. By then, all the money has been made. You must invest before the trend, if you want to profit from the trend.
But it’s not even about the trend. Or about profits. It’s about buying great companies at great prices. It’s looking at the company like you own it. It’s always more than just the stock ticker.
Success means knowing what a good price looks like. It’s understanding what you’re willing to pay, and what a company’s true intrinsic value is. It’s understanding when the market is overcome by optimism. Or by pessimism.
Fear and greed determine short term market results. The news is absolutely fixated on short term market results. So is the media. But you don’t have to be.
Remember the words of the great Benjamin Graham:
“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”
Investor Takeaway
There’s not much that’s exciting about being a value investor. Very few people want to take a carefully disciplined approach which necessarily avoids the most exciting stocks. But buying assets that trade close to their real intrinsic value, providing future cash flows to investors, will provide long term investment returns, whether exciting or not.
And this is why value investing continues to work. And will always work.
Even in the most explosive of bull markets, not every industry flourishes. Business cycles happen everywhere and to so many companies and industries. Fear and greed hits industries everywhere, often at different times. This creates opportunities for astute investors.
There’s always been something good to invest in for the long term. Some time periods have more than others, but you should always be able to find stocks trading close to their real intrinsic value if you look hard enough.
Value investing works because people are irrational. They are emotional, impulsive, and unpredictable. Just as you can be sure that they will create massive bubbles of excess optimism, they will create opportunities with their excess pessimism.
It’s a problem. But it’s also the solution.
