Welcome to our official value investing guide. This post will have links to all of the resources you need to get a full understanding of this very successful stock market 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. Popular managers with past success include Warren Buffett, Benjmain Graham, Seth Klarman, Joel Greenblatt, Peter Lynch, and John Templeton. Current value investors include Bill Ackman, David Einhorn, and Carl Icahn.
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. The five must-have metrics are the price-to-earnings ratio (P/E), price-to-book ratio (P/B), debt-equity ratio, free cash flow and the price/earnings to growth ratio (PEG). There is a lot of focus on the long-term growth potential of a stock. Strong value investors additionally look to buy with a margin of safety.
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
—F Wall Street by Joe Ponzio
—Warren Buffett’s Three Favorite Books by Preston Pysh
—Value Trap Indicator by Andrew Sather
—Beating the Street by Peter Lynch
—Irrational Exuberance by Robert Shiller
Three principles to stick by when doing value investing
- 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.
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. 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 pros – 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 is a wonderful company to buy in to in the financial space.
Thirdly, look for companies that are operated by honest and competent people. A great CEO is a big asset for an enterprise. Additionally, efficient managers have created billions of dollars of value with their abilities. 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 must be trading at a discount.
Strive to Find an Advantage
Buy when everyone wants to sell and sell when everyone wants to buy
Basically, do the opposite of what everyone else is doing. This is the ultimate way to get the best returns when investing. 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 after some investors got a lot of flak for not joining in.
In a situation when an investor buys shares of a company at a very high price market in a bull market, the investor must wait for the share prices to go very much higher. For this to happen, the investor needs to hold onto the shares for a very long time between three to five years. When the investor waits for market corrections, he or she makes a higher return on investment. So be prepared to ride the ups and downs of every market. Patience is a virtue that should not be taken lightly especially in markets that react quickly.
Think Long term
Keep in mind that bull markets generally last 36 months. 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 stock trends. 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 are mean-reverting over the long run.
Avoid the mainstream media
The only reason to be watching the news or paying attention to the newspapers is just to get confirmation that a certain stock or trend has really moved in a certain direction. One thing to know is that the market gets repriced before news gets past the specialist wires. Market news impacts prices in sub-seconds so tomorrow’s front page or tonight’s newsflash can’t help a trader. Neither can the Internet news. Anyway, a good professional 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 care about gains and losses over the short-term. You don’t want to be reluctant to realize a loss. One way to negate short-term loss aversion is to invest in low price stocks and pay attention to those whose market values have declined. The equities that are going up in price need to be sold and the proceeds can be used to invest further in stocks which have seen a decline in sare prices.
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 potency 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 will soon occur and this predictably results in a loss.
Look for the undervalued stock
You won’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.’ This is actually not a bearish move. You have to be bullish about the companies you choose to invest in. 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 profit margins, 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 definitely 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”.
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. 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. Your broker. The analysts. Executives. Employees.
All of Wall Street is caught up in this frenzy. Today Telsa (TSLA) is hot. Tomorrow it’s not. Momentum guys, growth guys, technology guys, trend following guys. They’re all names for the same herd.
You know what you don’t hear about on Wall Street? The value guys. The contrarians. The investors who buy a stock and don’t make a profit until 3 years from now.
Value Investing is Contrarian
There’s nothing sexy about being a value investor. No one wants to take a carefully disciplined approach. The herd doesn’t want to invest intelligently with time tested principles.
And this is why value investing continues to work. And will always work.
Even when value investing is more popular– it goes in and out of phase like anything else– the true contrarians will continue to profit. You see, value investing is all about avoiding the herd.
During times of value investing popularity, the opportunities are found outside the herd. The so-called value investors will all bid up the same stocks. But in doing this, they turn value opportunities into non-value opportunities. The herd won’t know when this happens. So they will keep piling in. And then there will be opportunities elsewhere.
Even in the most explosive of bull markets, not every industry flourishes. Business cycles happen everywhere and to every company and industry. In the past year for example, we’ve seen the general stock market rise while gold stocks have been left behind. I bet that in a year or two you will have seen a big rebound in gold stocks. It’s just the nature of industry rebounds.
There’s always undervalued stocks to buy. Some time periods have more than others, but you can always find one if you look hard enough. You can look to other industries, other countries, and even other asset classes. Value investing doesn’t necessarily have to be tied to stocks.
Value Investing is Consistent
My whole point is that value investing is so different than the rest of Wall Street. Another of its biggest reasons for success is that its methods are consistent. With a lot of mainstream analysts, they will invent different metrics for different companies.
For example, they’ll say that for Apple you have to look at margins. For Tesla look at top line growth. For Chevron look at cost per barrel, and for Netflix look at subscriber count.
This is ridiculous, and yet it’s the madness that rules our markets! How can you possibly hope to succeed when you are inventing new strategies for every stock? It’s like trying to find a needle in a haystack.
This kind of thinking reminds me of the dot com bubble.
During that time, mainstream analysts were inventing all sorts of vain metrics to rationalize overvaluation. Even though the soaring internet stocks were clearly overvalued in fundamental ratios, people kept buying them.
They would “analyze” an internet company by looking at their traffic, click through rates, and other obscene metrics. The truth was too obvious to heed, and so most investors ignored it. All the while the internet stocks were insanely overvalued in the most basic of fundamentals.
But people will always find an excuse to dismiss the truth.
It’s different this time, they said. It’s a new economy this time, they said. Ah, you fools. So they said during the technology booms in 2007, 1999, 1950s, 1929, 1900s, and beyond.
Yes technology changed our world each time. But each time, the thesis for value investing held true. That, my friends, is quite an accomplishment.
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.