To better understand what is value investing, you need to know first:
What is investing?
And why do we bother to invest in something?
The answers to these questions seem to be so intuitive. However, it’s not that simple. really.
I’d like to quote Warren Buffett’s words about investment as the best answer to the above questions.
“ Investment is putting out money to get more money back” Warren Buffett
This leads to our main question:
What is value investing, and how does it work?
Value investing is the art and science of finding assets that have been temporarily undervalued for whatever reasons and hold on to these assets until the market recognizes their true value.
This is why we look for something valuable that is being sold at a discount to its true value to invest in.
Your goal when you buy an asset at a lower price is to make more money out of this asset.
What happens when an adequate number of stock market participants realizes its intrinsic value and bids up the price of the asset.
In other words, when you buy an underpriced valuable asset. Then you’ve got more value for money as the asset has more upside potential.
Imagine, what would you get if you invested your money in something that doesn’t worth it or you’ve bought an overpriced asset?
I think it’s now pretty clear that when you invest in a business that is not worth what you pay for you would have a hard time getting more money back from the business.
And the worst-case scenario is you might lose some or all your invested capital in that business.
Who is the founder of value investing principles?
Benjamin Graham, the professor at Columbia Business School, was the first to put sound principles for investing based on the value of the assets.
Graham developed the concept of value investing with David Dodd in 1934 in their book Security Analysis. Then he popularized it in 1949 in his widely known book The Intelligent Investor.
So Graham is often regarded as the father of value investing.
Why you should pursue value investing
To avoid losing your money as that should be the first and most important thing to care about as a value investor. As well as increasing your odds of generating profits over time.
A value investor takes only informed decisions. That is of course based on studying the business fundamentals and reading carefully the key financial metrics of the company. Read more about how to build assets here.
What is your clue that value investing is a successful investment approach?
Needless to say that buying assets at a discount to their true value align with the logic of making profits.
With that said, value investing strategy has well-known practitioners who amassed great fortunes by sticking to its principles over years. Such as:
Benjamin Graham, David Dodd, the Berkshire Hathaway CEO Warren Buffet who often regarded as the world’s most successful investor, Charlie Munger (Buffett’s right hand man, and his partner too), and Peter Lynch the manager of Magellan Fund, who generated annual returns of more than double the S&P 500 stock market index for 13 years on average.
There are also other more big names of successful value investors that we may mention elsewhere.
How to invest like value investors
Look for businesses within your circle of competence
When you focus on selected businesses within your circle of competence that means you’ll be more likely able to make smart decisions and avoid making big mistakes.
What is your circle of competence?
It’s the areas where you are more knowledgeable and familiar with.
While you’re looking for the areas that you think you know and understand, try to answer this question:
Where should we devote our limited time in life to achieve the most success? Charlie Munger
Of course, you can widen your circle of competence but smoothly and as you grow.
However, you should keep respecting the boundaries of your competence area to avoid setbacks and maintain focus.
The business should meet the value investing principles
- The company should have a consistent record of revenue and earnings.
- Does it have a good return on equity (ROE) over many years?
- Is there credible management behind the business?
- Does it have a sensible price that aligns with the value investing principles that we discussed earlier?
- What about the advantages that the company has to protect it from fierce competition.
- What about the debt to equity ratio? The higher the ratio means the company depends on debt for funding its operations and so more of its returns are going towards servicing debt. So these businesses should be out of favor for value investors.
Invest in businesses that have stood the test of time
How many years the business has been providing a reasonable return on equity, the more the number of years the better.
Look for big brands with a big track record of success. Read more about branding and big brands here.
Don’t follow the herd mentality
One of the defining characteristics of stock market participants is overreacting to good or bad news.
This in turn leads to high swings in stock prices and sometimes makes a big difference between the market share prices and their intrinsic value.
In this case, according to Buffett and all savvy value investors, you need to go in the opposite direction.
“Be fearful when others are greedy, and greedy when others are fearful” Warren Buffett
As when the bad news dominates the stock market, you’ll see waves of sell-off and the prices go to the bottom away from the shares’ intrinsic value.
In this case, value investors know that is the time to find stocks that meet their criteria. So they will go buying greedily.
On the other hand, when the good sentiments are dominating the stock market the share prices soar high.
Then value investors go selling to garner profits from shares they’ve bought at low prices when the stock market participants were pessimistic.
Cash is a position
If you cannot find a business that is worth your money and meets value investors’ principles. According to Buffet, it’s far better to keep cash in hand until hanging fruits appear on the horizon of investment. As he considers that cash is a position in this case.
Intrinsic value and key financial metrics
The key to using a value investing strategy as an investment approach is knowing the true value of the assets. That is called in financial terms the intrinsic value.
How important the intrinsic value is in stock valuation?
In Buffett own words “intrinsic value is the only logical approach to evaluating the relative attractiveness of investment and businesses”
What is the intrinsic value?
Intrinsic value is the present value of the company’s future cash flows.
Since there are many assumptions involved in calculating the intrinsic value so it is often a range rather than a precise number.
The proponents of value investing take Buffett’s opinion in this regard into account.
“It’s better to be approximately right than precisely wrong” Warren Buffett
Key financial metrics
There are some helpful financial metrics that value investors use to determine how far the current stock price is from the company’s intrinsic value.
The ratio compares the company’s stock price to book value per share.
What is book value?
It’s the company’s net worth divided by the total outstanding shares.
What is the company’s net worth?
Company’s net worth = Assets – Liabilities.
When the ratio is less than 1 it’s a positive sign that the stock is selling for less than the company’s net worth.
In this case, the stock is most probably undervalued. However, that isn’t enough for the savvy value investor to make investment decisions. For him, that is only a sign to start a further analysis.
The ratio compares the company’s stock price to its annual earnings. The lower the ratio the better. As it means that the stock price is undervalued since it is not reflecting the company’s earnings.
However, as we mentioned earlier there is no one metric that we can rely upon. We often need further analysis to make informed decisions and pick the right value stocks from the market.
Free cash flow
Cash flow is the lifeblood of the business. Free cash flow is the amount of money that has leftover after funding all the business operations needed for the business to continue running.
Free cash flow (FCF) = Operating Cash Flow – Capital expenditures
A positive free cash flow is indicative of corporate financial health. Companies with enough free cash flow in hand tend to consider expanding or developing new products.
Margin of safety
It’s the number one principle that the value investor should take into consideration.
As it keeps your losses at an absolute minimum when the market swings wildly.
In Buffett’s own words “Margin of safety-the three most important words in investing”
“It’s adherence to the concept of a margin of safety that best distinguishes value investors from all others who are not as concerned about loss.” Seth Klarman
What is the simple definition of safety margin or margin of safety?
It’s the difference between the current stock price and its intrinsic value that makes your investment safer and has enough upside potential.
The greater the difference the better the investment. That is of course after taking into account all the other aspects of value investing that we referred to earlier.
How much a margin of safety should be a target?
The great investor and mentor Benjamin Graham argued that “an undervalued stock is priced at least a third below its intrinsic value”
It doesn’t, however, mean that there aren’t better opportunities. During a market crash, you can find gems in the ruins.
Buffett himself once said, “we bought amazing businesses for a quarter to its real value”.
Value investing and patience
It’s no secret that patience is tied to all kinds of success. But in the case of value investing patience is critical.
As value investors should develop a long-term strategy for their investments to pay off.
“If the job has been correctly done when a common stock is purchased, the time to sell is almost never.” Warren Buffett
Value investing and speculation
Unlike speculation, value investing is only best suited to those who have long term focus.
The value investor has made his decision after studying the business thoroughly. So he knows that he will be rewarded handsomely in the future of his investment.
Speculators, on the other hand, focus on the hottest companies in the stock market that he expected to make significant gains in the short term.
The value investing approach has helped many well-known investors around the world building significant fortunes. So it is worth following. Though the strategy is crystal clear most would-be investors couldn’t develop the patience and long-term vision needed for the strategy to pay off.
It turns out that the real challenge to be a successful value investor is to resist all the temptations associated with the hottest stocks in the market.
Just follow the value investing principles and follow the suits of those who made it.