Many investors look to Warren Buffett – and others like him – as a beacon of investments. There is, after all, no doubt that Warren Buffett has been extremely successful at what he does. But how did he and his contemporaries get to where they are today? What was their strategy? The short answer is value investing. Buffet is one of the value investors, which means that he buys stocks for lower than they are worth.
This appears to be a fairly basic concept: of course we always want to get something for less than its perceived value. But actually executing a successful value investment strategy can be quite difficult. To succeed at value investing, you must not only be sufficiently comfortable with the stock market, but you must also know how to assess stock value. Furthermore, you would also need to know when to sell a stock and how to assess a company’s financial performance.
In this article, we will discuss in more depth the value investment field, as well as some of the basic principles for value investing itself.
So, What Kind of Investing Do Value Investors Do?
As we said above, value investing is the strategy of investing in stocks that they believe are less than market value, or that the stock market is underestimating. Hence these stocks are being traded for less than their intrinsic value. This approach makes a lot of sense in theory, but of course, the trick is to pull it off effectively.
However, if you do not do your due diligence in choosing undervalued stocks to invest in – or if you simply pick wrong – you could have a problem on your hands. You could suddenly end up with a whole lot of stocks at market value (or below) and that you now must attempt to make a profit.
Some Principles that Value Investors Follow
Let’s discuss a few principles that are extremely important in the value investing field.
They don’t follow trends
First, one of the key traits of value investors is that they do not follow the herd. Some very successful investors watch the stock market closely to see which stocks are trending, thus determining which stocks to invest in. Value investors do not. They base their investments off of their own independent financial analysis, not market trends.
The margin of safety
Another critical tenet – perhaps the most important tenet – of value investing is the margin of safety principle. The margin of safety principle essentially sums up the reasoning behind value investing. Thus, it states that if you buy stocks at discounted prices, you will dramatically improve your chances of earning a profit when you sell them at a later date.
The margin of safety principle is also important because it contains the premise that even if the stock does not perform as well as you thought it would, you are less likely to lose money on it since you paid less for it upfront.
The effective market hypothesis
This next principle is actually one that value investors disavow. But it is still important to discuss, as it helps one to better understand the thinking behind some value investing.
This principle is the effective market hypothesis, and it holds that the price of a given stock already has all of the relevant information about its company. As a result, the price already reflects the stock’s intrinsic value.
If you believe in the effective market hypothesis, it would make value investing irrelevant, as no stocks would be undervalued.
Hence, value investors disagree with this hypothesis because it essentially stands against their fundamental principle.
How Do Value Investors Determine the Value of Stocks?
Knowing which stocks to invest in – or which are underperforming – is the key to value investing. So how can value investors tell if a stock is being undervalued?
There are a variety of metrics that come into play when assessing a stock’s value.
The value of a stock, or its intrinsic value, is derived from a comprehensive financial analysis of the company in question.
This includes the company’s:
- financial performance
- cash flow and profit margin
- business model
Investors can find much of this information in the financial statements and investment reports of companies they research, as we discussed in our last post.
Price to book value
One of the most important metrics is the price to book value, also referred to as the book value. This particular data point calculates the value of a company’s assets and then compares that number to the price of the stock. They consider the stock undervalued if the price of the stock is lower than the value of the company’s assets.
Price to earnings
Another commonly used metric when considering buying stocks for value investing is the price to earnings metric. Price to earnings essentially evaluates a company’s earnings history and then determines whether or not the price of the stock reflects its entire earnings track record.
The free cash flow concept is also an important one to consider when determining if a stock is undervalued, and thus worth investing in. Free cash flow calculates the company’s cash flow. This is the cash assets that result from the company’s operations after subtracting their expenditures.
If the company has notable cash flow left over, it has free cash flow and is highly desirable in terms of buying stocks in that company.
Value investing with mutual funds
Value investing can certainly be overwhelming, especially when going about it on your own as a private investor. This is where value investing with mutual funds comes in – most major fund companies offer both actively and passively managed value funds.
The specific approach to value investing varies significantly based on the company. So, if you are interested in value investing, you might consider working with a fund manager at a major company to get started. Since there is some variance in the type of value investing company by company, you should have some flexibility in terms of what exactly you’d be signing up for.
Two Types of Investing Strategies for Value Investors
What exactly do we mean when we talk about “types of value investing”?
Like many other investment strategies, value investing exists on a continuum. This continuum goes from passive value investing to active value investing.
A passive strategy is the most basic version of value investing: buy stocks after your financial analysis of their intrinsic value. Afterwards, you wait for the market to adjust to their actual value, and then sell them for a profit.
An active approach to value investing is has more involvement. It consists of buying undervalued stocks with the intention of raising the stocks’ market value by encouraging the company to make improvements. As a result, the company would become more valuable.
Active value investors are typically in it for the long term. Through their fundamental analysis, they purposefully seek out companies that could make changes and thereby increase their market value.
This could mean many different things: maybe if the company:
- makes just a few simple financial tweaks, resulting in better cash flow, thus increasing the value of their stock
- has a problem with management, and after a change, the company can run more efficiently, which would also increase the stock value
Due Diligence is Key for Value Investors
As you can imagine, active value investing is much more of a commitment than passive value investing. In order to effectively pull off an active value investment strategy, the investor must be confident in the research they have done regarding the company in question. And they also must be confident that they will be able to persuade or work with the company to make the changes necessary to boost the price of the stock.
Most beginners to value investing take a passive approach (either on their own accord or through mutual funds), while investors with more experience take on active value investing. And then, of course, there is a wide middle ground between active and passive value investing.
For more ideas on investments, and in particular alternative investments, read this recent article.
Have you thought about becoming a value investor, but are not ready to commit to a fully active value investing strategy? We would can consult with you about your options and can help you choose the strategy that works best for you.
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