The Concept Of Value Investing
This post covers an investment strategy called value investing. See what it’s all about and if it’s something you’d do!
Author: Value of Stocks
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The Concept Of Value Investing
Value investing can be defined in many ways. Although the notion has been in practice for quite some time now. Value investors have drifted from the initial concept.
Charlie Munger has said:
“Basically, all investment is value investment in the sense that you’re always trying to get better prospects that you’re paying for”
Charlie Munger is often known for his wisdom, and he is right. Despite his idea, many value investors have different views on it. Value investing can be defined in many ways. Benjamin Graham, often recognized as the father of value investing, was the first to propose a value investment strategy. According to him, by buying low price-to-book and low price-to-earnings stocks, investors could wait for a reprice and sell the stock higher.
Value Investing: A Simple Idea
The idea behind the value investing concept is simple. You want to pay less than what something is worth. Determining what a stock is worth, enables you to know when to buy it cheaply. Oftentimes value investors will look at the balance sheet, focusing on its assets and liabilities, trying to calculate the value of stocks. Ben Graham advocated for researching a company’s earnings going back ten years. By studying the company records, you can see how consistent the numbers are.
In essence, value investing refers to investors looking to buy undervalued stocks or value stocks. Some market players are looking for anything they can buy now and sell higher a week later. All this hassle and stress are not experienced by value investors. A value investor will analyze stocks, according to certain metrics such as the price-to-book, price-to-earnings, and dividend yield, in the hope of finding a stock that has a higher value than what it is currently trading at.
price is what you pay, value is what you getWarren Buffett
Main Ideas Behind Value Investing
1 – Stocks are not lottery tickets
As it was said by Peter Lynch a share of stock is not a lottery ticket. It represents an ownership interest in the underlying business. When acquiring stocks, look at the underlying business. Focus on how the business is doing. The stock price fluctuation will reflect that in the long term.
Stocks should not be bought with the intention of selling them for a higher price next week. It represents the right to receive future cash flow distributions from the business, while at the same time benefit from the company’s success.
2 – Focus on intrinsic value
Investors should focus on valuing companies. Being able to value a company correctly is a strategic part of being a successful value investor. Only by valuing the company correctly, can you decide at which price it is undervalued. The financial results of the company are the go-to place to start your research. Analyzing the company’s financial statements is the key to determine a stock’s intrinsic value.
3 – The markets need to be inefficient
The stock market is inefficient, and to be a successful value investor, the market needs to be this way. Otherwise, if the market was efficient at all times, value investors would not be able to purchase undervalued stocks.
The Efficient Market Hypothesis is something value investors frown upon. They strongly believe stocks often trade either above or below their intrinsic value. By determining the intrinsic value of different stocks, value investors can profit by buying those stocks under their intrinsic value.
4 – Approach it strategically
To be successful at picking stocks, you need to take it seriously. Investing is not a hobby you put one or two hours a week into. To be successful you have to do deep research, keep up to date with the news and dedicate as much time as you can. There are millions of market players. If you want to succeed and do better than them you either work harder, or you develop a special strategy.
5 – Establish a margin of safety
A value investment requires a margin of safety. A margin of safety, a notion initially introduced by Seth Klarman in a book with the same name, is the concept of calculating the value of a security based on its assets. It can be calculated using the working capital position of the company, its past earnings or assets, or a combination of some or all of the above.
Once you establish the margin of safety of a specific stock, now you know at what price the stock will be interesting. The bigger the margin of safety, the better your odds will be of having a profitable investment. The margin of safety was designed to prevent any miscalculations the value investor may be liable to.
What Value Investing Is Not
As we have seen, value investing is the process by which an investor buys a stock worth more than the price paid. This fact alone separates value investing from most investment strategies. True value investors will often overlook the price fluctuations and instead focus on the operational part of the business. As time passes the stock price will converge to the business value. If the business is growing and compounding over time, that should be the main focus for investors. The price action in the short term will only distract you from the big picture.
Some value investors value stocks considering relative prices, meaning the price relative to peers. This means an investor will look at stocks in the same industry. By comparing prices he/she may find that the market will value earnings in one company much higher than in another. Although this is an extremely valid investment strategy and theory – It is not value investing.
Value investing requires the investor to value the business, by calculating the business’ intrinsic value independently of the market price. Comparing prices of different stocks, although useful, is not what value investing is about.
What Do You Need To Value A Business?
By now you probably think that you need to be a math genius, in order to value businesses. The truth is investing requires basic math skills. It is not rocket science. Besides the simple math skills needed, you also need to be highly knowledgeable of how some industries or companies operate. You should also invest in what you know. Focus on your circle of competence, and analyze stocks within that circle.
Contrarian investing is often referred to as a sub-category of value investing. In fact, there are a lot of similarities between value and contrarian investors. In essence, both strategies try to look for cheap stocks. Contrarians will tend to look at the price action, and look for falling knives (which is usually used to describe falling stocks).
Value Investing Is All About Valuing Stocks
Value investing is nothing more than buying a stock for less than its value. This is done by calculating the value of stocks, without considering the market price. The value is calculated based on discounted cash flows, and the value of assets, or working capital. Buying stocks simply based on a low price-to-earnings, price-to-book or price-to-cash flow is not enough. While a valid investment strategy overall, value investing requires an estimate of the business value. Without an estimate of the value, investors will not know which price to pay.
Remember that whenever you buy a security you are going against the general consensus. The market sets a price according to the general consensus of what the price should be. Whenever you buy or sell, try to think of what the person on the other side of the trade is thinking. It is interesting that whenever you buy or sell a security there is someone on the other side of the trade, taking the exact opposite opinion. Imagining what the other person must be thinking can be an excellent exercise to put things in perspective. You can not be a value investor unless you are willing to calculate business values. To be a value investor, you don’t have to value the business precisely – but you do have to value the business.