Value Investing – What is Value Investing?

What is value investing?

Value investing meaning is an investment approach centred on identifying stocks that are undervalued by the broader market. The targeted stocks, according to this strategy, typically appear inexpensive in comparison to their actual revenue and earnings potential. Practitioners of value investing anticipate that the stock’s market value will increase as more investors recognize the true intrinsic value of the company’s fundamental business. The larger the gap between the intrinsic value and the current stock price, the more significant the margin of safety for value investors seeking promising investment opportunities. This margin of safety is crucial for mitigating potential losses, as not every undervalued stock may successfully recover. Therefore, value investors rely on this margin of safety to minimize their risks in case their assessment of a company proves inaccurate.

Understanding value investing in simple terms

Now, that we know what is value investing let’s understand this in much simpler terms. The fundamental principle behind everyday value investing is quite simple: understanding the true value of something enables significant cost savings during the purchase. Analogous to buying a television either on sale or at full price, where the TV remains the same in terms of screen size and picture quality, stock prices operate similarly. A company’s share price can fluctuate even if its valuation remains constant, indicating that there isn’t an absolute or intrinsic value for a company’s stock. However, there are relative values.

Stock market participants have the flexibility to buy or sell shares without being confined to a fixed price. Consequently, stocks, like televisions, experience periods of varying demand, leading to price changes. If a company’s fundamentals and future prospects remain unchanged, the value of its shares is essentially the same despite differing prices.

Just as savvy shoppers argue against paying full price for a TV, recognizing that TVs frequently go on sale, astute value investors apply a similar philosophy to stocks. Unlike televisions, stocks don’t follow predictable sale schedules like Black Friday, and their discounted prices aren’t advertised. Value investing involves investigative work to uncover these concealed sales on stocks and acquire them at a discount compared to their market valuations. By holding onto these value stocks for the long term, investors stand to gain substantial rewards.

How did value investing get started?

The trajectory of value investing has undergone a transformation over the years. Originating during the Great Depression and its aftermath, the strategy initially revolved around acquiring companies whose assets surpassed the market value of their stocks. This approach was influenced by the prevalent scenario of numerous companies going out of business, making it advantageous to purchase stocks below the value of their assets, especially in the context of potential liquidation.

Over time, value investing has evolved beyond a sole focus on asset values to encompass a more comprehensive analysis of a company’s cash flows and earnings. In its contemporary form, value investors delve into assessing a company’s competitive advantages, seeking to determine whether a stock is significantly undervalued. This shift reflects a broader and more nuanced understanding of a company’s intrinsic worth beyond just its asset value.

Is value investing right for you?

If your primary investment objective is to minimize the risk of permanent losses while enhancing the likelihood of positive returns, you likely align with the core principles of a value investor. In contrast, individuals who gravitate toward pursuing the most popular companies in the market may perceive value investing as unexciting, given that growth prospects for value-oriented firms often appear modest at best.

Value investors need to exhibit resilience. The process of identifying value in investments often involves eliminating more stocks than it reveals, making it a potentially frustrating approach, particularly in a bullish market. It’s not uncommon for stocks you exclude from your buy list during your search to continue rising in value during bull markets, despite being initially deemed too expensive. However, the payoff manifests when the bull market concludes, as the margin of safety inherent in value stocks can significantly facilitate weathering a downturn.

Why invest in value stocks?

The allure of a good deal is universal, and value investing caters to this preference by targeting stocks priced below their intrinsic value. This investment strategy is particularly attractive to those who appreciate bargains. The key to profiting from a value stock lies in other investors recognizing the disparity between its current market price and its true worth. Once this realization occurs, the share price is expected to rise, yielding profits for those who bought in at a discount.

Moreover, the appeal of a margin of safety is significant for many investors. Acquiring a stock for less than its inherent value doesn’t guarantee immunity from further price declines, but it does reduce the likelihood and severity of such downturns. For individuals who identify as defensive investors with a low tolerance for risk, a well-selected value stock offers a dual benefit—protection against losses and the potential for gains when the market acknowledges the stock’s true value.

While value investing demands patience, as it often takes time for a value stock to be revalued at a more appropriate and higher level, the returns can be substantial for those willing to wait. This patience becomes a virtue for investors seeking sizable returns in the long run.

How to find value stocks

Successfully engaging in value investing necessitates thorough research. Conducting extensive due diligence involves examining numerous undervalued stocks to evaluate a company’s intrinsic value in comparison to its current stock price. The process often requires scrutinizing dozens of companies before discovering a genuine value stock.

While the research-intensive nature of value investing may seem daunting to potential practitioners, there are strategies to streamline the identification of promising value stocks. A comprehensive understanding of diverse methods for valuing a company and assessing its business outlook enables investors to efficiently eliminate unsuitable stocks, allowing them to focus more quickly on the most promising candidates. In essence, mastering the intricacies of valuation techniques and business evaluation serves as a valuable toolkit for value investors, helping them navigate the market with greater precision and effectiveness.

What makes a great value stock?

Value stocks are known for their inexpensive valuation compared to their assets or key financial metrics like revenue, earnings, or cash flow. However, the best value stocks possess additional appealing characteristics, such as established businesses with a long history of success, consistent profitability, stable revenue streams, and dividend payments (although the latter is not a requirement). It’s important to note that a company with all these attributes may not necessarily be a great value stock since some stocks may appear attractive but are actually value traps. These value traps can continue to decline in share price, despite seeming like a good investment opportunity.

What are the best value investing strategies?

When you want to purchase an undervalued stock, it is essential to conduct thorough research on the company and make sensible decisions. Christopher H. Browne, a value investor, recommends assessing whether a company is likely to increase revenue through the following methods:

– Raising prices on products
– Increasing sales figures
– Decreasing expenses
– Selling off or closing down unprofitable divisions

When it comes to value stock investing, evaluating a company’s future growth prospects can be quite challenging and speculative since there are no quantitative software programs to provide supportive numerical data for the answers to those questions. However, one approach that Warren Buffett recommends is to invest solely in industries that you have personally worked in or are familiar with, like cars, clothes, appliances, and food. Another strategy is to invest in companies that sell high-demand products and services. While predicting innovative new products’ market share can be challenging, evaluating how long a company has been in business and how it has adapted to challenges over time is much easier.

Insider Buying and Selling

For our purposes, insiders refer to senior managers, directors, and shareholders holding a minimum of 10% of the company’s stock. The unique insights that managers and directors possess about their companies make it reasonable to infer positive prospects when they buy company stock. Similarly, substantial stock ownership by investors suggests a belief in profit potential. On the contrary, an insider’s stock sale doesn’t automatically indicate negative news about the company; it could be driven by personal financial needs. However, a widespread pattern of insider selling might prompt a more thorough investigation into the underlying reasons for the sales.

Analyze Financial Reports

Value investors must inevitably delve into a company’s financials to assess its performance and compare it to industry peers. The financial reports, namely the SEC Form 10-K for annual results and SEC Form 10-Q for quarterly results serve as crucial documents. These reports are mandatory filings with the Securities and Exchange Commission (SEC), readily accessible on either the SEC website or the company’s investor relations page.

The insights gained from a company’s annual report are substantial. This comprehensive document not only outlines financial performance but also provides a detailed overview of the products and services offered. Moreover, it offers valuable insights into the company’s strategic direction and future trajectory.

What are the risks of value investing?

Like any investment approach, value investing carries the potential for losses, despite being considered a strategy with relatively low to medium risk. Here, we outline some of these risks and explore the reasons behind potential financial setbacks.

The Figures are Important

When engaging in value investing decisions, many investors rely on financial statements. It’s crucial to ensure that your analysis is based on the most recent and accurate information. Failing to do so could lead to poor investment choices or missed opportunities. If you’re not yet confident in your ability to interpret and analyze financial statements, continue studying these subjects before executing any trades.

A helpful strategy is to thoroughly examine the footnotes accompanying Form 10-K or Form 10-Q. These notes provide a detailed explanation of a company’s financial statements, including accounting methods and additional insights into reported results. If the footnotes are unclear or if the information appears dubious, this insight can guide your decision on whether to proceed with the stock or not.

Extraordinary Gains or Losses

Certain incidents that may appear on a company’s income statement are considered exceptional or extraordinary. These events, often beyond the company’s control, are labelled as extraordinary items—gains or extraordinary items—losses. Examples include legal disputes, restructuring efforts, or natural disasters. By excluding these from your analysis, you can gain insights into the company’s future performance.

However, it’s essential to approach these items with critical thinking and exercise judgment. If a company consistently reports the same extraordinary item year after year, it may not be as extraordinary as it seems. Likewise, recurring unexpected losses over several years could signal underlying financial challenges for the company. Extraordinary items are meant to be rare and nonrecurring. Additionally, be cautious of a consistent pattern of write-offs.

Ignoring Ratio Analysis Flaws

There isn’t a single way to determine financial ratios, which can be problematic. The following factors can influence how ratios are interpreted:

• Ratios can be calculated using before-tax or after-tax numbers.
• Some ratios may not provide accurate results but lead to estimations.
• Depending on how earnings are defined, a company’s earnings per share (EPS) may differ.
• Comparing different companies based on their ratios, even if they are the same, can be challenging since companies follow different accounting practices.

Buying Overvalued Stock

One of the primary risks facing value investors is the potential to overpay for a stock, leading to the risk of losing a significant portion of the entire investment. This risk is also present when purchasing a stock close to its fair market value. Opting for undervalued stocks serves to mitigate the risk of financial loss, even in cases where the company’s performance is subpar.

It’s crucial to remember that a fundamental principle of value investing involves incorporating a margin of safety into every investment. This implies acquiring stocks at a price that is approximately two-thirds or less of their intrinsic value. Value investors aim to minimize the capital at risk in potentially overvalued assets, emphasizing the importance of avoiding overpayment for investments.

Not Diversifying

Conventional investment wisdom often emphasizes the high-risk nature of investing in individual stocks, advocating for diversification across multiple stocks or stock indexes to gain exposure to various companies and economic sectors. However, some value investors argue that a diversified portfolio can be achieved with a small number of stocks, as long as they represent different industries and economic sectors. Christopher H. Browne, a notable value investor, suggests owning a minimum of 10 stocks, while Benjamin Graham recommends looking at 10 to 30 stocks for diversification.

On the contrary, another school of thought suggests that focusing on just a few stocks may lead to significant returns. The authors of the second edition of “Value Investing for Dummies” propose that a larger number of stocks in a portfolio may result in average returns. However, this advice assumes a high level of proficiency in selecting winning stocks, which may not be the case, especially for those new to value investing.

Listening to Your Emotions

Managing emotions in investment decisions can be challenging. Even if you can maintain a detached, analytical approach when assessing numbers, feelings of fear and excitement may arise when using your hard-earned savings to buy stocks. Importantly, after purchasing a stock, the temptation to sell may intensify if the price experiences a decline.

It’s crucial to remember that the essence of value investing lies in resisting the urge to succumb to panic and follow the crowd. Avoid the trap of buying when share prices surge and selling when they dip, as such behaviour can significantly erode your returns. Engaging in a follow-the-leader mentality in investing can swiftly become a risky game.

How to learn value investing?

Enroll in our comprehensive value investing course at EduBridge for a deeper understanding of the financial markets.