Value investing, we should adopt this investment strategy because the famous Warren Buffett does it right?
Not quite so.
While Warren Buffett is a well-known investor and popularised this strategy, there are certain characteristics that made him successful in doing so that doesn’t apply to the average joe.
Continue reading to find out more about value investing and if it’s for you.
What is Value Investing?
Value investing is a style of investment that seeks to identify undervalued companies and then invest in them using various strategies, including:
- Buy-and-hold – buying shares when they are cheap and holding on to them until they become more expensive.
- Fundamental analysis – looking at the financial statements of a company to determine its intrinsic value.
- Technical analysis – analysing charts or graphs to predict future price movements.
- Style analysis – comparing different types of investors (e.g., growth vs. value) and their approaches (e.g., fundamental vs. technical).
The basic premise behind value investing is that most stocks go through cycles where they are overpriced for some period of time before becoming undervalued. This concept can be illustrated by the following example:
A stock has been trading at $100 per share for two years. It then falls to $80 per share. A value investor would buy this stock because it is now cheaper than it was during those 2 years.
In essence, based on the investor’s analysis of the company’s financials, he determines that indeed $100 is the fair value of the company after analysing its fundamentals, and expects the share price to go back up to $100.
Therefore, he can expect to make $20 per share from this – or 25% returns on this strategy.
How does Value Investing work?
There are 2 ways how value investing works – Quantitative and Qualitative.
Quantitative Value Investing
This type of value investing focuses on numbers and uses mathematical formulas to calculate the worth of a business.
It looks at the balance sheet, income statement, and cash flow statement of a company and compares these figures with those of similar businesses.
The most common method used by quantitative value investors is the discounted cash flow model.
In this model, an analyst calculates the future earnings, dividends, and capital gains of a company over time.
These calculations are then compared with similar companies to determine whether the current share price reflects the true value of the company.
Qualitative Value Investing
Unlike quantitative value investing which relies heavily on data, qualitative value investing takes into account factors such as management quality, competitive advantage, brand equity, and other intangible assets.
To do this, analysts will look at the market reaction to a company’s news events and analyse the behaviour of the stock price.
They also consider the company’s track record and reputation within the industry.
You already know this would be a difficult thing to do as it involves a lot of guessing of the future without any financial data.
Personally, if I had to choose only one for my investment decision, I’d go with the quantitative value investing strategy as it’s backed by the company’s financials.
However, it’s best to employ both methods together as there are many internal and external factors that can affect the price of the stock, many of which are both predictable and unpredictable.
- Changes in earnings forecasts
- The introduction of new products or services
- Corporate governance issues
- Competition from other firms
- Political events such as wars or natural disasters
- Stock market volatility
- Company management problems
- Management’s desire to return cash to shareholders
- Dividend yields
- Interest rates
- Exchange rate fluctuations
- Government regulations
- Economic conditions
- Market psychology
- Other factors
Why do I need to learn about value investing?
As mentioned above, value investing is based on the idea that most stocks will experience periods of being overpriced followed by periods of being underpriced.
By identifying these opportunities, you can make money by purchasing shares at low prices and selling them at high prices.
However, not all stocks follow this pattern. Some stocks rise rapidly after going public and others fall sharply. If you were to try to apply value investing to every single stock, you would lose money.
So how do you know which ones to invest in?
You need to have a good understanding of the business sector in which your investments are located.
You also need to understand what makes each company unique. For instance, one company might manufacture widgets while another manufactures steel beams. Both companies produce goods but only one produces widgets.
If you don’t know much about the industry, you should find out. Successful value investors read books, magazines and newspapers to get information about the economy, politics, technology, etc.
Also, talk to people who work in related industries. They can give you insights into the trends in the industry.
Having a thorough understanding of the industries you’re placing your investments in helps you understand which stocks are a good pick and which aren’t.
What are the key characteristics of value investing?
The key characteristics of value investing are that value investors believe that investors are irrational, there is intrinsic value in the selected stocks, abide by a margin of safety, and have patience.
To start off, they believe that investors are irrational and that stock prices do not accurately reflect its fair price. Therefore, creating opportunities for the value investor.
Value investors believe that there is an inherent value in the selected stocks. It’s important to note that this does not mean that the stocks are “worthless” just because it’s cheap. It simply means that they believe that it’s an undervalued stock and it’s likely to appreciate.
They also believe that there is a margin of safety built into the stock. The margin of safety refers to the difference between the current price of the stock and its intrinsic value.
This is important as sometimes stocks don’t reach their fair value, no matter how good your analyses were and how long you wait.
Not forgetting that this is important as it determines how much profits you’ll make from your investments. The larger the margin of safety, the higher the returns.
How do I choose my investments?
Before choosing any particular stock, you must first decide what kind of investor you want to be. Do you prefer to buy individual stocks or unit trusts?
Are you interested in long-term investments or short-term trades?
In addition, you need to consider your risk tolerance. Some people like to play it safe and avoid risks, whereas others enjoy taking big gambles.
Finally, you need to think about your time horizon. A person who wants to retire in 20 years may not care as much about returns as someone who needs the money now.
On the other hand, someone who is saving for his/her children’s education may put less emphasis on return than on safety.
Once you have decided what type of investor you are, you can start looking for potential investments. Here are some questions that will help you:
1) What is the market capitalisation of the company? Market capitalisation refers to the total value of all outstanding shares of a company. It is calculated by multiplying the number of outstanding shares times the share price.
2) Is the company profitable? Profits are important because they indicate whether the company is able to generate enough revenue to cover its costs.
3) Does the company have a competitive advantage over its competitors? Competitive advantages come from factors such as lower production costs, better technology, or greater brand awareness. These advantages allow companies to charge higher prices and sell their products or services to customers at a higher margin.
4) Does the company have strong management? Strong managers tend to make good decisions when confronted with tough situations. They also know how to manage their own resources effectively.
5) What is the company’s track record? Track records show how successful a company has been in the past. You can find out a lot about a company’s history by reading its annual reports and financial statements.
6) Has the company experienced recent changes in strategy or business model? Sometimes new strategies require companies to cut back on expenses. As a result, these firms might experience a temporary decline in earnings. This could be an opportunity for investors to purchase low-priced stocks.
7) Is there anything unusual about the company? For example, is the company involved in litigation or facing environmental problems? If so, this information can be useful in determining whether the company is likely to continue growing.
8) Is the company diversified? Diversification means having investments spread across different industries and countries. In general, a well-diversified portfolio reduces the chances of losing everything.
9) Is the company’s stock undervalued? Some companies have high P/E ratios because investors expect them to grow quickly. To avoid getting caught up in this trend, it is best to look for companies whose P/Es are below the industry average.
10) Is the company‘s industry attractive? Industries that are growing rapidly are always attractive investment opportunities.
11) Is the company’s product or service unique? Unique products or services are valuable assets that can increase the company’s profits.
12) Are there any special events related to the company? Special events include mergers, acquisitions, bankruptcies, and liquidations. Such events can create short-term volatility in the stock price. Investors should try to identify potential events before they occur.
13) How much does the company pay in dividends? Companies usually pay dividends to shareholders to reward them for keeping their money invested with the firm. The amount of dividends paid each year indicates the degree of confidence the company has in its future growth.
14) Is the company currently experiencing financial difficulties? Financial difficulties may affect a company’s ability to meet its obligations. A company that cannot repay its debts will not be able to invest in expanding its operations.
15) Is the company’s debt level increasing? High levels of debt can lead to financial distress. It is therefore important to monitor your portfolio to ensure that you do not end up buying securities that are too heavily leveraged.
16) Does the company have a good reputation? Reputation refers to the way other people perceive a particular company. Good reputations make it easier for businesses to attract customers.
17) Have the company’s competitors recently gone out of business? When a competitor goes out of business, it creates a hole in the market that must eventually be filled. This leaves room for competition and increases the likelihood that the remaining players will succeed.
Value Investing Vs Growth Investing
The difference between value investing and growth investing is that value investors focus on companies that are cheap relative to their earnings.
This is done through analysing the statements and financial ratios of the company.
Growth investors prefer to purchase shares of companies that are expected to generate higher returns over time.
Value Investing vs Dividend Investing
Dividend investing focuses on maximising your dividend income by selecting stocks that pay the most dividends.
Value investing aims to purchase stocks that are undervalued and look to make money from capital gains.
Value Investing Vs Index Investing
Value investing and index investing differs from each other in many ways. Both types of investment strategies involve selecting stocks based on some sort of analysis. But there are differences in how they go about doing so.
Index investing involves purchasing a basket of stocks that represents a specific sector or type of security. The goal of index investing is to achieve broad exposure to a group of stocks without having to analyse individual companies.
This is commonly done via an exchange-traded fund.
Value investing focuses on individual companies rather than entire sectors. Value investors look for quality companies with strong competitive advantages and high-profit margins.
These characteristics allow them to withstand changes in the broader environment.
Things to look at as a value investor
A value investor seeks to find undervalued stocks by analysing a number of factors such as:
1) Earnings per share – how much cash a company generates per share of common stock outstanding.
2) Cash flow – how much cash a business produces after paying all expenses.
3) Return on equity – what portion of total revenue is returned to owners through dividends and capital gains.
4) Price to book ratio – the current share price of a company divided by its net worth. A P/B value below 1 indicates that the stock is undervalued.
5) Dividend yield – the annual dividend payout divided by the price of the stock.
6) P/E ratio (price to earnings ratio) – the price of a stock divided by its earnings per share. This is usually compared against the industry average.
7) Debt ratios – the amount of debt compared to the size of the company’s assets.
8) Sales growth rate – sales growth rates are typically lower than earnings growth rates. However, when sales grow faster than earnings, this can indicate an improving economy.
9) Market cap – the total market value of the company.
10) Industry trends – industry trends can help predict future economic conditions. For example, if a certain industry is growing rapidly, then this could mean that stock prices would increase as well.
The above are just some essential ratios that most look at, but we suggest analysing more than just the above, something we’ll cover a little bit more later.
Should retail investors choose value investing as a strategy?
Retail investors should consider whether value investing is right for them.
Many people think that only professional investors should invest in value stocks because these stocks have historically been less volatile.
This means that you may not experience the stock market’s same ups and downs as others who own growth stocks.
However, it is important to remember that value investing has proven itself over the years. It is one of the most successful investment strategies around due to Warren Buffett and Benjamin Graham.
If you decide to use value investing as your primary strategy, make sure you do your research before buying any stock. You don’t want to buy into a company just because it’s cheap.
Instead, focus on finding companies and choosing a strategy that meets your short and long-term goals.
This might or might not be value investing.
How to Become a Value Investor
There are several steps involved in becoming a value investor. First, you need to learn how to identify undervalued stocks.
Then, you must develop the skills necessary to analyse those stocks and determine which ones will provide the best returns in the long run.
Finally, you need to implement your strategy and monitor your investment portfolio regularly.
Learn How To Identify Undervalued Stocks
The first step towards becoming a value investor is learning how to identify undervalued stocks. There are 2 main ways to go about identifying undervalued stocks.
The first way involves using technical analysis. Technical analysis uses charts and graphs to analyse the past performance of a particular stock.
If you’re looking for a simple way to spot value stocks, this is probably the best option.
The second method involves using fundamental analysis. Fundamental analysis looks at a company’s financial statements, balance sheet, and income statement.
This type of analysis requires more work but it provides a better understanding of what makes a company valuable.
Once you’ve identified a few potential candidates, you’ll need to dig deeper into their fundamentals. You should look at everything from the quality of management to the strength of the business model.
This would allow you to identify more investment opportunities for yourself.
Develop Skills Necessary to Analyse Stocks
After you’ve learned how to identify undervalued securities, you’ll need to develop the skills necessary to evaluate each candidate. When evaluating stocks, you’ll need to understand the following:
- Financial Statements
- Balance Sheet Analysis
- Income Statement Analysis
- Company Management
- Business Model
It takes time to become familiar with all 5 aspects of valuation. But once you’re comfortable with the basics, you can start applying them to real-world situations.
Implement Your Strategy
Now that you know how to find undervalued securities, you can begin implementing your strategy. Once you’ve found a few good candidates, you’ll need a plan to manage your portfolio. Here are some things to consider when developing your strategy:
- Time Horizon
- Risk Tolerance
- Investment Style
- Portfolio Size
- Asset Allocation
- Monitoring Frequency
- Market Timing
- Tax Efficiency
- Exit Strategies
- Retirement Planning
- Insurance Needs
- Other Considerations
You’ll also want to make sure that your investment style matches your risk tolerance. For example, if you prefer to take smaller positions, then you may want to choose an active approach like momentum investing.
On the other hand, if you prefer to invest in large-cap growth stocks, then passive index funds may be a better choice for you.
You’ll also have to decide whether you want to use a systematic approach or a non-systematic one. A systematic approach means that you follow a specific set of rules to pick investments.
However, a non-systematic approach allows you to apply different criteria to every investment.
Finally, you’ll need to decide how much money you want to allocate to equities. Some people prefer to keep most of their assets in cash while others prefer to put 80% of their wealth in equities.
In conclusion, there are many factors to consider when choosing a value investing strategy. It helps to learn as much as possible before making any decisions.
We hope this guide has helped you gain a better understanding of the basic principles behind value investing.
If this seems like too much for you, you can always let a financial advisor help you invest.
Otherwise, sign up for a brokerage account and all the best!
Good luck on your journey!