Investing Strategies: Value Investing
The three broadest categories of fundamental investment strategies are Value Investing, Growth Investing, and Income Investing. The analysis used for all three strategies is essentially the same. They all focus on the company’s value while ignoring short-term market movements, and they always choose long-term holding periods. The main difference is how much risk you are looking for.
For example, value and growth are closely related, but growth investors usually look for new and unpredictable companies, while value investors are usually looking for established, stable, predictable companies. Income investors are looking for even more stability than value investors.
The investing strategy that you choose depends on your preference, but you should be aware that even the best investors use multiple strategies, and great investment ideas don’t always fit neatly within one strategy. A value investment can sometimes also be an income investment, and the best growth companies eventually become value investments.
Overall, you should be flexible with your approach and be willing to evaluate investments using any of these methods. If you stay too close to one strategy, you might miss a great opportunity.
Value investing is the most well-known fundamental investing strategy. The reason is it so well-known is because it is the strategy that Warren Buffett used to become one of the richest men in the world.
Value investing originated from the ideas of Benjamin Graham. The basic rule of value investing is to find the intrinsic value of a company, and only make an investment if the current market price is less than the company’s intrinsic value.
The original ideas proposed by Ben Graham were based on the purely quantitative evaluation. He would only consider investing in companies that were selling for less than 2/3 of net current assets. When the share price moved above net current assets, he would sell. Using this method, he was able to achieve annual returns of over 19%.
Graham’s investing style is too strict for today’s markets. It worked well when information was hard to find, but the market has changed. Since then, other investors have expanded these principles to include qualitative value.
Graham’s central principle is still fundamental to value investing: Focus on the value, and pay a price that is less than the value.
Warren Buffett’s method of value investing expanded on Ben Graham’s ideas to include the company’s cash flows. He suggests that you should stick with businesses that you thoroughly understand, and only invest in companies where the future cash flow is predictable.
One important addition to the value strategy is the idea of “look through earnings.” The way to calculate look through earnings is to look at the stocks that you own, and find how much you would be earning on that stock if you owned the business privately. For example, if you own 100 shares of a stock that is selling at $25, and its diluted earnings per share are $2.5, then your look through earnings are $250 [$2.5 per share * 100=].
The look-through earnings concept is a way for you to evaluate the returns on your portfolio, but it is also a way to find hidden value in companies that are holding a lot of stock. When you add the look through earnings numbers to the company’s earnings numbers, you might find that the value of the company is higher than reported.
There are also a couple of major problems with value investing. One is that it is very difficult to determine intrinsic value. The other is that as more people use the strategy, it becomes less effective. Both of these issues can be overcome with hard work and patience. Hard work and patience will also help you see the difference between real value and what is called a value trap.
For example, the simplest way to find a value stock is to search for P/B ratios or P/E ratios that are lower than average. But sometimes the reported numbers are either not real or they are temporary, meaning that the value you see is an illusion. When the true numbers of a value trap come out, you end up with nothing. This is very common among Chinese companies and very small companies. The best way to guard against it is to read the financial reports carefully and focus on the source of the cash flow.
ii. What to look for in a value stock
Warren Buffett has a 12 point checklist for scoring potential value investments. It is laid out by Robert Hagstrom in the order that Buffett uses (always look at the price last) :
1. Is the business simple and understandable?
2. Does the business have a consistent operating history?
3. Does the business have favorable long-term prospects?
4. Is management rational?
5. Is management candid and honest with its shareholders?
6. Does management resist the institutional imperative?
7. What is the return on equity?
8. What is the company's free cash flow?
9. What are the company's profit margins?
10. Has the company created at least one dollar of market value for every dollar of retained earnings?
11. What is the value of the company?
12. Can it be purchased at a significant discount to its value?
This is a fairly exhaustive checklist, but if you follow it carefully, you will be right more often than you are wrong. However, some expert investors feel that it is not necessary to precisely answer each of the questions on this checklist. James Montier has developed a condensed version of just three questions:
1. Valuation: Is the stock seriously undervalued?
2. Balance Sheet: Is the company going bust?
3. Capital Discipline: What is management doing with the company's earnings
iii. Value Investing Mindset
To be a successful value investor, you need to be able to think in a certain way. You must be analytical, patient, and prudent. If you can do that, then you can become a successful value investor.
Being analytical means being independent. Value investors ignore short-term market sentiment and short-term price swings. They focus on the fundamental level of the company’s business performance. This style becomes very unpopular during long bull markets, but disciplined value investors don’t care if their strategy is popular. It has already been proven to work in the long run.
Being patient means sticking to your investment criteria and waiting for your investment thesis to play out. Sometimes value investors can go many years without finding an idea that fits their approach, and sometimes it takes many years to see if an investment idea has become successful. If you want to make money in a hurry, then you will struggle with the value investing strategy.
Being prudent is tied to being analytical and being patient. It means that you should do your best to avoid becoming over-confident in your own analysis. Always evaluate both the best-case and worst-case scenarios. Your expectation should be somewhere in-between.