Explore Value investing- Meaning, strategies, advantages and risks
Ever wondered how Warren Buffet picked the best of stocks? Buffet follows the Benjamin Graham school of value investing, a technique that focuses upon evaluating stocks based on their intrinsic value which they believe is higher compared to their current market price. After all, if you know the true value of a stock, you’ll know the right entry points, enabling you to maximise returns.
Value investing is an investing strategy that involves the picking of stocks that seem to be trading for less than their intrinsic value. In more simplified words, value investors believe that the stock market works on the behavioural finance principle, that is, prices are prone to heavily fluctuate based on various factors such as bad news and herd mentality regardless of the company fundamentals. In this article, we will take you through everything you need to know about value investing and why it would be a high return yielding investment strategy for amateur and experienced investors alike.
Intrinsic value of a stock
Intrinsic value can be defined as the true worth of a company’s stock regardless of the price it is listed on the market. Therefore, when certain stocks with strong fundamentals are discounted in the market, they’re basically undervalued. There are various metrics followed by value investors for finding the true value of a stock. The most common metrics include price-to-book, price-to-earnings and free cash flow.
- P/B or Price-to-book
P/B can be defined as the aggregated value of a company’s assets compared to its stock price. A stock can be considered under-valued if its price-to-book value is more than that of the stock price, assuming that the company is not going through a financial crisis.
- P/E or Price-to-earnings
P/E reflects the analysis of a company’s earnings history to see if it reflects on its stock price, hence, understanding the true value of the stock.
- Cash flow
Free cash flow is another major metric used to measure the worth of a company. It is the total revenue generated by a company or its operations minus its combined cost of expenditure such as operating and capital expenses. This is mainly used to analyse debt and net profit of a company.
What causes the undervaluation of stocks?
Many investors believe that the price of a stock does not always compliment the true value of the company. The efficient market hypothesis is deemed to be untrue by many because stock prices may become overvalued or undervalued for various reasons. Here are some of the common cases of stock undervaluation, that is, a stock priced below its true intrinsic value.
- Herd mentality
Mass selling and buying occurs either due to the fear of missing out, or due to a fear of incurring huge losses. However, this widespread investor behaviour of buying when the market is rising, and selling when it’s falling, causes excessive moves in the stocks prices, thus complicating intrinsic values.
- Bad news
Bad news becomes the most adverse case of stock undervaluation. A widespread news about one small setback of a company enables a herd mentality that will force mass selling of the stock. Such a case can drastically reduce stock prices in turn causing severe undervaluation.
- Market crashes
Market crashes generally occur when the market has reached all-time highs. In such a situation, unsustainable prices lead to panic among the inventors leading to mass selling. This scenario causes a market crash and affects the prices of almost all stocks in play.
- Temporary ups and downs
Even a good company faces setbacks, but that doesn’t undermine its long term value. No company is immune to temporary ups and downs in the economic cycle as profits and losses depend on several aspects such as customer mood and seasonality.
- Underrated stocks
Beyond the common analysis and forecasts, there lies a horizon of opportunities in undervalued stocks like small caps, start-ups or even foreign stocks. These stocks are less likely to be in people’s radar and hold high intrinsic value.
Qualities of a value investor
- Stays away from the herd mentality
Value investors don’t follow the herd. When everyone else is buying, they’re often selling or standing back. When everyone else is selling, they’re buying or holding. Value investors don’t buy stocks because they’re trendy. Instead, they invest in companies that aren’t the common choices of investors under the condition that the financials check out.
- Purchase for less
The major aspect of value investing is to purchase assets for less than their actual worth and profit when they return to the intrinsic value or above. It doesn’t give you quick returns, however, they can give you immense returns on a mid to long term basis with proper investment planning.
- Patience
Some stocks with strong fundamentals might be overpriced at a given moment in time, therefore, you might want to consider buying the stock with the most value at that moment, and if no stocks meet this equation, you’ll have to play the waiting game.
- No to Efficient-market-hypothesis
Value investors refuse to believe in the efficient-market hypothesis, a theory that states that stock prices directly reflect the value of a company. Instead of this ideology, value investors believe that stocks may be over or underpriced based on several factors.
How to do value investing- Strategies
Finding an undervalued stock takes thorough research on various aspects of the market including financials, psychology and most importantly, sensible decision making. Here are some of the most used techniques used by value investors to understand the intrinsic value of a stock.
- Financial reports
Financial reports present a company’s annual and quarterly performance results. The annual report and the quarterly report are SEC Form 10-K and SEC Form 10-Q respectively. A company’s annual report explains a lot of things. It elaborates the products and services offered as well as where the company’s vision and progress.
- Insider trading
Insiders are basically stakeholders that own at least 10% of a company’s stock. Therefore, If they are purchasing its stock, it’s safe to assume that the company’s fundamentals are favourable and a mass selling by the insiders could indicate the existence of a serious concern in the company.
- Financial statements
Financial statements such as balance sheet, income statement, and the statement of cash flows provide a bigger picture of the company’s financial condition. While a balance sheet consists of the liabilities and assets in a company, an income statement provides a detailed understanding of the revenue generated plus the expenses incurred in a company.
- Couch potato value investing
Couch potato investing is a strategy of buying and holding a few investing entities such as mutual funds for which someone else has already done proper analysis. In the case of value investing, these funds would generally invest in value stocks, that is, in those that are undervalued.
Is value investing safe- Risks involved in value investing
- Exceptions to consider
Some incidents such as lawsuits, restructuring, or even natural disasters that may have a huge impact on the company’s value should be considered as exceptions. These are generally beyond the company’s control. However, if these exceptions are recurring on a regular basis, they may not be extraordinary. In this case one should assume that the company is facing regular financial setbacks.
- Buying overvalued stock
In the search of the perfect moment to accumulate the shares of a company, investors sometimes end up overpaying for stocks. What to keep in mind is that an undervalued stock means your risk of losing money is reduced, even when the company doesn’t perform to expectations.
- Not diversifying
You can have a diversified portfolio even if you only own a small number of stocks, as long as you choose stocks that represent diverse industries and sectors of the economy. Nevertheless, Benjamin Graham, the father of value investing, recommends choosing 10 to 30 stocks to efficiently diversify your holdings.
- Emotional biases
Humans, in most cases, are driven by emotion. No matter how sure you are about your analysis, some emotions like fear or excitement will always be the final judge to your calls. Remember, value investing requires taking things slowly and creating your own path. Therefore, avoid the pitfall of purchasing when stock prices rise and selling when they decline.
The final word:
“If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.” This line by Warren Buffet pretty much sums up Value investing. Value investing is a long term thing. There will be times when you would want to sell your stocks when situations demand, but the essence of value investing lies in investing in potential stocks with a long-term outlook, holding them until you feel like they have reached their true intrinsic value.
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FAQs On Value Investing:
1. How does value investing differ from other investment strategies?
Value investing differs from other investment strategies primarily in its focus on identifying undervalued stocks. Unlike growth investing, which focuses on companies with high potential for future growth, value investing seeks to buy assets trading at a discount to their intrinsic value.
2. How do value investors identify undervalued stocks?
Value investors identify undervalued stocks by using various techniques to assess the intrinsic value of a company’s stock such as P/E, P/B, dividend yield, and free cash flow.
3. Is value investing risky?
Value investing, like any investment strategy, carries its own set of risks. While it is often considered a conservative approach compared to strategies like growth investing or momentum trading, it is not immune to risk.
4. What is the capital required for value investing?
The capital required for value investing depends on several factors, including your financial goals, risk tolerance, investment strategy, and the current market conditions.
5.What is meant by value investing?
Value investing is an investment strategy that involves buying stocks or other assets that appear to be trading below their intrinsic value. Investors seek out undervalued assets with the expectation that their true worth will eventually be recognized by the market, leading to potential profit.
6.What is an example of value investing?
An example of value investing is purchasing shares of a company whose stock price is lower than its intrinsic value based on fundamental analysis. For instance, buying stock in a company with strong financials, a competitive advantage, and a low price-to-earnings ratio relative to its peers would align with a value investing approach.
