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.

Key elements of value investing include:

• Intrinsic Value: This is the fundamental worth of an asset, determined by analyzing its financial statements, business model, and future prospects.
• Margin of Safety: Value investors strive to buy assets at a price significantly lower than their intrinsic value, creating a “margin of safety” to cushion against potential downside risks.
• Long-Term Outlook: Value investing is a patient strategy that focuses on long-term gains. Investors are willing to hold assets for extended periods, allowing the market to recognize their true value.
  
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Key metrics of value investing:

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.

Value Investing vs. Growth Investing:

While both value and growth investing aim to generate returns, their approach and investment focus differ significantly:

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.

Value investing in different asset Classes:

Value investing principles can be applied to various asset classes:

• Real Estate: Identify undervalued properties with potential for appreciation through renovations, location improvements, or market trends.
• Bonds: Focus on bonds with attractive yields, low credit risk, and potential for price appreciation.
• Collectibles: Analyze the historical value, rarity, and future demand for collectibles like art, stamps, or vintage items.

The future of value investing:

Value investing, with its focus on fundamental analysis and long-term value creation, remains relevant in the dynamic world of investing. However, certain trends influence its future:

• Technological Advancements: New technologies and data analytics tools are transforming the way investors assess companies and identify value opportunities.
• Market Trends: Market volatility and rapid changes in economic conditions require value investors to adapt their strategies and be flexible in their approach.
• Changing Investor Behavior: With increasing participation of younger, more short-term-oriented investors, value investing principles face challenges in gaining traction.

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:

What is meant by value investing?

• Value investing is a strategy where investors buy stocks that are undervalued compared to their intrinsic worth, aiming for long-term gains as the market corrects the price.

What is an example of value investment?

• An example of value investment is buying shares of a company with strong fundamentals but a low stock price due to temporary market factors.

What is value on investment?

• Value on investment refers to the potential profit or return generated from an investment, typically calculated based on the difference between the purchase price and the current or future value.

Is value investing good for beginners?

• Yes, value investing can be good for beginners as it focuses on buying undervalued stocks with strong fundamentals, which can offer more stability and less risk over the long term.