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We have not yet talked a lot about value investing on this blog. Since I have received many questions from you about this subject, I thought it would be a good time to cover value investing on this blog.
Value investing is a form of investing where investors evaluate the value of a company to find undervalued stocks in the stock market.
In principle, it makes a lot of sense to choose stocks based on their prices and their real values. But how does it work in practice? It is what we see in this article.
Value Investing is an investing philosophy where investors buy securities that are underpriced based on some analysis of the companies. The entire philosophy rests on a correct analysis of companies.
In practice, finding the value of the securities is not that easy. How do you find the real value of a company? If the fundamental analysis of the company is invalid, you will never know if the stock is underpriced or not. And you will end up buying bad stocks and losing money.
Benjamin Graham has established value Investing. He is often called the father of value investing. Another person often related to value investing is David Dobb. These two were professors in the same business school. And they both taught many other investors, including Warren Buffet.
Warren Buffet is probably the most famous value investor these days. He had an excellent track record of beating the returns of the stock market. He has often credited Benjamin Graham’s approach for his success.
Value of a stock
To find if a company is undervalued on the stock market, you will have to find its real intrinsic value. If this value per share is higher than the share price of the stock, then the stock is undervalued. In theory, the price should go higher in the future to rejoin the real value of the stock. So, you should buy it and make a good deal.
But finding the intrinsic value of a company is not an easy thing. Value Investors look at many aspects of a company to discover its intrinsic value:
- The financial performance of the company: Revenue, earnings, cash flow
- The company’s reputation and brand
- The company’s business model
- The target market
- The competitive advantages
On top of that, there are some important metrics you can look at for each company:
- The book value: the value of all the assets of the company.
- The Price to Earnings (P/E): the stock price related to the earnings of the company
- The Free Cash Flow: The cash generated from the revenue after expenses have been paid.
It takes a lot of work to find a company’s intrinsic value. Finding the intrinsic value is not merely something you can do by taking five minutes and checking some metrics.
You will need some real analysis if you want to find a proper intrinsic value. Some people believe that looking at a few metrics will let them find deals in the stock market. But they are wrong. If you want to replicate the success of Warren Buffett, you will need to put in a lot of effort. There are no simple metrics.
Margin of Safety
Even value investors need some room for errors in their estimation of intrinsic values. While they trust their values, they know they cannot be correct all the time. And they also know that sometimes the market does not act rationally.
So, value investors use something called the margin of safety. They use this to define their entry points into the stocks.
As an example, if you think the actual value of a stock is 100$, at which point will you want to buy it? Some investors will want to buy it at 90$, while others would want to buy at only 60$.
Different value investors have different margins of safety. Based on their risk tolerance, they can use different margins of safety.
For instance, Benjamin Graham used a 66% margin of safety. He was only buying stocks that were priced at less than 66% of their intrinsic value.
The efficiency of the market
Many people believe that the stock market is efficient. It would mean that all the available information is already priced in the markets. If the market was fully efficient, it would make value investing impossible to work.
This hypothesis is called the Efficient Market Hypothesis (EMH). This hypothesis has not been proven, but it has not been invalidated either. However, since several value investors have beaten the returns of the market, the market cannot be fully efficient.
But that is not to say that the market is entirely inefficient either. It makes it difficult to find good deals.
Opportunities for undervaluations
There could be several reasons why a stock could be undervalued based on its actual intrinsic value:
- A Market Crash can make many stocks become undervalued in case of a massive selloff.
- Some good stocks sometimes go unnoticed.
- Even some good stocks can lose a lot of value because of bad news.
In these events, it is easier to find excellent opportunities to invest.
Passive Value Investing
While active value investing can take a lot of work, it is also possible to invest passively. Stocks are generally split into two groups:
- Value Stocks
- Growth Stocks
And there are many ETFs and Funds for both groups. So you could buy shares of ETFs that have value stocks instead of investing in all the stocks.
Another way that many people follow is to invest in holding companies of value investors. For instance, if you wanted to follow Warren Buffett investing, you could buy shares of Berkshire Hataway company since this company is mostly the holdings that are decided by Warren Buffet. You can invest like him by investing in his company.
Now, passive value investing is unlikely to make you rich. You will have lower returns than if you were a true successful value investor. But it is much simpler and has better diversification. But historically, in the long-term, value stocks have outperformed growth stocks.
Should you do value investing?
I do not believe everybody should follow this philosophy. I do not say that because I believe it does not work. It has been shown to work. And many people have become rich with value investing.
But, real value investing takes a lot of work and dedication. Actual value investors are making this their job. They are professional investors.
For simple investors like me and you, value investing is too complicated. And it is also increasing the risks. It is challenging to get the correct valuations. Just because some people exhibit very high returns in their portfolio does not mean you can replicate it.
Now, if you want to invest in value stocks, you can allocate a portion of your portfolio to a Value ETF. I would not recommend you invest actively in value stocks. It is too much work and too much risk for most people. While you may overperform the overall market for some time, it will be challenging to do that in the long-term.
You should not be exalted by people claiming very high returns by value investing. Do not forget that for each people beating the market, there are ten more people that underperformed!
Value investing is an investing approach where you analyze a company to find its intrinsic value. Once you have the intrinsic value, you can buy stocks where the stock price is lower than the intrinsic value.
The idea is that in the future, the stock price will join its real value. If you can find an undervalued stock at a substantial discount, you can make a significant profit.
Now, this is the theory. It takes a lot of work actually to make this work. Finding the intrinsic value of a company requires a thorough analysis. You will not make profits with value investing just by checking a few metrics on your computer.
If you want to invest in value stocks, I would not recommend selecting value stocks yourself. But you could invest in value stocks with an ETF. There are many Value Stocks ETF available. But remember that in the last two decades, growth stocks have outperformed value stocks. So, you have no guarantee of beating the market.
If you want to find value stocks yourself, remember to do the work. Do not try to take shortcuts. It takes work and dedication. Do not follow blindly other investors just because they are boasting significant returns. Being blinded by large returns is a big trap in the investing world!
For now, I do not plan on any value investing. But if I were to invest in value stocks, I would simply invest in a Value ETF.
If you want to learn more about value investing, you can read about the story of Warren Buffett.
What do you think about value investing? Are you investing in value stocks?