What is Value Investing?

Investopedia, the Wiki of investing, describes Value Investing as a strategy to pick stocks that seem to be trading for less than their intrinsic value (a measure of the underlying value of a company, basis its cash flow and qualitative and quantitative factors, over a period of time). In simple terms, Value Investors identify stocks that are trading for less than their value—according to the Value Investor. They believe that the stock market is undervaluing these stocks and that the price doesn’t correspond to that particular business’s fundamentals. The market’s reaction—or overreaction—offers an opportunity to buy the stock at a discounted price—on sale, as it were.

How Does Value Investing Work?

The basic concept behind Value Investing is simple enough. If you know the real value of something—be it a stock or a product—you know how much you can save if you buy it on discount or on sale. Discerning shoppers know this, and wait for occasions like Black Friday to pick up desired items at throwaway prices. Unfortunately, there are no fixed sale occasions like Black Friday for stocks, so it is up to the investor to do the due diligence to estimate their true value and pick the stock up at a discount, at the opportune time.

The Importance of Intrinsic Value

It follows that to know if a stock is trading at a discount, one needs to figure out its true, or intrinsic, value.

There are many formulae to do this and they all comprise a combination of factors such as financial performance, revenue, earnings, cash flow, and profit as well brand fundamentals, like the business’s brand equity, customers, and USP/s. Estimating the intrinsic value also involves metrics like Price to Book (P/B), Price to Earnings (P/E), free cash flow, debt to equity ratio, sales, revenue growth, etc. These metrics can help the investor judge if the stock’s price—as compared to its intrinsic price—is sufficiently attractive.

Principles of Value Investing

Maintain a margin of safety

Everyone has a different risk appetite and your margin of safety depends on it. In other words, you decide what should be the bargain price for a particular stock, referencing the true value of the stock as per your estimates. For instance, if you feel a particular stock is worth Rs 100/- and trading at 70/- and your margin of safety is 25%, this fits well with your margin, and will give you a more than healthy profit when it fulfills your estimate. The rule of thumb is to choose stocks valued at ~2/3 their intrinsic value.

Markets are inherently inefficient

The efficient market hypothesis believes that the price of a stock already factors in all available information about the company, and, thus, reflects its true value. Value Investors do not subscribe to this theory, believing instead that a variety of reasons may cause the stock to be over or under-priced. For instance, a rumour that stampedes investors into panic selling, or over-estimates about the success about some unproven technology: the dot-com bubble is a good example.

Do not follow the herd

In many ways, Value Investors are contrarians, i.e. they don’t follow the masses. When others are buying, they are selling or holding back, and vice versa. They don’t buy trendy stocks and often invest in less-glamorous stocks. They are also known to take closer looks at plummeting stocks and choose to invest if they believe the fundamentals are strong and can turn back the tide of the company’s falling fortunes.

Have Patience

Two different investors can come to completely different decisions about a company. That’s because there are several different approaches one can take. Some investors focus only on future growth potential and estimate of cash flow, some do both, some put heavy stock in external trends, others don’t… But, while the approaches may differ, the concept of purchasing the stocks for less than their intrinsic value is a constant. Thus it follows that the value investor must hold the stock until it pays off—years, even. Which is can be a piece of good news as long-term capital gains attract lower tax rates.

Strategies for the Value Investor

Research

One common feature in every strategy is research; for value investors this means researching the company and asking common sense questions such as:

Is the company likely to improve revenue by either raising prices or sales volumes? Or by lowering expenses and maybe shutting down lame-duck divisions?

Research into a company also includes competition research as this impacts future growth prospects. Though there may not be any quantitative answers to this, it can be circumvented by only picking companies that one is personally familiar with, or companies that sell high demand products.

Promoter activities

Following the stock-market actions of a company’s leadership—senior managers, directors, large shareholders can be instructive, as they have unique knowledge of the company. After all, they are running it. So, if they are buying its stock, it’s clear they believe growth is imminent. Be circumspect though. For instance sale of stock by a large shareholder could simply point to a need for cash, not necessarily bad news about the company’s performance.

Financial analytics

A company’s financial reports throw up a lot of information about the company, and it is critical for the value investor to study them in order to understand how well the company is performing and compare it with industry peers. The annual report is the most basic one—it offers information about the company, its offerings and growth prospects. The annual report contains other important financial reports that are equally insightful, they are:

Balance Sheet: this gives you details about the assets the company owns and liabilities—including accounts payable, debt, etc.

Income Statement: This shows how much revenue is being earned and expenses made by company.

Couch Potato Strategy

This is a passive strategy that involves following the actions of someone who has already done the investment analyses—mutual funds for instance, or high value investors like Warren Buffet or Rakesh Jhunjhunwala, in India.

Value Investing Risks

Every investment strategy comes with a risk of loss and value investing is no different, even though it is a low-to-medium risk. Some of the main sources and reasons for these risks are:

Inaccurate or insufficient calculations: If your information is not up to date or your analytics of financial reports deficient, you risk loss.

Extraordinary gains or losses

Some incidents, like lawsuits, natural disasters can give you a lopsided view of a company’s prospects. Excluding the correct ones will give you a more real picture of future performance.

Errors in Ratio Analyses

Buying Overvalued Stocks

Not Diversifying: Investing in multiple stocks spreads risk, if you choose different industries and economy sectors. Benjamin Graham, a reputed value investor prescribes picking 10 to 30 stocks. However, it is important that the more the stocks you have in the portfolio the higher the chance of an average return.

Being Emotive Successful value investing depends on making rational decisions. If anxiety and excitement come into the mix, you may be tempted to sell if prices fall or go with the herd. This sort of behavior can decimate your returns.

The Bottom Line

Value investing is a long term strategy, and it hinges on the ability to make rational decisions based on analytics of different metrics and factors that affect a company’s growth and earnings prospects. It assumes an ability to be stoic in the face of panic, make accurate calculations, stay within your margin of safety, and above all, be patient.