Value investing is the method of finding stocks that are either undervalued, or that trade for less than their intrinsic value. Like most investing strategies, each person has a different style and execution. However, there are some core principles that all value investors should share.
With value investing being the most famous strategy out there, utilised by the investing elite such as, Peter Lynch, Warren Buffett, and Kenneth Fisher, it is soon becoming a favourite among everyday people trying to save for the future.
This way of investing can be daunting, but by mastering the skills taught in this article, you can capitalise on opportunities you might of missed in the past.
What is Value Investing?
Warren Buffett is probably the most famous investor in the world. He owes his success and fortune to the value investing strategy, which was taught to him by his good friend Benjamin Graham.
Value investing is an investment strategy that involves picking stocks that are trading for less that their intrinsic or book value. Value investors actively seek out companies that the stock market is underestimating, as they believe that the share price does not mean value.
Wall Street overreacts to good and bad news, resulting in a companies share price changing in the short term. However as value investors, we know that small movements in share price in the short term do not correspond to a company’s long term fundamental value.
For value investors, overreactions to news can be a good opportunity to buy shares in a company at a discounted price.
Value Investing in a Nutshell
Value investing is a basic concept that you probably use every day.
“If you know the true value of something, you can save a lot of money when it’s on sale”Every Value Investor Ever!
By using fundamental analysis to determine if a company is financial sound, ran properly by experienced leaders, and has a business model that encourages growth, you can pretty accurately determine the company’s intrinsic value.
By understanding what a company’s value is, you will know what price you happy to pay for it. The small fluctuations in share price on a daily basis don’t matter to you, because you know what the underlying value of the company is.
Just like a savvy shopper who waits for Black Friday to buy that new TV, you will wait for a dip in the market to purchase those shares.
The last part of being a value investor is to never sell… Unless the underlying value of the company changes. By holding these companies long term, investors can be rewarded handsomely in the way of dividend, or asset appreciation.
4 Core Principles of Value Investing
#1. Intrinsic Value
The big one… The one everybody is talking about… It’s as hard as you might think.
We use discounted cash flow to calculate the future value of a company, then we test it against others in the industry to see if the company is worth investing in.
Investors use various methods and metrics to find a variation of intrinsic value for a company. Intrinsic value is a combination of financial figures such as revenue, earnings, and cash flow. You then testing your value against the company’s brand, business model and target market… To see if your valuation is achievable for the business type.
Some main metrics I use to value a company include:
- Price-to-Book (P/B): Commonly called the company’s book value, this measures the value of the company’s assets and compares them to the stock price. If the price is lower than the value of the assets, the stock is undervalued, as long as the company is not in financial difficulties.
- Price-to-Earnings (P/E): Comparing the historic earnings with current earnings is a good place to start to see if a company is growing or not. This metric uses a company’s earnings track record to determine a fair stock price.
- Free Cash Flow: Free cash flow is generated from company revenue after expenditures are subtracted. There are lot’s of cash flow nominals shown on financial statements, but Free Cash Flow is money left after all expenses are paid, including capital purchases. If a company has free cash flow, they can use it to pay off debt, invest in grow, or reward investors with dividends. We use Free Cash Flow to calculate our intrinsic value below.
We have put together an easy to use spreadsheet for you to use for free. Using free cash flow to give you a fair value for a company stock. The link below will take you to a Mailchimp landing page where you can request your spreadsheet.
You can check out our other free value calculators over on our Investing Resources page.
#2. Never Think Short Term
We are not day traders, we are investors… I already told you that you need to learn never to sell. Well, if you plan on investing your money, you need to be prepared to leave it for at least 5 years.
The value of a company doesn’t change overnight, it rarely changes in the course of a year, you might wait decades for an investment to realise its true potential.
Because we are buying stocks on the understanding that they are undervalued, you need Wall Street to also realise that the company is undervalued. This means you could be waiting for huge growth, a new product to be brought to market, or a boost in earnings. This is why you can’t expect short term returns.
#3. Fear is Your Friend
Fear is what drives the market down, bad news, changes in management and other reasons we’ll get into later cause people to panic and be afraid of a downturn.
When the stock price drastically moves in days or weeks, most likely, the underlying value of the business has not changed. The company is still fundamentally worth the same.
Just because investor fear has moved the market, doesn’t mean the fear is justified. You will see dips, corrections, and possibly crashes very often throughout your investing career. But the number 1 thing to remember is… You can get them on sale!
#4. Buy Businesses not Stock Symbols
There is only one thing all investors can agree on… It is that you need to buy into a business, not a stock symbol.
What this means is, you need to stop looking at trends, listening to new bulletins, and focusing on charts. You need to perform proper analysis of the company, finding out what they do, how well they perform, and if growth is in their future.
I know on this website we can’t stop talking about the fundamentals of a company, I also know a lot of people have no idea what fundamentals are.
- If you look at the financial health of a company, that is a fundamental.
- Researching the CEO and other high ranking members to understand their experience and goals, that is a fundamental.
- Making a judgement call based on a personal feeling you get from a company, that is a fundamental.
Fundamentals are more personal than procedure based. What is a fundamental to me, might not matter to you, so you need to develop your own set of rules to follow…
The first rule should be… Focus on businesses, not stock symbols.
Searching for good businesses rather than good stocks can be time consuming, but the time spent researching can pay off tenfold in years to come.
A lot of investors use stock screeners to help cut their research time. Stock Screeners work by only showing you companies that fit specific criteria that you enter, such as PE Ratio limits, Earning potential, growth rate, as so on. Then you can investigate the business, it saves hours of searching time spent on Yahoo Finance.
They can be quite expensive, but I use Finviz which has a free version, but you can also upgrade for $24.99 to access more companies. The layout of Finviz might seem complicated, but it is very easy to use. Check it out here.
Why Stocks Become Undervalued
The stock market is not a very efficient system, stocks don’t always reflect their true value. There are a few factors why a stock might not reflect its true value, but we are more concerned about the ones that are undervalued.
Market Moves/Herd Movement
People tend to invest irrationally based on emotional or fearful reasons, rather than market research.
They live by the rules… If the market is going up, then buy. And… If the market is going down, then sell. They look at companies and think, “If I had invested 3 months ago, I’d be up 20%”. This causes them to develop what the kids are calling FOMO, the fear of missing out. When stock price is down the opposite happens, because they don’t want to hold a losing stock.
Instead of holding companies long term throughout movements, or periods of herd mentality, they sell. Causing them to accept the loss, rather than wait for market to bounce back.
Minor market corrections can cause the herd to make it a full meltdown, so keep an eye out for companies that are going through uncertain times… The underlying value of the company might still be good.
When the market, or individual companies reach an unbelievable high, it usually results in a ‘bubble’ forming. This is where investors become too confident and the share price reaches an unsustainable level.
When share prices reach these high levels, it causes investors to panic, leading to a massive sell off. Examples of these types of situations are… ‘The .com Bubble’, the 2008 housing crisis, and Bitcoin.
The share prices of the tech stocks in the 1990s and early 2000s shot up to unsustainable levels, way beyond what the companies were worth. Investors realised this and got out quick, causing a domino effect for other investors to start selling.
The market has historically recovered from such crashes… So, buying solid companies when the economy is on the bottom is a great opportunity… Because the underlying value is still there, only the investor confidence has left.
Big companies in highly desirable industries get all the news time, all the paper articles, and all the attention. But you can find a really good opportunity looking at smaller cap stocks, or stocks in other countries. These are what the majority of people are not looking at.
Most investors want in on the next big tech stock, not the boring industrial manufacturer, so a lot of these very profitable companies go unnoticed.
That is why some of the stocks lower on the glamor scale can be undervalued, because Wall Street doesn’t give them a chance. Unlike Facebook, Apple and Amazon, who have been affected by the herd mentality, making them overvalued… Proctor & Gamble and Waste Management remain solid, fairly valued companies.
Bad News Stories
Great companies can be thrown by bad press, even today we see massive companies face setbacks because of little news stories that frighten investors.
Things such as lawsuits, employment cases, recalls, and scandals can be bad news for companies. However, just because a company goes through a bit of bad press, doesn’t mean the value goes away, unless the news is catastrophic.
There may be certain news that impacts a companies fundamentals, such as earnings reports, or product recalls. But realistically, you need to make the decision whether or not the company will bounce back.
The basic fluctuations of business success throughout the year. Companies are not immune to the economic cycle, toy companies see large earnings over the Christmas period, whereas clothing companies tend to see similar effects in the summer months.
The consumer has a massive effect on the share price of a company, so having an informed knowledge on the cyclicality of the company can be powerful.
Knowing that investors will tend to sell in certain times of the year can reduce the amount you spend on shares massively.
Value Investors don’t Follow the Herd
As a value investor you will usually go against popular opinion. You will develop what is known as a ‘contrarian’ characteristic, where you feel comfortable buying when others are selling, and you will stand back when others start to buy.
Value investors don’t buy trendy stocks, because they are typically overvalued. They stick to what they know, and what is financially stable.
The only reason a value investor would consider purchasing a household named company, or a tech giant… Is if the share price dipped, but the financial health of the company remained strong. Believing the company will bounce back, and the share price will recover.
Finally, value investors don’t care about small news stories, or what’s popular, they only care about intrinsic value and future potential. They buy companies they want to own, because they believe the company will reward them. As value investors, we want to know a company has sound principles, solid financials, and a plan for growth… Otherwise, we do not invest.
Passive Value Investing Takes Time
It is possible to become a completely passive investor using the value investing strategy. You would be able to gain dividends from long term stocks, and also gain asset appreciation. But it takes time to build up to this level.
What you are looking for is the ability to purchase a set of stocks, hold them for 10 years, and do nothing else… It’s difficult to do.
You need to be super confident in your picks, build your position quickly to avoid missing the boat, and you need to have a good brokerage that rebalances your account when dividends are paid.
Being completely passive with value investing is never a good idea… I would strongly recommend looking at your positions at least once per month, also checking quarterly reports and annual returns of the companies you are invested in.
The only real way to be a passive value investor is to invest in a mutual funds or ETF that follows the same strategies, and look for the same principles as you do. That way, you can just give them your money, and they will do the research, and invest for you.
How to Manage your Risk when Value Investing
There is still a significant risk when investing, even when value investing. Companies do not always do what investors want, they can also be very unpredictable, making them not the safest way to store your money.
But if you can put your emotions to one side and manage your risk using these techniques, you can promote a safe investment portfolio that will hopefully do very well.
Don’t Forget… Figures are Important
Using financial statements to your advantage is the best way to minimise risk in your investment. Relying on other peoples analysis is never a good idea, whether it’s Bill down the office, or Bill Ackman on Bloomberg TV, always look at the financials yourself.
If you don’t look at the documents yourself, you could be missing a key part of the puzzle. News stories either highlight one good aspect, or one bad aspect of a company. They might boast about having record high revenue, however the net profit is still negative.
Don’t get me wrong, looking through financial statements can be boring, but there is another way… Reading footnotes, which can be found on a Form 10-K or a Form 10-Q briefly explain a company’s financial statements.
If you read the footnotes on these forms and see something you like, you can read the full financial statement. Rather than reading everything, you hand pick ones you like from an independent form, made by the SEC. It will save you hours upon hours in researching time.
Learn When to Cut a Loser
There are some cases, when an income report will come out or a lawsuit will hit the papers, and you just need to sell.
Extraordinary cases such as these almost never happen, but when they do, you need to react. Normally when we research companies we do not include the possibility of things like this happening, but they can.
If a company you own is down, check the financials, check the management team, check the business health, and think about if short term problems can effect long term progress. These signs will give you a good indication if the company will survive the downtrend, or if you need to cut your losses.
You might get some wrong, sell a loser that comes back stronger… But if a company appears to be rebounding, there is no reason why you should research them again, and maybe buy back in. But all you need to think about is, at the moment in time, when the company was struggling, you made the right call based on the fundamentals of the company. There is no way of predicting a miracle recovery.
Avoid Overvalued Stocks
Overpaying for stocks is the main cause of risk in a value investors portfolio. Not only do you not stand to gain anything from the purchase, but you also run the risk of losing a portion of your money if the shares depreciate.
You need to build a margin of safety for yourself. That means buying stocks at around two thirds of their intrinsic value or less. Value investors want to risk as little capital as possible, so try not to overpay for companies.
Diversify your Assets
Individual stocks can be risky… If you put all of your money in one company, your portfolio lives and dies by the success of that one company.
However if you were to split your money across 4 or 5 companies, it gives you a much higher chance of making a profit, especially if the companies are well researched.
Christopher H. Browne recommends owning a minimum of 10 stocks in his book “Little Book of Value Investing”, also according to Benjamin Graham you should choose up to 30 stocks for a well diverse portfolio. But 10 to 30 stocks for a beginner can be overwhelming, so starting with 4 or 5 is fine.
A lot of investing experts agree more with Christopher H. Browne, and think the more stocks you hold in a portfolio, the more likely you are to have an average return that reflect the overall market. This is based on the assumption that you are good at choosing winners.
Don’t Ignore Ratio Analysis
We have discussed various ratios such as the P/E ratio, P/B ratio and so on. As we know these ratios help us as investors determine the financial health of a company.
Unfortunately, if you look at Yahoo Finance, they calculate the P/E ratio of companies completely differently to Morningstar… Which can be problematic, which one do you trust?
Basically, depending on what you see as success, or financial health you want the ratios calculated in a certain way. Some of the ways ratios can be interpreted are below:
- Ratios can be calculated either using pre-tax figures, or post-tax figures. For value investors, we worry about free cash flow, so post-tax calculations are better.
- Some sites use estimated figures, which they then correct after accurate figures are available. Accurate figures are always better, websites like to give investors their opinions of companies, but don’t trust them.
- On major stock research sites, they compare companies based on ratios, even if the ratios are the same. Just because a website says one company is better than the other, doesn’t make it true.
- Stock analysts can have different definitions of the term earnings, so include capital purchases and sales, and some don’t. Leaving investors who care about cash flow in the dark.
When it comes to ratios and research, look at how the website or analyst is calculating them. If they fit your principles, then stick with them, at the end of the day… The analysts are looking to make money from traffic, so don’t believe everything you read.
Why you Shouldn’t Pay Attention to the Market
Although you need to be informed and diligent to become a value investor, you do not want to spend 7 hours a day looking and thinking about the stock market.
You have no interest in 99% of the market. Also, you can’t influence 100% of it. All you can do is work on your own portfolio.
Checking your companies once per month is enough, unless there is urgent news that need attention. Reading quarterly reports, and annual returns is all it takes to keep on top of your investment health.