What is value investing? It is an investment strategy to buy undervalued stocks. Undervaluation is a condition where a share is trading at a discount to its estimated intrinsic value. Beginners can remember intrinsic value as the true worth of a business.
Few famous value investors are Warren Buffett, Peter Lynch, and Joel Greenblatt. The founder of value investing is Benjamin Graham and David Dodd.
All value investors follow a theory: “The market does not price its stocks fairly all the time.” As a result there will always be few stocks which will be available at a price below its intrinsic value.
Value investing principles can also be used to screen out low-quality stocks. This is done by flagging low-quality stocks as fundamentally weak. High-quality stocks trading at overvalued price levels are also avoided in value investing. How? The estimated intrinsic value of such stocks will be less than their current market price.
Value Investing: An Investment Strategy
The stock market is full of stocks. There are more than 5,000+ number stocks on the Bombay Stock Exchange (BSE).
For a potential investor critical question is, out of all stocks, which is good for purchase? Value investing strategy answers questions like these. Apart from value investing, there can be three more strategies. Let’s know a bit about them:
- Passive Investing: This form of investing asks investors to invest in a basket of stocks instead of individual stocks. Examples of such baskets are mutual funds, index funds, ETF’s etc. Hence, a person who is following a passive investing strategy will not care about individual stocks. Read about: Index investing.
- Technical Investing: Here the strategy is to target those stocks which are showing a momentum. The focus is only on taking advantage of the price movements. It cares least about price valuation and fundamentals of the underlying company. Read: Technical analysis for long term investors.
- Growth Investing: Here the strategy is to find those stocks whose underlying companies are destined to grow fast in future. This investment strategy will point towards a stock even if it looks overvalued (High PE multiples). Read: Fastest growing stocks.
- Value Investing: Out of all stocks trading in stock market, value investors will pick only fundamentally strong stocks trading at undervalued price levels. To judge undervaluation, value investors estimates the intrinsic value. To judge the quality of a company, fundamental analysis is done. But in order to do these exercises, basic requirement is to learn to read and comprehend financial statements. Read: Process of value investing.
Typical Characteristics of Value Investors
The way value investors practice investing is different from other investors. Here are a few characteristics that are unique among value investors:
- Lazy: Value investors do deep analysis and then they wait for the right opportunity to invest. Hence, externally they may appear as lazy. Most of the time value investors do nothing. They do not buy and sell stocks all the time. Instead, most of the time they are sunk deep into reading and analyzing companies. The number crunching is done to identify value stocks.
- Contrarian: Value investors do not invest in stocks with a herd mentality. Instead, they buy stocks when others are selling. When others sell? When the market is crashing. What is the significance of this timing? During such times, even fundamentally strong stocks are available at a discounted price.
- Hold Forever Mentality: They buy such stocks that can be held forever. This mentality makes them defensive about which companies to buy. A weak company that may not survive the next 20 years, will automatially be avoided. The stocks that they buy will not only survive but will also grow continually for a very long term.
- Financial Interpreter: Value investors invariably displays two key skills: (a) they easily read and interpret financial statements, and (b) they know to estimate intrinsic value. These two qualities in combination makes them a good stock analyst.
- Blue Chip Bias: Most value investors have a strong affinity for blue-chip companies. Why? Because these are prime stocks of the market. Value investors target to accumulate blue chip stocks at a discount. They rarely invest in non-blue-chips. But when its done, it will be for the opportunity arising from the irrestible margin of safety.
The Process of Value Investing
Understanding the process of value investing can be easy. But it is not as easy to implement. To make it easier, the investor must build a circle of competence. Why? To understand the relationship between implementation and the circle of competence, check the link. It will give reasonable clarity.
Allow me to talk about the process of value investing. The process starts with screening stocks based on their history.
- Stock History: Value investing is about picking established companies that have a long history trail. Example: My stock analysis worksheet does not accept stocks that have less than 10-years price and financial data. Warren Buffett will probably look at, at least last 15 years data of a company to estimate its intrinsic value.
- Business Fundamentals: Stock’s 10 years financial data should be checked to estimate the financial health of a company. Idea is to shortlist those stocks which are fundamentally strong. Warre Buffett calls such companies as one having an economic moat. There are steps one can follow to identify companies with a moat.
- Price Valuation: It is the ultimate screener. No matter how established is the company, no matter how strong are its business, it is not enough. Value investor’s is not finished till it calculates the intrinsic value. To be more sure of the estimates, a suitable margin of safety is also applied. Finally, comparing current price with intrinsic value value will highlight if the stocks is undervalued or overvalued. Undervalued stocks becomes a good buy.
How to Buy Stocks Like Value Investors?
- How we buy stock: If we are investing on our own, we tend to buy stocks of popular companies. What are popular companies? The companies that are making a buzz in the market. But the problem with such stocks is that, their market price is often overvalued. Read: Stock trading for beginners.
This way we end up buying overvalued stocks, leading to losses, right? So who is the culprit? We ourselves. Our decision to buy a popular stock is falsified.
- How value investors buy stocks: Even a good business does not perform well all the time. They too face the heat of the market. When they are not doing as well, their stock price also takes a beating. But such short-term turmoils are temporary. Value investors target such companies and buy them when they are not doing as well. Good companies always tend to bounce back and regain the lost glory.
The point is, we must always be on the lookout for good companies whose stocks price has seen a temporary correction. Generally, companies with quality management tend to bounce back. Warren Buffett’s decision to invest in a company is weighed heavily on his analysis of the management who runs the business.
Consider the case of Tata Steel & Tata Motors. These are the flagship companies of the Tata Group. Probably they will not cease to do business in the next 100 years. But it is facing hard times for the last 5-6 years.
The management is doing everything to maintain the shareholder’s value. Today (in 2020), Tata Steel has taken over Bhushan Steel. Tata Motors has launched new premium cars. This is a hint of their competence. A common man must always be on the lookout for such business to buy their stocks.
But the problem is, when we see the past 10-years’ performance of these companies, it is hard to estimate their true value. In the last 10 years, the company has not performed as well. They have been making low sales and lower profits. This is where the faith in the company’s top management comes in handy.
Curb the urge to buy stock NOW
In stock investing, people often regret those investment decisions taken in a haste. Hence, value investors follow a two-step approach.
- Step 1: Value investing is about identifying companies that are fundamentally strong.
- Step 2: Once a strong company is identified, go to the next step of analyzing its price.
Idea is to judge if it’s a quality stock and if its price is undervalued or overvalued. Try to realize what these two steps are trying to accomplish. They are putting brakes on our urge to buy stocks now.
In order to estimate intrinsic value, one needs to read companies’ financial reports. This reading takes time. It also makes us aware of the “real things” happening inside the company.
Circle of Competence
The hearth of value investing is attributable to one’s skill to estimate intrinsic value. The more accurate will be the estimation, the better will be the investment decision. The assurance will come from one’s own understanding of the company’s business. Buying stocks of businesses we can understand is what’s called investing within one’s circle of competence.
Stock investing must be practiced within one’s circle of competence. What does it mean?
Value investing is not only about Stock Analysis. It is more about understanding the company. Analysts who understands a company, tend to estimate its intrinsic value more accurately. Why? Because it helps them to foresee future growth. The intrinsic value of a stock is heavily dependent on its future growth rate assumptions. Read about stock valuation.
In this article, I’ll try to present to you a few basic questions that you can ask about any company. Answering these questions will give one a deeper understanding of the business.
How to know what is in my circle of competence? Look for companies operating in the same sector as your employer. Suppose your employer is “Infosys”. It operates in “IT Services and Consulting”. Try to analyze stocks of this sector.
This way we can start testing our circle of competence. After some experience, we can even expand our circle (domain).
How to build the circle of competence?
One can build a circle of competence from scratch. The right way to do it is to download the annual report of a company and start reading it from front to back. Once the reading is done, repeat the same process for another company in the same sector.
After reading the annual reports of two companies, try answering the following questions, or look for the answers in the annual reports. One can also take the help of the internet.
- Product & Customer:
- Is it an established company, or it is a new start up?
- What are the products and services of the company?
- Which are the top products or services of the company which is generating maximum revenue?
- Who are its end users?
- These products and services are in high demand?
- The products and services are unique in comparison to its competitors?
- How does the company sell its products and services?
- Geographically, where are the products and services of the company get sold?
- The Company:
- Company’s top management is reliable?
- How stable are the company’s sales?
- The company’s brand recognition is strong?
- How big is the company now, compared to its competitor?
- The customer base is widespread?
- The company operates in a sector which is regulated by government?
- How satisfied are the employees of this company?
- During economic slowdowns, the turnover is affected?
- How price sensitive are the product sales?
- Financial Data:
- Is the company able to generate positive free cash flow.
- How predictable is the free cash flow for next 10 years?
- Is current price above or below its intrinsic value?
Answering these few questions can help the investors to make an informed guess about the company (it’s stock).
More about building circle of competence:
- Utility of the questions: First, these questions works as a “self appraisal” for the investor. How? If one can answer all at one go, it means the company is within the circle of competence. If one cannot answer these questions, then these are the information that must be sought before investing. Moreover, while answering these questions, a general feeling will also develop about the company and its quality.
- Where to get the info: The best source of such information are company’s annual reports. You can also subscribe to the news feeds of the company using google alerts.
- How experts do it: Expert does it a bit differently. They will talk to people who know the company. Even they will talk to the customers to get an outside perspective. Warren Buffett even talk to the employees to get the inside-story. Suppliers can also worth as a litmus test. How a company treats its suppliers talks loads about its top management.
Value investing has its core in the value estimation of companies. How it is done? By estimating its future cash flows. Once the future cash flows are known, they can be suitably discounted to calculate their present value. To understand the present value concept, read about how to value a bank deposit.
The calculated present value is called “intrinsic value”. The accuracy will be the future cash flow estimation, precise will be the intrinsic value calculation.
[Note: Future Cash Flow = Future Free Cash Flow]
This is where the role of the circle of competence comes into play. A person whose circle of competence is in the Retail Business will be able to estimate, more accurately, the future cash flows of companies like Avenue Super Mart, Trent, etc.
Hence for a value investor, the focus should be on knowing enough about the company so that it helps in judging future cash flows as accurately as possible.
[Read: About Discounted Cash Flow (DCF) Model of Intrinsic Value Estimation]
Margin of Safety
No matter how knowledgeable is the investor, there is always a possibility of error in dealing with future cash flow estimation. Why? Because no one can predict the future with precision.
To take care a part of this ‘future unpredictability’ issue, value investors prefer dealing with blue-chip stocks. Future cash flows of these companies are slightly more predictable than others. But unpredictability still remains.
Hence, value investors use another tool to take care of the unpredictability. It is called “Margin of Safety”. Here it is assumed that the analyst has overestimated the future cash flow. As a result, the calculated intrinsic value is inflated.
To adjust the inflated intrinsic value, a suitable factor of safety is applied to it. The use of a factor of safety is a common practice in engineering design. The same analogy is applied here.
How much margin of safety shall be applied? There are no fixed rules. A person who is less sure of his/her future cash flow estimation may even apply a margin of safety of 1/2 (50%).
A more conventional margin of safety is 2/3rd (66.6%). But a person who is more sure of his estimations may even be satisfied with a 10% Margin of safety.
If one wants to invest in the stock market, learning to practice value investing is a must. The investor must at least know how to value the stocks of companies. This way he/she will at least not invest blindly.
There are two main ways of valuing stocks. One is done using financial ratios, and the other is through intrinsic value calculation.
People who do not want to go into the hassle of intrinsic value calculation can follow the financial ratio approach. But it is not as reliable. An investor must at least follow either of the two approaches.