What is value investing? It is an investment strategy to buy quality stocks at “undervalued price”. What is undervalued price? A market price below its intrinsic value is undervalued.
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 overvalued. How? Because by following value investing principles, the estimated intrinsic value of low quality stocks often comes out too low compared to its current market price.
Value Investing: An Investment Strategy
Stock market is full of stocks. There are more than 5,000+ number stocks in Bombay Stock Exchange (BSE).
For a potential investor critical question is, out of all stocks, which is good for purchase? This is what a specific investment strategy will answer for an investor. Basically there are four types of investment strategies around:
- 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: Index Funds.
- Technical Investing: Here the strategy is to target those stocks which is showing momentum. The focus is on taking advantage of the price movements only. It cares least about price valuation and health 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. 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 company’s intrinsic value. Read: Process of value investing.
Typical Characteristics of Value Investors
The way value investors practice investing is different from other investors. Here are few characteristics which is unique among value investors:
- Lazy: Value investors rely on deep thinking. Hence, externally they often look like lazy. Most of the time value investors are doing nothing. They do not buy stocks all the time. Instead, most of the time they are sunk deep into reading, doing maths and calculations. The number crunching is done to identify value stocks.
- Contrarian: Value investors do not invest in stocks with a herd mentality. Instead, they will buy those stocks which others are selling. Hence they are able to get them at a substantially discounted price. When majority are buying stocks for day trading, value investors buy them with intensions of holding forever.
- 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 value investors unique in the world of stock investing.
- Blue Chip Bias: Most value investors has a strong affinity for blue chip companies. Why? Because these are prime stocks of the market. Value investors target to accumulate only blue chip stocks at a discount. Read here to know why they do it…
Process of Value Investing
Understanding the process of value investing is easy. But it is not as easy to implement. To make the implementation easier, investors must build their “circle of competence“.
But before we discuss more about circle of competence, allow me to talk about the process of value investing first. The process starts with screening stocks based on its history.
- Stock History: Value investing is about picking blue chip stocks at discounted price. They represent established companies which has a long history trail. Example: My stock analysis worksheet does not accept stocks which has less than 10 years 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. Value investors will invariably invest in only those companies which are fundamental power houses. Read: Moat companies in India.
- Price Valuation: This is the ultimate screener. No matter how established is the company, no matter how strong are its business, it is not enough. Value investors will not rest till it calculates the intrinsic value. To be more sure of the calculation, they will also apply a suitable margin of safety. Once this is done, 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? Such companies which is already making lot of buzz in the stock 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 popular stock is falsified.
- How to 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 does not make the company bad. Read: Invest in share market.
Good companies always tend to bounce back and regain the lost glory. The point is, we must always be in the look-out for such companies – “companies not doing well today, but is likely to improve in future“. Read: Investing in bear market.
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 next 100 years. But it is facing hard times since last 5-6 years.
The company is doing everything to maintain the shareholders value. Today (in 2020), Tata Steel has takeover Bhushan Steel. Tata Motors has launched new premium cars. This is a hint of their competence.
A common man must always be in look-out of such business to buy stocks. When we see the past 10 years performance of these companies, it is hard to estimate their intrinsic value. It is because, in the last 10 years, the company has not performed as well. They have been making low sales and lower profits.
But looking ahead in future, the prospects looks more promising.
- Step 1: Value investing is about identifying companies which are fundamentally very strong.
- Step 2: Once a company has been identified as one representing strong business, go to the next step of estimating its intrinsic value.
Idea is to judge if the stock is trading at undervalued or overvalued price levels. Try to realise what these two steps are trying to accomplish. They are putting brakes on our “urge to buy stocks”. How?
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.
The key to value investing is ones skill to estimate intrinsic value. The better will be the estimation, if one try to analyse a business he/she understands. This is called “investing within ones circle of competence”.
Circle of Competence
Stock investing must be practiced within ones circle of competence. What does it mean?
Value investing is not only about Stock Analysis. It is more about understanding the core business operations of the company. Analysts who understand core business of a company, tend to do better stock analysis. Value investing is about understand the “underlying business” behind a stock.
In this article, I’ll try to present to you few basic questions that you can ask about any company. Answering these questions will establish how good or bad is the underlying business of a stock.
The purpose of answering these question is that, we must invest only in those companies whose business we can understand in and out. This is what is called as investing within once circle of competence.
How to know what is in my circle of competence? Look for companies operating in 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.
How to build the “circle of competence”?
One can build a circle of competence from scratch. The right ways 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. You can also take help of 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 (its 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. My personal litmus test are the suppliers. How a company treats its suppliers talks loads about its top management.
Value investing has its core in value estimation of companies. How it is done? By estimating its future cash flows. Once the future cash flows are known, it can be suitable discounted to calculate its present value. Read: How to value a Bank deposit?
The calculated present value is called “intrinsic value”. The accurate 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 “circle of competence” comes into play. A person whose circle of competence is say in Retail Business, will be able to estimate (more accurately) the future cash flows of stocks 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 future to 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 on it. Use of factor of safety is a common practice in engineering design of products. 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 10% Margin of safety.
If you want to invest in stock market, you must learn to practice value investing. The investor must at least know how to value 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 other is through intrinsic value calculation.
For 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.