Hello! Today, I have a great guest post from Chris about value investing. Chris started a digital marketing business that focuses on freelance writing, content marketing, and SEO — all while working full-time and playing dad to two kids. You can check out his blog – Money Mozart to read more.
Have you been thinking about getting into the investing game, but have no idea where to start when it comes to choosing a strategy? Find yourself totally overwhelmed by the sheer amount of options and information?
Then you may want to take a look at one of the best long-term, proven investing strategies around— value investing.
Let’s take a deep dive into this technique, learn more about value investing, and explore why you should care about it in the first place.
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What is Value Investing?
Value investing is a simple concept that involves just what the name implies—buying investments that are a good value. The trick is understanding what makes an investment “good.”
Stock prices vary daily, regardless of their true value. That means that on some days, a stock’s price may be far higher than its value, and on other days, it might be far higher than its value. These stock prices are affected by many different factors (more on that later), and these fluctuating prices influence most investors to buy and sell with a herd mentality—but not value investors.
Value investing is a calculated, fact-based approach to investing. Intelligent investors who practice this strategy understand that there are plenty of stocks, bonds, and other types of investments out there that are undervalued and sell for far less than they’re worth.
Instead of concerning themselves with the emotionally driven practice of buying and selling, a value investor looks at the facts, identifies undervalued stocks, and jumps on the opportunity to buy them while the price is low. Then, when the value rises, they sell them for a considerable profit.
That might sound like a quick way to strike it big, but this process takes time. The price of an undervalued stock typically doesn’t skyrocket overnight, so it could take years to see a profit. Because it’s a strategy based on facts and common-sense, though, it’s a medium-to-low risk way to invest. Even better, when those prices do rise to reflect or surpass the actual value, the payouts are well worth the wait.
Why Would a Stock Be Undervalued?
Value investing is all about identifying and purchasing undervalued stocks. But why would stock for a company with strong long-term potential be undervalued in the first place?
The biggest reason why a stock might be undervalued can be summed up in one simple word—fear.
When a company underperforms, investors get scared. They’re worried that the underperformance is an indication of what’s to come. If things continue as they are in that given moment, there’s no chance for the company to have a successful future.
What do they do? They sell their stocks before the price drops even more.
When a lot of investors have this mentality and buy into this fear, they all sell at the same time, causing the price of that stock to plummet.
While this drop in price makes it look like the company in question is low-value, the given price of the stock doesn’t actually equate to the real value or the future potential of the company. It merely means that at this given moment, the company is undervalued.
Of course, the price could have dropped for numerous reasons–it isn’t always related to underperformance. These factors can include:
- The CEO or owner was involved in a scandal that’s gone viral
- Product recalls
- A low point in the natural business cycle
- A change in upper management
The potential reasons a company might be undervalued on any day are endless, but when you jump on the opportunity to purchase these undervalued stocks, you’ve increased the value of your investment.
To better understand this emotional trend of buying and selling, and to understand how you can beat it, we’ll take a look at what the father of value investing himself, Benjamin Graham, has to say.
Benjamin Graham’s Principles of Value Investing
Have you ever heard of the “Mr. Market” concept? It’s a well-known metaphor for the stock market created by Benjamin Graham.
In his 1949 book, The Intelligent Investor, Graham created Mr. Market and asked readers to view him as a business partner.
While Mr. Market is very on top of things, he can also be a bit unstable. Some days, his perception of value will be completely on point and anchored in reason—but on other days? He lets his emotions get the best of him, either by being far too optimistic and hopeful or afraid.
Those emotions impact Mr. Market’s logic, and on those overly-emotional days, his offers to buy and sell additional interest will seem nothing short of ludicrous. Of course, in the metaphor, Mr. Market is the stock market itself.
You wouldn’t let a business partner’s emotions sway you into believing that your investment’s value had radically changed overnight if the facts and your reasoning were telling you something different, right?
Why should you let the stock market do the same?
Think Mr. Market’s is letting his emotions dictate his price? Then don’t bother with it. He’ll be there with a new price for you the next morning.
Viewing the stock market like this allows you to separate yourself from the daily ups and downs emotionally. You’ll find yourself making sound decisions based on what you know, as opposed to Mr. Market, who is making decisions based on his feelings.
You can choose whether you want to buy or sell at any given time. You never have to do something just because everyone else is doing it, even if everyone else includes successful and intelligent people.
Just because Mr. Market is feeling things at an extreme one day doesn’t mean the real value of your investment has actually changed, just that Mr. Market’s mood has.
At some point, you’ll find him feeling very afraid about the value of his stock and see that he’s trying to sell it off as soon as possible. That’s where you identify Mr. Market as undervaluing a company and pounce on the opportunity to buy it yourself.
Then, when Mr. Market’s perspective on things changes (as it always does), you’ll find him ready and willing to buy that investment back from you for a good chunk of money—far more than you initially paid for it.
How Do You Do Value Investing?
Is value investing just buying low and selling high, then? That’s exactly what it is.
Unfortunately, it’s also easier said than done. After all, if it were that simple, everyone would be doing it.
The key to successfully practicing value investing is to accurately know the current value of a given company and predict its future potential. This data is called the “intrinsic value” of an investment.
A few different things factor into the intrinsic value of an investment, including:
- PEG (price-to-earnings ratio)
- EPS (earnings generated per share)
- Expected growth
- Margin of safety
Determining intrinsic value is not an easy thing to do accurately and consistently. While you stand to profit significantly when your estimations are right, you can lose a lot if you’re wrong. That’s why it’s so important to study the past and the present and compare that information to market forecasts.
Successful value investors combine this information with Graham’s principles. They put their emotions aside as they study the facts and work out what the true value of a stock is and what that value is likely to be months and years down the road.
This is where value investing sets itself apart from simple speculation.
While speculators are often throwing money at the next big thing and taking a huge risk on whether it will be a successful investment, value investors are taking calculated risks based on reason and fact.
If you can put aside your emotions, ignore your hopes and fears, and actively choose to make decisions rooted in logic and fact, you can make value investing work for you.
Does Value Investing Still Work?
Value investing has been around for nearly a century, and it’s not going away any time soon.
If you follow the news, you’ll undoubtedly hear some outlets say that value investing is dead and discuss how it can never be a profitable strategy for investors again.
But the simple concept of buying low and selling high has been proven to work time and time again. While various stock market cycles may make it look like a bad strategy, things do come full circle, and those value stocks that were once undervalued will once again be priced at (or higher than) their intrinsic value.
Which brings us to our next question…
Is Value Investing Right for You?
While the potential to earn big with value investing is there, that doesn’t mean it’s right for everyone. Countless investors have fallen in love with the idea of making Warren-Buffet-amounts of money through value investing only to fail miserably.
So, how do you know if value investing is the right strategy for you?
First, it’s important to remember that value investing will not get you rich overnight. You’ll have to be okay with playing the long game and have the patience to see it through. It can take months or even years to see a profit from value investing, which is why it should be a part of your diversified portfolio rather than all of it.
Before you start, you’ll need to remember that there is a risk in value investing. Even with the most calculated research, you can still lose. Making logical decisions and evaluating the facts will give you an excellent shot at success, but no investment is guaranteed.
Next, you’ll need to be okay with being a lone wolf who doesn’t follow the pack. You’ll need to ignore what everyone else seems to be doing and only make the moves you believe are right. If you don’t, all your hard work will go to waste.
Finally, you’ll need to consider the most challenging aspect – your emotions. You can never let your emotions get the best of you as a value investor. While plenty of people start out believing that they are or can be emotionally detached from their investments, the tables quickly turn once big fluctuations in price start to occur.
It’s easy to get caught up with the whirlwind of excitement once those prices start to rise, and it’s even easier to feel the fear once they start to drop. Prepare yourself to put these emotions aside before you even begin doing your research.
Then you can get started value investing.
What if Value Investing Isn’t for You?
If value investing seems too slow for you, then there are other approaches to consider. Growth investing, for example, looks at companies that are either smaller in market capitalization or less mature, but have massive potential for growth.
I think this strategy is more in-line with gambling, personally, so I would instead recommend something called GARP investing (Growth at a Reasonable Price). GARP investing seeks to find a middle-ground between value and growth investing by finding companies that have high growth potential, but still meet some of the key principles and metrics of value investing.
How Do I Get Started with Value Investing?
Value investing is all about the research. To be successful, you absolutely can’t begin buying until you’ve evaluated the investment thoroughly and looked extensively into its future potential.
Your research should look at a variety of different factors. Don’t take the first opinion you come across as scripture–use your own reasoning and common sense to make a decision.
When you’re just getting started, you should look at companies in an industry that you have some knowledge about and, ideally, some interest in. You’re going to be spending a lot of time looking into the details of these companies, so picking an industry you enjoy can make it feel even more like time well-spent.
Having some knowledge of the industry already will give you a head start on your research. You’ll already be familiar with the types of products they sell, their business practices, who their competitors are, and what kinds of expenses they might have. If you’re not familiar with the industry already, you’ll have to put even more time and effort into learning all this information.
As you become more experienced, you can branch out and learn more about other industries, too.
When choosing a starting point for your research, you can use these points, recommended by successful value investor Christopher H. Browne:
- Has the company recently raised its prices on its products or services?
- Has the company discovered a way to increase its profits while also decreasing its expenses?
- How are the company’s competitors doing?
Of course, you’ll then need to dive into more detailed income reports and future market forecasts to make your final decision.
Is Warren Buffet a Value Investor?
An inspiration for value investors everywhere, Warren Buffet is probably the most famous example of a value investor you’ll ever find. Buffet is a very wealthy man who became wealthy because of his success in value investing.
According to Forbes, Buffett has a net worth of about $76 billion, making him one of the world’s wealthiest men. For years, value investors have studied his strategies and attempted to emulate his success in their own practices.
Much like Benjamin Graham, Buffet is also very good at breaking down complex financial concepts by turning them into a metaphor that just about anyone can understand.
In addition to an incredibly successful value investor, Buffet is also known for living frugally–well below his means. He still lives in Omaha, Nebraska, in the same house he bought for $31,500 in 1958.
Look at this frugality as another example of emotional detachment from wealth. Buffet doesn’t get caught up in the highs of buying huge mansions or the world’s most expensive supercars, which has allowed him to maintain his wealth for decades.
Need more value investing inspiration? A few other well-known value investors include Charlie Munger, Seth Klarman, Christopher H. Browne, and Peter Lynch, just to name a few.
What Are Value Investors Buying?
Unfortunately, there’s no simple answer as to what value investors are buying and selling at any given moment. After all, if the answer was that easy, there would be a lot more Warren Buffets in the world. Of course, there are a few common practices you can incorporate into your own strategy.
Value investors are certainly keeping an eye on companies making products that are in high demand and that are likely to be in high demand for the long run. While the trends of today are not always guaranteed to be the trends of tomorrow, every industry has some products that aren’t going to go away any time soon.
These companies are likely to hold significant long-term value and show strong market stability, even if they’re undervalued at any given moment.
Value Investing: Wrapping It Up
When done right, value investing is one of the best strategies you can put your time into. While there is a lot of effort and patience involved, making your moves based on the knowledge you have rather than faith, hope, and fear will pay off big in the long run.
Plus, separating your emotions from the stock market and knowing each stock in your portfolio is there for a good reason will give you sincere peace of mind that’s quite uncommon amongst the majority of investors.
So, what are you waiting for? Start your research and begin value investing today.
Are you interested in value investing? What is your investing strategy?