Value investing is not a field of study or a subject like economics, accounting and finance. It is rather a concept that has been introduced by Benjamin Graham, a very successful investor and entrepreneur. Graham has tried to pass on his knowledge and expertise gained through investments in the market in the shape of a classic book titled “The Intelligent Investor”. Because of his efforts to popularize this kind of investing, he is also referred to as the Father of Value Investing. Some other big names in the list of value investors are Warren Buffet, Seth Klarman, Charlie Munger and David Dodd. All these are prime examples of investors who have always stayed ahead of the market.
In simple terms, these value investors used strategies that allowed them to beat the market. They figured how to increase their annual returns and keep them consistent. This strategy has worked for the past several decades. Let’s find out how it can work out for you too.
The core idea behind value investing
The idea behind value investing is to find companies whose stocks are worth more than their value reflected by the market. If you are an experienced sale shopper, you know a little bit about value investing already. In fact, you will be happy to know that you already possess some of the skills that are necessary for becoming a value investor.
Let us understand this with the help of an example. Normally, most people are content buying soda when it is selling at $6 a dozen and feel great when they get it at a discount of 50%. But you are not like other consumers and continue to wait till soda prices fall to their lowest values of the year. You do not buy even when prices fall to $4 for 12 piece pack as you know the sales cycle of soda will bring prices down to $2. Now you pay only a third of the original price of this soda that you can store at home as it can last long.
Value investing is nothing more, nothing less. The same principle applies to the stocks listed at a stock market. Some are overvalued while there are also companies whose stocks are undervalued and available at a fraction of their actual value. As an investor, your eyes should be on companies whose stocks are available at prices that, according to your judgment, are lower than their intrinsic value. Value investing is different from buying driven by greed when stocks are available at a low price or selling under panic when prices suddenly crash. In fact, this is what most investors actually do. They buy and sell guided by the demand and supply forces acting in the market rather than looking at the fundamentals of the company. They never take into account the future valuation of stocks. Value investors buy stocks that they feel are undervalued. They know that the prices of these stocks have fallen below their intrinsic value and thus are able to make a huge profit when prices of such stocks go up as the market tends to rectify itself.
How do you buy and sell stocks in value investing?
Now that the core idea of value investing is clear, the value investor needs to do some research and analysis to identify the intrinsic value of the stocks that he is interested in. The next step involves comparing the intrinsic values with actual prices of these stocks at the stock market. The goal is to select stocks which are grossly undervalued at the market to reap the profit when the market corrects itself in future. At the same time, remember that you should diversify your portfolio. Select a range of undervalued stocks to keep risk down.
Rationale behind value investing
There are many experts who cannot understand the rationale behind value investing. These are actually skeptics who feel that buying undervalued stocks in the hope that their prices will bounce back is a long-drawn strategy that is not necessarily correct in all cases. They point out cases of undervalued stocks that never recover to reflect their intrinsic value. These market experts recommend buying stocks that are hot-sand-rising to make quick money. But if one looks at the investment strategies of great investors like Benjamin Graham and Warren Buffet, it becomes clear that the most crucial thing in value investing is knowing the intrinsic value of the stock of a company. Prices at the market are artificial and they can rise or fall anytime, but if you are patient and diligent when it comes to doing research and analysis, you will be on the winning side.
It is like a television that you can buy at MRP or wait till it goes on sale and is now available at a heavily discounted price. You get to enjoy the same quality and features of the TV irrespective of the price you have paid. The same is the case with the intrinsic value of a stock. It remains the same even though the price at the stock market may be higher or lower. If you know the intrinsic value of a stock, you can buy or sell it depending upon its price at the stock market.
How value investors look at the intrinsic value of a company
For successful value investing, you have to learn how to determine the intrinsic value of the stock of a company. This is possible if you can study its fundamentals such as ROE, P/E and earnings to arrive at the true worth of the company. Value investors do not go by advertising and promotion as they are interested in finding out the intrinsic value of the stock. These investors are also different from those who do trading and those who indulge in growth investing. While investors belonging to these categories are desirous of quick results, value investors know that their investment would bear results sooner or later though it usually takes a few years time for them to strike it rich at the stock market.
Companies that contributed to rise of Warren Buffet
Warren Buffet is sometimes referred to as the Wizard of Omaha. All his life, Buffet has been a follower of the principle of value investing propounded by Benjamin Graham. There is a long list of companies that have contributed to his wealth but names of some of the most important ones are Petro China, BYD, Freddie Mac, Berkshire Hathaway, and Wells Fargo. The following is the break-up of investment, years held, and the return on investment.
Company Total return Years held
Wells Fargo 9417% 24
Berkshire Hathaway 1745300% 49
Freddie Mac 1525% 13
BYD 671% 6
Petro China 720% 5
Stock market is more like a “weighing machine” than a voting machine
Benjamin Graham, the father of value investing, expressed the opinion that the stock market behaves both as a voting machine as well as a weighing machine. If one looks at it in the short run, it appears as a voting machine that tells you about the popularity levels of different companies. You become aware of the public opinion about the companies in the short run. But this opinion is fickle and based upon the prospects of the company in the short run. But when one takes a look at the market in the long run, it appears as a weighing machine that reflects the true value of the company.
As long as you are confident, hard-working and patient, you can make a lot of money as a value investor.