If you had the choice between paying full price, over paying or getting a discount, which you would choose? A sane person would take the discount. The shopping habit of actively searching for deals, bargain hunting is the basic idea behind a value investing strategy. Seriously, who doesn’t like a discount?
Most people like the idea of buying things for less. So why don’t more people use the same strategy when it comes to investing?
Understand, shopping for food and cloths is not the same as shopping for stocks. A store buys products from the manufacturer with the hope of selling it at the regular price. Sometimes the store buys too much and is forced to have a sale to get rid of the extra inventory.
With stocks, before you can buy, someone must be willing to sell their shares first. And sell them at a price you’re willing to pay. Of course with this type of market place, one of the two parties ends up the greater fool. Either selling to low or buying too high. Value investing looks to take advantage of this.
What is Value Investing?
Value investing is simply buying a stock at a price lower than its real value or intrinsic value. When doing so, you buy it at such a discount that you lower your risk of loss. The stock is then sold when it reaches its intrinsic value.
Value investors focus on fundamental analysis, researching the:
- P/E or price/earnings ratio
- Price/Book ratio
- Debt/Equity ratio
- PEG ratio
- Free cash flows
Value investing isn’t some new concept. Ben Graham brought it to the forefront of investing when he taught it back in the 1920s. A few things have changed along the way. But the basic principles still apply.
The Key Principles
Value investors focus on these four key areas when investing:
- The market is inefficient – a hotly debated topic, the efficient market theory is based on the belief that stocks are never overvalued or undervalued but always fairly valued. All the information available is directly reflected in the stock price and the markets are devoid of irrational behavior. Value investors don’t buy it!
- Build in a margin of safety – The difference between the intrinsic value and the market value. The larger the margin of safety, the lower the chance of losses. Graham preferred stocks priced at two-thirds or less of their intrinsic value. That margin of safety provided enough room for error when calculating a company’s intrinsic value.
- Intrinsic value above the current market value – There is no exact formula for intrinsic value. If you stick two value investors in a room with the same company information, you’ll get two different values for the same company. Generally, intrinsic value is the total value of all the assets in the company (buildings, machinery, desks, patents, trademarks etc), its ability to produce income and possibly growth.
- Patience – discipline is key. A stock can stay undervalued for a long time, but eventually it will reach its real value. A value investor has the patience to wait.
You don’t need to be a Wall Street super genius to become a value investor. Anyone with a stock screener, basic math skills and the ability to read a balance sheet can do it. It just takes practice. In the end, it always come down to buying something for less than it’s worth.