There are many investment strategies used by a myriad of both individual and professional investors. Some prefer the growth strategy while others prefer a value approach. While both good in their own regard, a combination of the two trumps them both, and here’s why. In this post, We will discuss about Value Investing.
The fundamental goal of value investing is, quite simply, to buy a stock when it is low and sell when it is high. Seems easy, right? Though it may seem like common sense, the vast majority of investors do not do this. Very few use this strategy effectively. Some of the greatest investors of all time, such as Warren Buffett and Benjamin Graham, used a value approach in their investing careers.
The primary characteristic of a value investor is that they love finding good deals. It might be best to think of them as shoppers who scour through the Sunday newspaper for coupons. This is exactly what they do, but instead of looking through the paper for good deals, they look through the universe of stocks.
Value Investing Stocks
At any point in time, there are dozens of companies whose stock is depressed. There are many reasons for this to happen, such as disappointing quarterly results, unexpected charges, changes in leadership, boring products, etc.
A value investor will weigh the drops in stock value with the news that caused it. If it appears to the investor that the market overreacted (as it almost always does), then he or she might pick up some of the shares at a discount and wait it out.
In addition, a value investor does not look for companies who have yet to prove their products. A great example of this is the biotechnology industry.
Many of the smaller biotechnology firms don’t even make money at this stage, as they are still undergoing heavy research and development and clinical trials. A true value investor would never invest in a company that does not make money.
How To do Value Investing
Value investors want to see that the company is making money and that the stock is cheap relative to the value of the company. There are many ways of determining this, but perhaps the most widely used method is to look at the price-to-earnings ratio (P/E) of the company.
This ratio allows the investor to quickly determine the value of the stock relative to the amount of earnings generated by the company. The lower the ratio, the better the bargain the investor is getting.
This isn’t true in all situations, of course, and must not be used as the sole measure for evaluating a stock. The point is that value investors seek quantifiable facts to determine whether a stock is undervalued or not.
This, as value investors call it, is a “safety net.” If the company is undervalued to begin with, bad news or a market downturn will not affect the stock as much as a stock which is overvalued.
By using such quantifiable measurements, the value investor can safely stay away from using his or her emotions in stock selection. How many times have you received a “hot tip” from someone who claims they know what they’re talking about and assure you of great returns? Value investors ignore “hot tips,” hype, and market hysteria.
Below, you will find a list of both the positive and negative aspects of value investing.
Value Investing And It’s Pros:
- Reduces risk of underperforming by choosing investments which have a built in “safety net”
- “Hot” stock tips, hype, and mass hysteria do not affect the decisions a value investor makes
- Produces steady, consistent gains that regularly outperform the S&P 500
Value Investing And It’s Cons:
- Generally the potential returns for value investing are smaller than those of growth investing.
More often than not, those who choose the value approach consistently outperform the market. In the last 30 years, the S&P 500 has obtained compound annual returns of 13% per year. Also in the last 30 years, small-capitalization companies (smaller than 2 billion dollars) that were considered value obtained compound annual returns of 15%, better than all other types.
Value Investing Warren Buffett
As discussed earlier, the most successful investor of all time, Warren Buffett, is a champion of value investing. His company, Berkshire Hathaway (NYSE: BRK-A), has been one of the top performing insurance companies of all time. Buffett’s personal success, as well as the success of Berkshire Hathaway, is a testament to the power of value investing.
Value investing utilizes a strict methodology that is based on facts, not hype. Never forget that the majority of investors lose money because they did not control their emotions, a typical failing of most growth investors.
What if you could combine the pros from each of the strategies and reduce as many of the cons as possible? I’ll tell you what would happen: you would achieve returns even better than 15% and likely breaching 20%. This can be done by combining both strategies into a value/growth blend approach.
The value/growth blend approach to investing requires the use of the valuation metrics described previously as well as a utilizing certain growth criteria. While most of the valuation metrics utilize hard facts, the growth aspect is much more difficult to understand. No one knows what will happen in the future.
If someone says they do, run for the hills. If an investor views the world economy as a whole, though, he or she can get a pretty good sense of macro-economic trends likely to be significant in the next few years.
This is not an exact science, and requires much research and a vast amount of economic knowledge. When performing this test, it becomes apparent that there are several industries that will most likely see prolonged growth in the next decade.
Value Investing Benjamin Graham
Benjamin Graham is widely regarded to be the founder of modern value investing. His greatest student, Warren Buffett, attributes much of his success to Graham’s teachings. In this article, we will provide an in-depth look at Value Investing Strategy of Ben Graham, the father of modern value investing.
Though Graham believed that much research is necessary and that no stock screening methodology is perfect, he did give us some guidelines on how to perform initial screening techniques to limit the number of investments that should be researched further.
The following is a list of the attributes he suggests investors look for first, and they just happen to make a wonderful initial screener for potential investments. All of these come directly from his masterful work, “The Intelligent Investor,” a book which Warren Buffett hails as “by far the best book on investing ever written.”
1. Price-to-book (P/B) ratio of less than 1.2.
Intangible assets such as intellectual property, brand name recognition, and customer base, are not reflected in the price-to-book ratio. Therefore, you could theoretically go for a P/B of less than 1.5, rather than 1.2 that Graham suggests.
He recognized this fact as well and commented that the P/B could be up to 2.5 if the company has significant intangible assets. To maintain a margin of safety, however, we will look for a P/B of less than 1.2.
2. Earnings per share (EPS) should have grown by an average of 3% per year for the past 5 years
Accelerated EPS over a significant period of time is a sign of a solid business model, and of a capable management team. In this exercise, we go back 5 years, looking for 3%+ growth in earnings.
3. The price-to-earnings (P/E) ratio should be below 15.
Perhaps the most common valuation metric, the price-to-earnings ratio allows us to understand the earnings power of the company compared to its price. A high P/E ratio is common among “growth” stocks who are expecting phenomenal growth, but Graham believed that there is no way to be sure growth will continue at a pace that justifies the high price.
While it is true that average P/E ratios vary from sector to sector, sticking with the low 15 benchmark will help maintain the safety-net that Graham believed to be crucial to minimizing risk.
4. The quick ratio should be above 1.5
In “The Intelligent Investor,” Graham suggests using a current ratio of above 1.5. The current ratio represents the current assets divided the current liabilities. This ensures that if the company faces a crisis, they have 50% more assets than liabilities to work with.
Tweaking this criterion slightly, we are going to use the quick ratio instead, which is a more conservative number because it disregards any current assets that might be difficult to unload in a tight situation, such as inventory.
5. The company should pay out a dividend
Dividends, in Graham’s opinion, are a very important indicator of a company’s financial health. Not only that, but they indicate a shareholder friendly management team. For this screener, we locate stocks that pay out more than 2% annually.
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As investments are subject to market risks and price fluctuation risk, there is no assurance or guarantee that the investment objectives shall be achieved. Past performance of securities/instruments is not indicative of their future performance. This post is only for Educational purpose.