Value investing is a widely established investing paradigm that investors can approach to make long-term returns on the stock market. While most people prefer to invest in stocks passively, many successful and famous active investors have achieved incredible market-beating returns for consistent periods of time.
Many of them follow at least some value principles when picking the investments that led them to their huge amount of compounding wealth.
If there is someone who can be called the most successful and well-known investor in today’s time, it would probably be Warren Buffett.
The chart above shows the incredible performance that Buffett and his company managed in the past several decades.
Buffett is the prime example of a fundamental value investor and has proven to the world that value investing can consistently crush the market over many decades in a row. The fundamental beliefs of value investing are what made Buffett become one of the wealthiest people on earth.
What is Value Investing?
“Price is what you pay. Value is what you get.”
The core of value investing is to find and buy companies that are trading at a lower price than what they are truly worth, with the expectation that its stock price is eventually going to rebound and potentially increase much further along with the company’s growth, as the market acknowledges the true value of the company.
To define how much a stock is really worth, a value investor needs to find the intrinsic value of it. There are several ways to determine the intrinsic value of a company but probably the most common valuation method is the discounted Cash Flow Analysis (DCF). The true value of a company is essentially the amount of all future cash flows added up together and discounted to the present. This may sound complicated at first but after some practice and use, beginners become used to it.
Why Should Value Investing Work?
As mentioned above, it is vital for a value investor to buy companies that are priced below their intrinsic value. The intention of this approach serves several two main purposes. The price point at which investors buy a stock plays a critical role in the future return of the investment.
The lower the price at which investors are able to buy a stock, the higher the return that can be achieved from future price appreciation. Secondly, the amount of downside risk effectively decreases with a lower entry price. Good quality businesses that are extremely undervalued aren’t likely to drop even further than okay businesses that are heavily overvalued.
Value investors believe that the market is behaving inefficiently. Market prices are defined by investors and investors act irrationally by human nature on different events when they’re occurring. The market may oftentimes either overestimate or underestimate certain qualities of a company.
This can create stock price fluctuations that don’t fall in line with the fundamentals of the company, potentially leading stock prices to fall in undervalued or overvalued levels.
While, many people view value investing as simply buying stocks with low price-to-earnings ratios, low price-to-book, and strong free cash flow, it is in fact much more than that. Advanced value investors know exactly what to buy and when to buy. They dive deep into a company’s prospects, reading their annual reports, shareholder letters, and find out how the business competes in its operating industry.
This part of the analysis oftentimes takes more time, effort, and practice than the quick review of general financial numbers. When times come and the price of a certain stock falls into an attractive level, they don’t hesitate to buy since it’s already clear for them that they’re investing in a great company.
There is oftentimes a clear distinguishment between value investing and growth investing. This may lead people to think that value investing is all about finding cheaply priced stocks, but the growth factor does also plays a very important role in the valuation process of a stock. When a business is expected to grow fast, the true value of the business will also have to adjust to the growth.
Value investors essentially try to find businesses that are trading at a discount of their true value.
What Are Good Value Businesses?
There are several qualities and metrics which value investors might look for in a business to actually consider buying it when it’s priced at a discount. Each investor has different criteria that they want to see from a company but there are several guidelines that every business generally needs to have to be taken into consideration for most value investors:
- A stock must be stable. It is very hard to determine the intrinsic value of a business if its financials are not growing consistently at a predictable rate. A business with very inconsistent earnings is more likely to continue with that uncertain growth than a business that is steadily producing more and more cash flow.
- The risk needs to be as low as possible in relation to the return. Of course, a stock and its future performance can’t be fully predicted but the odds can be taken into one’s favor if the risk is minimized as much as possible. Factors that can indicate the risk of a business include the overall financial health of the company, the amount of debt it has, the integrity of its management, and the long term prospects of its operating industry.
- The company needs to have an economic moat. Nowadays, nearly all companies constantly stay in rivalry with competitors operating within the same industry. An economic moat refers to the ability of a business to defend itself from the competition to not lose any market share or profitability in the long term. The moat has to be some kind of advantage over other businesses that is not duplicatable and only available to its own business. Value investors are destined to find companies with economic moats, as the chance is much greater for the business to withstand any down pressure and uncertainty in the long run.
As already mentioned, most value investors generally buy financially sound companies with great long term prospects and a healthy balance between risk and reward, while trading below their fair/intrinsic value.
Such investments can pretty much fall into any category of the market, ranging from small-caps to large-caps even including growth companies with high P/E ratios. Warren Buffett’s Berkshire Hathaway has recently acquired a big stake in Amazon (AMZN) earlier this year. The P/E of Amazon is at such a high level that many investors wouldn’t have expected Berkshire to make such an investment in the first place. Actually, most companies might be good value picks as long as the price is right.