Here is my views on what value investing is:
Value investing is to buy a stock for less than its intrinsic(fair value) value. To do so you need to be able to value the stock so that you can estimate the intrinsic value. If you can’t value the stocks in some way, then I would call it speculation and not value investing.
Remember that when you buy a stock you buy a small part of the whole company and not just a ticker symbol. If you wouldn’t buy the whole company(if you had the money) you should not buy a single share of the company. You sell the shares (company) when its stock price is substantially above the intrinsic value. You repeat this process again and again over the decades with each stock you buy. Value investors analyze the fundamental characteristics of the company (financial statements) speculators invest based on the recent price action of the stock with no regards to the fundamentals.
Why do you want to use a value investing strategy?
Simple: It’s a strategy that has been proven to give a very high return and beating the market for many decades.
Why does value investing works?
Investors tend to overreact to bad news and headlines of a company and at certain times stocks are sold off regardless of their value, creating a oppertunity for value investors to buy companies for much less than what they are worth. Over time the market realize its error and will later at some time price the stock correctly (at its intrinsic value)
Here is an illustration that shows what value investing is:
As you see from this graph WMT (Walmart) from 2001-2010 has from 2001 to 2007 has had a price higher than its intrinsic value. (not a good time to buy) But during this time the intrinsic value of the stock has grown while the price has been stagnant or even dropping somewhat. because this is a high quality company and the intrinsic value has steadily been growing.
As you see in 2007 the intrinsic value became higher than the stock price and until 2010 was growing faster than the stock price. (probably a good time to buy)
Some stocks are difficult to value, because they are small fast growing companies, concepts stocks, cyclical commodity companies or just very poor quality companies. The future of these companies are very difficult to foresee, so it’s in many cases best to ignore companies you can’t value with confidence. They can of course be great investments but its much harder to analyse them and their success is more determined by luck and events that we cant foresee or predict.
So when you look for companies to value I advice to look for companies that you actually can estimate what they will earn in the future. That means that in general you should look for companies with these characteristics:
-Companies with a moat (sustainable competitive advantage) You want companies with a moat because these companies are more likely to increase their profits and intrinsic value over the next decades.
-Stable earnings growth past 10-20 years
-Stable margins (gross, operating and net margins)
-Low debt (less chance for the company to get into trouble and destroy value (intrinsic value)
-Good management ( You want a managment that is shareholder friendly and allocate the capital in the best possible way)
-High return on invested capital (indicate a moat)
-Positive and growing free cash flow past 10 years (Free cash flow can be used to pay a dividend to shareholder, pay back debt, invest in the business, buyback shares)
-History of share buyback at the correct times (when the stock is below its I.V) (This indicate that the management is a smart capital allocator)
You can look for these companies and analyse them in a fast and easy way with The Warren Buffett Spreadsheet
Companies with these characteristics are high quality companies. These are in general the companies you want to look for. The reasons are many:
-More likely that you will be able to hold and not sell during a bear market
-These companies tend to grow their earnings and then also their I.V over time, so time is the friend of the high quality companies and enemies of the poor quality companies.
-Less turnover in your portfolio ( you can probably hold these companies for 5-20 years)
-Less stressful to hold these companies(easier to be relaxed when you know that your portfolio consist of high quality companies that will grow their value over time)
Of course you need to buy these companies when they are on sale, that means not necessarily when the stock price has dropped, but when they are selling for substantially less than their intrinsic value. So how much is substantially? That depends on the predictability and quality of the company. With a high quality company you can allow yourself to buy with a 25% margin of safety. That is a price that is 25% lower than your estimated intrinsic value. For a lower quality company or a company operating in an industry where the future profits are harder to predict you want to have a higher MOS, maybe up to 50%.
Margin of safety is an important concept in value investing. You don’t want to buy the stock AT its intrinsic value, you want to buy it for LESS. You want to this because bad things can happen with the company that lower the intrinsic value of the company, so you want to have a MOS as a buffer in case the company does not perform as you expect.
Remember also that investing is a game of probabilities and nothing is certain. That means that you should diversify with at least 5 stocks. You want to be better than market on the average. In a 10 stock portfolio you can expect at least 3 of them to underperform, but as long as the other stocks perform well it will offset the loss you got on the 3 underperforming stock. This is the interesting thing about stock investing. A stock can maximum go to zero, that means a 100% loss, but another stock in your portfolio can be a multibagger going up 10-100 fold from your buying price. Read more on why you should diversify
Also to make the value investing strategy to work you need to be:
Confident in your analysis, but still be able to change your mind if the fact change. (the fundamentals of the company change for the worse).
You need supreme patience and discipline: You need to be able to hold a stock for many years trough bear and bull markets, confidently sticking to your estimated intrinsic value of the stock.
You need to be able to be rational and sell when the fundamentals change for the company and there is no chance for improvement in the future ( like for example tech companies like Nokia and Kodak)
You need to be able to hold even if the company appear somewhat overpriced. You don’t want to sell a high quality company unless it become very overpriced.
You need to be able to sit with cash and not being invested for a long time untill you find a company with high quality selling for a low price. This can be mentally hard in a bull market when it seems like all other are making money taking big risks.
You must be able to stick to the value investing strategy even if value investing is out of fashion. In the past years growth stocks has been the hype and value stocks has underperformed. This has however changed lately. You might underperform the market for 3 years in a row with a value strategy and you must stick to the strategy to gain the long-term benefit, not jumping unto another strategy in times of underperformance.
You need to be brave and be confident in your analysis even if the market disagrees with you. With disagreement I mean that the market price the stock much lower than your estimated intrinsic value. Look here for my views on how you can beat the market.
That’s it. Who said value investing is easy? It’s not and to better your chances you should be a learning machine as Warren Buffett and Charlie Munger recommends and read some of my recommended investing books
Also check out my free value investing tools page with lots of checklists and excel spreadsheets for free download