Introduction to Value Investing
All stocks market investors tries to outperform the market. If market is going in negative then they would like to make at least minimum positive returns and if market is bullish, they want to beat that bull. This is human psychology and it is no different for value investors. Value investing is one stock market investing strategy that investors can use to outperform the market. Value investing is not rocket science, all of us has that knack of value investing built in our mind. Consider yourself shopping for a pair of jeans, suppose you get your hands on a pair of Levis, one brand new costing $50 and other one having same price but is a year old and available at discount of 30%. Considering that both are Levis and are good shape, you will certainly go for the discount. Similar theory is applied in stocks investment as well, due to some reason or other, some quality stocks may be available at discounted price; value investors will these stocks over other so called ‘hot stocks’.
Explaining value investing for a lay man
Yes its true and this is the beauty of value investing, even a lay man use value investing and make money. There are ‘Four’ very simple to understand principles of value investing. (1) Always know true value of company before buying its stocks. By knowing true value of a stock (also called as intrinsic value) you can easily judge if you are paying high or low to buy them. True value of stock can be calculated by using simple technique explained in other article. (2) In calculating true value of a stock, the concept of margin of safety plays a very important role. Stock market is unpredictable, in order to neutralize this unpredictability, one needs to buy stocks maintaining margin of safety. If a stocks is valued at $10, then by applying margin of safety you must buy it say at $6.66 (2/3 of true value). (3) Buy those stocks which others are selling. Generally people buy those stocks which everyone else is buying. This is a big mistake. Value investing tells you to buy stocks of fundamentally strong companies which are available at discounted price. (4) Value investing is more a game of chess than a sprint race. You need to watchful & intelligent while playing the game of value investing. Do not buy stocks just because your friend has suggest you to buy it. Do your own stock analysis and then buy stocks.
Why at all quality stocks will become undervalued
As I said earlier, people do buy and sell stocks simply because someone else has told them to do so. At times this herd mentality causes the stock prices to fall below its true value. Though fundamentals of the company is very strong, still people sell their holdings because everyone else is doing it. There can be other instances where stocks price can fall below its true value. (1) During stocks market crashed as that of 2008. Where we saw some most quality stock prices falling abnormally simply because US banking stocks were in deep trouble. (2) There are instances when investors become so engrossed in buying stocks like Microsoft, Apple, IBM, Google, Axon that stocks like Amazon, Tata Steel, Wells Fargo etc goes unnoticed. A careful watch on such blue chip companies will allow you know they are going out of favor resulting in its market price falling below its true value. (3) People generally go for known blue chip companies like Microsoft, Apple, IBM, Google etc but not all blue chip companies are known to them. If you can develop a list of all know and not so famous blue chip stocks then by tracking them you will know which stock has been ignored by the market. (4) Due to some bad news, it has been observed that stocks market reacts very critically. When Reliance Industries announced that its oil exploration is not giving expected results then market saw a big dip in their stock prices. Though everyone knows that RELIANCE has strong fundamentals still people are selling their holdings.
How we can locate an undervalued, quality stock?
As I said before, first of all develop a list of all possible blue chip stocks. In the nest step you will need to analyze their financial statements to calculate its true value. While reading the financial statements of these blue chip companies you need to calculate some important value investing ratios which will allow you to compare them with a standard. Some important ratios that all value investors must know are (a) EPS & EPS growth rate, 5 years, CAGR (b) P/E ratio, (c) Earning Yield. There is one more parameter which can be used as a very good indication of stock being undervalued. This is when companies inside (top managers) are buying their own stocks. Suppose if Ratan Tata is buying stocks of Tata Motors, then he exactly known that this stock is undervalued today and going to outperform the market in future.
Value investing is an art?
Yes, if you want to follow value investing to its core, you need the skills of a careful artist. All value investors answers the following basic questions before they buy stocks of any company (this is their way of estimating the true/intrinsic value of a company):
(1) Is it possible for this company to increase its profit by increasing its selling price without hampering its sales?
(2) Is it possible for this company to increase its profit by increasing its sales?
(3) Is it possible for this company to increase its profit by reducing its expenses?
These are some basic question that probably a lay investor will not be able to answer. An investor who is following the performances of the company very closely will only be able to answer these questions. This process of knowing and analyzing a company so as to evaluate its true value makes value investors an artists.
The skill of reading companies balance sheet, income statements and cash flow statements is also a matter of skill. Not many people in this world can analyze and correlate these financial statements. Value investors are those people who earns their bread and butter from these financial statements analysis.
Some most famous value investors we can follow
If one aspires to become a value investor they can follow habits and behaviors of some quality value investing gurus like Benjamin Graham, Warren Buffett, Charlie Munger, Christopher H. Browne, Irving Kahn, Walter Schloss etc. Following and reading about these value investors will probably give you more insights into value investing than any bookish information. Let me tell you these artists of value investing treats value investing very differently than you and me who treats investing in stocks.
Value investing is like buying Ice creams in winter. The Ice Cream will have the same taste and quality as before but you may get it at half their price is summer.