What is value investing? Value investing is an investment strategy.
One can use value investing to buy quality stocks at undervalued price levels.
What means by undervalued price levels?
When market price of a stock is below its intrinsic value, it is said to be undervalued.
People who buy value stocks are called value investors.
A well-known value investor of our time is Warren Buffett.
All value investors believe a theory. What is it?
The market does not price its stocks fairly all the time.
As a result all stocks trading in the market can be categorised as below:
- Undervalued and,
- Fairly Priced.
Which stocks are bought by value investors?
Good stocks trading at undervalued price levels becomes a good buy for them.
But does this theory not apply for all stock investors? Yes.
All investors target to buy stocks at cheap price.
But value investors does not buy any cheap stock.
They only buy fundamentally strong stocks available at market price below its intrinsic value.
How they do it?
First they check the business fundamentals of the company.
If the fundamentals are strong, they do its market price valuation.
Upon market price valuation, they know if stock is undervalued.
If stock has the following two attributes, value investors buy it:
- Fundamentally strong business.
- Available at undervalued price.
The bottom line is, unless the fundamentals of company is SUPER STRONG, value investors will never buy it’s stocks.
#1. Value investing is for lazy people…?
If deep-thinking people are referred as lazy, so be it.
Value investors are sharp and are always on their toes.
Why value investors leaves an impression of being lazy?
Because most of the time they are doing nothing.
They do not buy stocks all the time.
Instead, most of the time they are sunk deep into their maths and calculations.
But this does not make them lazy. They are more aware than other investors.
If they identify a good stocks, they will buy it within the next tick of the clock.
Value investors never miss a good opportunity to grasp a handful of value stocks.
#2. What makes value investing unique?
Value investors buy stocks at a price lower than what the market will pay for it in general.
They buy it at a discounted price levels.
What makes value investors unique is their independent thinking.
They do not follow a herd mentality.
They prefer to do the opposite of what market is doing.
It means if people are buying stock X, they will never buy X.
Instead they will look for those stocks which is low in demand.
Value investors also buy stocks with intention to hold them forever.
Buying stocks which are out of favour, and long term holding helps them to outperform others.
Value investing is a very simple concept. But in its simplicity lies the fun.
Value investing is like just like Yoga. As an exercise may look easy in the beginning.
But it has several layers underneath its skin.
#3. Value investing & hurdles on its way
For common men, what is the biggest hurdle in practising value investing?
Know-how to identify good stocks.
Why it is so?
Because one needs two key attributes here:
- Skill to judge a business.
- Skill to estimate intrinsic value.
Estimating intrinsic value of a company is a special skill. Now many can do this. Why?
Because to do this one needs to read and comprehend financial statements(Balance sheet etc).
How many people in this world has this skill? A tiny minority.
Hence less people are found to practice the theories of value investing.
Contrary to this, day-trading in stocks looks rather simple. Hence it has more followers.
But more than skill-set of an individual, value investing in itself is more demanding.
Why I say so?
Intrinsic value estimation is a must in value investing. But there are no set formulae to calculate intrinsic value.
As a result, even people like Warren Buffett only “estimates” intrinsic value of his stocks.
The estimated intrinsic value differs from person to person.
Intrinsic value of a company is not a definite value.
#3.1 Intrinsic value formula
There are several formula/methods to estimate intrinsic value of stocks.
Some methods are more stringent than others.
Hence they reproduce a conservative valuations.
Out of all methods, few have earned the tag of being more practical and logical.
These methodologies put forth a valuation by looking at a broader perspective.
What happens when one use both, stringent and practical methods?
The estimated intrinsic value will have a range.
- One value will be on too low (conservative).
- The other value will be higher (less conservative).
How does this range of values help the analyst?
It gives an idea that, the fair value lies somewhere in between these two range.
#4. Stocks, price-falls…
We all know that stocks price keep gyrating between their highs and lows.
If intrinsic value of a stock is say Rs.100. Why its market price will fall below this value?
This question become more relevant, when we are talking about stocks like Google, Apple, Microsoft etc.
Why at the market price of such companies fall below its fair price?
Stock price is volatile and hence it will fluctuate. This is a normal understanding.
There are several factors which effects stock price.
The two most evident ones are as below:
- Business fundamentals of the company.
- External factors like economy, sentiment etc.
A company may be fundamentally very strong.
But due to short term problems prevailing in the company, it may not be performing as well.
In such a situation many investors ignore the stock of such a company thinking it to be a bad bet.
This at times brings down the market price of stocks below its intrinsic value.
External factors like global economic crisis (year 2008, Brexit, oil price, inflation etc), can bring down price.
How people must act in case of price-falls?
Do not give much weightage to the short term price-falls.
Focus should be only on the following:
- Business fundamentals of the company.
- Current intrinsic value (price valuation).
#5. How we buy stocks?
Generally, how we buy stock?
If we are investing on our own, we tend to buy stocks of popular companies.
What are popular companies?
Such companies which is already making lot of buzz in the stock market.
But the problem with such stocks is that, their market price is overvalued.
This way, are we practising value investing principles? No.
Market price of such stocks does not trade below its intrinsic value.
So it means, we end up buying overvalued stocks, leading to losses, right?
This is the most common outcome when a common man enters stock market.
Who is the culprit? We, our decision to buy popular stock.
A value investors will never make this mistake.
How they keep themselves insulated from making such a mistake?
By knowing the estimated intrinsic value.
#6. How to buy stocks?
Even a good business does not perform well all the time.
They too face the heat of the market.
When they are not doing well, their stock price also taken a beating.
But such short-term turmoils does not make the company bad.
Good companies always tend to bounce back and regain the lost glory.
In such cases, their market price also show the same momentum.
Generally speaking, companies does not operate with a short term perspective.
They make strategies and run the operations with next 50 years in mind.
So a company which is not doing well temporarily, is likely to bounce back tomorrow.
They are not going to close-down just because it is not making enough profits last year.
The point is, a common must must always we in the look-out for such companies.
Companies not doing well today, but is likely to improve in future.
Low-profits (loss) today, may convert into large profits in future.
A company which is doing bad today, may not continue its bad performance in future.
This is something that a common man must always keep in mind while investing.
But it does not mean that, one should go and buy stocks of SICK companies.
This is where the analysis of business fundamentals comes to use.
How to know if the business fundamentals are good?
Following are the indicators:
- Runs on strong business ethics.
- Their business reporting is transparent.
- Has a good brand recognition.
- Their products are useful and unique.
- Has a talented workforce etc.
What do do you think, such a company will ever close their business? No.
It is advisable that look for such companies.
Those which are not doing very well today, but has strong ability to improve its profits in times to come.
This is what value investing is all about.
Take example of Tata Motors, Tata Steel.
These are the flagship companies of the Tata Group.
Probably they will not cease to do business in next 100 years.
But both these companies faced very hard times during in last 5-6 years.
But they did everything to maintain the shareholders value.
Today (in 2018), Tata Steel is talking about takeover of Bhushan Steel.
Tata Motors is launching new cars (like E-vision).
This is a sing of their competence.
A common man must always be in look-out of such business to buy stocks.
If when we see the past 10 years performance of these companies, it is hard to estimate their intrinsic value.
It is because the last 10 years of this company has not been very good.
They have been making low sales and profits.
But looking ahead in future, the prospects looks more promising.
Value investing is about identifying companies which are fundamentally very strong.
This is step 1.
Once a company has been identified as one representing strong business, go to next step.
The step 2 is about price valuation.
Idea is to judge if the stock is trading at undervalued or overvalued price levels.
Try to realise what these two steps are trying to accomplish.
They are putting brakes on our “urge to buy stocks“.
How they are applying the brakes?
By asking us to check “business fundamentals” and “price valuation”.
In order to these, one needs to read companies financial reports. This reading takes time.
It also makes us aware of the “real things” happening inside the company.
How this realisations helps us as an investor?
We tend to judge a company based on “facts” and not on assumptions.
If our judgement is positive, we can go ahead and buy its stocks.
In case of negative outcome, the stock is shelved for the moment.
The key to value investing is ones skill to estimate intrinsic value.
The better will be the estimation if one try to analyse a business he/she understands.
This is called “investing within ones circle of competence”.
Read more about it in the next chapter.