What is value investing? Value investing is a theory using which one buys 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 trading at undervalued price levels.
The people who buy value stocks are often referred as value investors. One of the most well-known value investor of our time is Warren Buffett.
Value investors have a theory that the market does not price stocks fairly all the time. As a result some stocks traded overvalued price levels and some trade at undervalued price levels.
Good stocks which trade at undervalued price levels, as the market didn’t price it fairly, becomes a good buy in value investing.
Equity investors does not buy any stock which is undervalued. They first check the fundamental of the underlying company; and if the fundamental of the company is found to be strong, only then they go ahead and buy it stocks.
The bottom line is, unless and until the long term fundamentals of the company is very strong, value investors will never buy it’s stocks.
So what is value investing?
It is an investment strategy which is followed by only lazy people? No.
On the contrary value investing is practiced by people who are sharp and are always on their toes.
Having said that, this is also true that, if a value investor identifies a fundamentally strong company trading at undervalued price levels, they will do everything to buy stocks of such a company.
Value investors never miss a good opportunity to grasp a handful of value stocks.
In a general way we can say that, in value investing people buy stocks at a lower price then normal.
In value investing, people does not follow a herd mentality. Instead value investors does things opposite to the popular demand.
It means, if people are buying stock X they will never buy stocks X. Instead they will look for those stocks which is in low demand.
This is a very typical characteristic of an investor who is following value investing.
Apart from this characteristic, in value investing people generally buy stocks and hold it for very long term.
These two typical characteristics has enabled value investing to outperform any other investment strategy practiced in last 100 years.
It is true that value investing is a skill which is not easy. Value investing is something like yoga. It is easy to pick, but it’s difficult to continue it has a habit.
Hurdle in value investing
The biggest hurdle of value investing is identifying undervalued stocks. Why it is so?
This is because, to identify undervalued stocks it is essential to know its intrinsic value.
Calculating intrinsic value of a company is a very special skill. People who have the aptitude to read and analyse companies financial statements can only calculate intrinsic value of Companies.
But how many people in this world know how to read and comprehend financial statements of Companies? A very tiny minority.
Hence identifying undervalued stocks by a common man is not so easy.
To make the topic of intrinsic value calculation even more complicated, there are no set formulae to calculate intrinsic value.
In fact, in value investing, people never CALCULATE intrinsic value, but they only ESTIMATE it.
Intrinsic value of a company is not a definite value. There are several methods of estimating intrinsic value of a company. Some methods are very stringent and hence gives a very conservative valuation of a company.
There are some methods which are very practical and logical hence they put forth valuation of company looking at the broader perspective.
A person who applies both these methods to evaluate intrinsic value of a company will find one value which is too less (conservative), and other value which is high (less conservative).
So here what a person gets is a range of value, one on the lower side and other on the higher side.
What does this range of values signify for a company? These values gives an idea that the accurate intrinsic value of a company will certainly lie in between these two range.
Value investing deals with identifying fundamentally strong companies and calculation of its intrinsic value. When market price Falls below the calculated intrinsic value, value investors buy the stocks.
Why stock price fall below its intrinsic value?
It is also important to know that why market price of a fundamentally strong company may fall below its intrinsic value.
This may happen due to fluctuations in the short-term profits of the company.
A company may be fundamentally very strong, but due to short term problems prevailing in the company it may not be performing as well as it is capable of. 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.
But in value investing investors do not give too much weightage to short term performances of a company. Instead they check the long-term capability of the company. If a company is not doing well presently, but is capable of earning high profits in times to come, value investors will rather invest in such a company.
Does common men practice value investing?
Generally what we common men do?
We buy stocks of those companies which are doing very well. But the problem of such an investment approach is that, a company which is already doing well, will surely have its market price soaring at sky-high levels. For sure, the market price of its stocks will not be available below its intrinsic value.
Common man always end up buying such over valued stocks, which are very popular.
But value investors never make this mistake. How they keep themselves insulated from making such a mistake? By knowing the estimated intrinsic value of the company.
This is very important for a common man to understand that a good businessmen, does not do business with a short term perspective. They would like his business to run profitably forever.
With such a mindset, suppose there is a company which is not doing a good business today. So what will happen to this business now? Will it close-down just because it is not making enough profits today?
In most cases the answer will be no.
Low-profits (loss) today may convert into large profits in times to come. This is something that we normal people never understand very clearly.
We always assume that a company which is doing bad today will continue doing bad in times to come.
I don’t say that this is a wrong assumption, but before concluding anything based on this assumption, it is important to check the fundamentals of the company.
A company which is fundamentally very strong, a company which has very strong business ethics, has very talented workforce, which has good technology and know-how to do its business, what do do you think, that such a company be closed down just because they are not making enough profits today?
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 is value investing all about.
A company which you think is going to close down after 10 years, don’t buy those stocks of this companies.
A company which is not doing well now, but it is going to continue doing its business for next 100 years, but stocks of such companies. Because low-profits (loss) is not going to stay long for such companies.
They will improve in times to come.
Such a situation gives us an opportunity to buy stock of good companies at undervalued price.
Take example of Tata Motors, Tata Steel. These are two companies within Tata Group which probably will not cease to do business in at least next 100 years. But stocks of these companies trade at a very low price today (Sep’2017).
If when we see the past 5 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 if you close your eyes and imagine yourself asking this question to Mr Ratan Tata, that “are you going to close Tata Steel and Tata Motors in times to come?”
His answer will be no.
And if Mr Ratan Tata is not going to close the business, for sure he’s not going to allow that business to run at a loss for a long time.
He and his team will eventually convert a loss making company into the into a profitable company very soon.
Identifying companies which are fundamentally very strong, but at present are trading at undervalue price levels is a part of value investing.
It may happen that, all the time the numbers will not give you the right picture. In those times you will have to judge a company based on its qualitative aspects only.
A company which displays both qualitative strengths and quantitative strengths are comparatively easier to analyze.
But the companies like Tata Steel and Tata Motors are those companies which will probably display only qualitative characteristics today.
Such companies should be seen from a third eye perspective. In value investing, such third eye perspective always helps.
Disclaimer: All blog posts of getmoneyrich.com are for information only. No blog posts should be considered as an investment advice or as a recommendation. The user must self-analyse all securities before investing in one.