The ultimate Q&A to Value Investing 101
Investing tips 07: I originally published this article on 27 Mac 2021 as a collection of my Quora responses. I have since revised it to also cover what is value investing, how and why it works, and the skill required. Revision date: 23 Jul 2021.
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| “Investment is most intelligent when it is most businesslike.” Ben Graham |
A stock market is a place where people buy and sell pieces of paper representing part ownership of companies. As such there are two main ways to engage with the stock market.
- Buy and sell pieces of paper. This is effectively a market sentiment-driven approach. You buy the popular stocks on the basis that this will cause prices to go up. Many use charts, trendlines, and technical indicators to help gauge market sentiments.
- Buy and sell part ownership of companies. You look for opportunities where the price is less than the value of the underlying business as determined by the fundamentals. You believe that price will eventually reflect the fundamental value.
Value investing belongs to the fundamental investing school. The heart of value investing is to buy stocks at a bargain by comparing the price with the intrinsic value. As intrinsic value cannot be known with certainty, you have a margin of safety when determining the intrinsic value.
Buy a bargain based on a margin of safety then becomes the defining concept of value investing. This post focus on what is value investing, how and why it works, and value investing skills.
It is part of a series meant for newbies. I focussed on answering the questions from the view of a bottom-up, stock-picking, long-term value investor.
I am coming from the perspective that you are interested to learn how to invest based on fundamentals. This requires you eventually to analyze and value companies.
If you don't want to do this, but still want to invest based on fundamentals, there are many third-party advisers who can do this for you. A good example is Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.
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Contents
1. What is value investing?
2. How and why value investing works
3. Skills required for value investing
1. What is value investing
Value investing is an investment philosophy, an approach to investing. It is an investment strategy that involved buying under-priced stocks. Under-pricing in this context is with reference to some value determined through fundamental analysis.
There are a few key concepts behind this strategy.
- Buy part ownership of businesses. There is a business behind every stock and you become part-owner of the company you invest in.
- You can determine the value of a company as determined by its fundamentals - usually referred to as the intrinsic value.
- Because you have to make assumptions in determining the intrinsic value, you adopt a margin of safety when determining when to buy. The margin of safety helps to minimize their losses when you are wrong about a company.
- You believe the market overreacts to good and bad news. This results in stock price movements that do not correspond to the company's intrinsic value.
- You buy at a discount to the intrinsic value. This generally reflects the margin of safety you have adopted. The greater the difference between the intrinsic value and the current stock price, the greater the margin of safety.
- You believe that eventually, the market price will reflect the intrinsic value. This then gives you the opportunity to gain from your investment.
- Invest for the long term. Stock prices are volatile in the short run. You want to hold long-term so that the market price reflects the business fundamentals rather than just market sentiments.
- Worry about the downside and let the upside take care of itself. While will always be investment risk, you can adopt measures to mitigate them.
This is a blog about value investing. As such there are many posts about the various aspects of value investing. I suggest that you refer to “An Introduction to Value Investing - confronting value traps” to start off.
1.1 Is value investing a thing of the past?
Value investing is about buying companies at a discount to their intrinsic value. So why would this be a thing of the past? What has changed is what you incorporate into the intrinsic value estimate.
Value investing is an investment concept:
- You are able to determine the intrinsic value of a company.
- Invest when the market price is trading at a significant discount to the intrinsic value.
- Have in place a series of risk mitigation strategies to protect yourself.
So, if you take the above perspective, then value investing is a timeless concept.
The question of whether it still works has to be seen in the context of a portfolio, time horizon, and your skill in analysis and valuing companies. If you have 20 to 30 stocks selected based on value investing principles and you have a 3 to 5 years investing horizon, value investing still works.
When you invest, there are 3 critical questions
- What to buy?
- How much to buy?
- When to sell?
Value investing through the price to intrinsic value comparison gives you the answer to the first and last questions.
As to how much to buy, you would want to commit more money to those with the higher margin of safety, those with the most conviction, and other factors that are part and parcel of the value investing process.
Given the above, why would you think that value investing is a thing of the past?
However, the fund management industry has a different perspective of what is value investing. They classify stocks as value or growth stocks depending on some PE or PB valuation metrics.
Indirectly they then deem buying “value stocks” as value investing. I think this is a wrong interpretation of the concept.
There is no such thing as a value stock. Value stock and growth stock is a fund management industry shorthand for stocks with low PE or PB. You should be more interested in whether a stock is trading below its intrinsic value.
If you follow the fund industry idea of value investing, you can see that it is not dead either.
1.2 How does a value stock give returns to an investor?
If you are a value investor, you look for opportunities when the stock price is trading at a significant discount (eg 30%) to the intrinsic value. You hold onto the stocks until the market re-rates.
I am a long-term value investor in that I analyze and value companies to buy and hold long-term. I then sell when the market price is > 20 % of the intrinsic value. So, I make from the difference between undervaluation and overvaluation.
I have been investing as a value investor for the past 15 years with a portfolio of 35 stocks. My average portfolio turnover is 10 % to 15 % annually - indirectly holding stocks for 7 to 10 years.
Once in blue moon, I am lucky to find a stock that becomes overvalued within a year. But I have even had sold off stocks after 10 years without seeing any major price change only to see the stock price doubled a few months after I have sold them.
The point is that you don’t control the holding period as you cannot predict market behavior. You can only control the discount and over-valuation.
I have gone through 2 cycles where the portfolio value had declined by > 40%. First in 2008/09 due to the US subprime crisis and recently in Mac 2020 due to Covid-19.
Notwithstanding the long holding period and the drawdowns, my portfolio CAGR over the past 15 years is 1.3 times the stock market index return. Not all my stocks made money but the ones that do more than offset the ones that don't.
I make money by selling the overvalued stocks and then reinvesting in other undervalued stocks ie I do not hold the stocks forever.
I guess that if I was good enough to identify stocks that would always be the best stock, then I would be holding onto stocks forever. But I always worry about the Kodak and Nokia of the world.
I am not good enough to identify “forever” good stocks so my approach is to have cycles of selling overvalued stocks and then reinvesting in other undervalued stocks.
The other point about being a long-term investor is that your total gain is from capital gain + dividends. I estimated that about 1/3 of my total return has been from dividends.
1.3 If you make a profit on a single stock, should you sell that amount and buy more shares?
If you are a long-term investor, I hope that you have a portfolio of stocks. Then as some stocks become profitable you sell them and use the cash to invest in new stocks.
However, from a value investment perspective, the sale cannot just be to lock in some profits. It must be because the price has exceeded the intrinsic value.
Warren Buffett has famously said that his holding period is “forever”. I think that this is because his stock-picking skills are such that the stocks he invested in, will continue to be the best stocks. And an updated valuation should support this.
If you don’t have his stock-picking skill, the best option is to sell when the price exceeds the intrinsic value. This is provided the analysis is based on updated parameters.
This is because over a period of time, there are changes to the business and what was valid when you first invested may no longer be valid.
1.4 Can you use value investing principles for day trading?
Day trading is based on price action ie you trade based on your reading on how the price is going to move. Price is sentiment-driven and the day trader is reading market sentiments.
Your success as a day trader may be due to your ability to read crowd behavior. I am sure it is not due to an understanding of businesses.
Value investing is based on buying when the price is significantly below the intrinsic value and sell when it is the opposite. Your success depends on your understanding of the business.
I am not sure why the day trader would want to use value investment concepts since intrinsic value does not change daily and does not depend on market sentiments.
The point is that there are several investing styles eg technical vs fundamental, factor investing, indexing, etc. Each has its own investment concepts and behavioral requirements. A buying signal under one style may not be a buying signal for another style. Given this, you should not mix the concepts.
1.5 When should I sell a stock if the value of that stock is 100% greater than what I invested into it?
I have found that there is more value investing literature about how and when to buy a stock than about selling.
When you talk of value are you referring to the price or the intrinsic value?
If the price is greater than the intrinsic value, you should sell. But if the price is still significantly less than the intrinsic value, you can still bet on it going higher.
If you had bought it without reference to any intrinsic value assessment and you don’t know how to assess the intrinsic value, I hope you had some other basis to buy eg momentum.
If you had merely bought it blindly, I wouldn’t push your luck too far.
2. How and why value investing works
There are two key reasons why value investing works.
- While the market can be irrational in the short term, it will be rational in the long term. During such irrational times, the market price will not reflect the value of the company as determined by its fundamentals. Eventually, the market will come to its senses and price the company based on its economic prospects.
- You take the opportunity of the market situation by buying when the market underrates the company and selling when it overrates it.
Value investing works because you are buying something at a bargain. You then have the potential to cash in once the market recognizes the stock's true value. But it requires patience because you do not know how long it will take for the stock to get repriced.
A good value stock can also provide protection against losing money. There is no guarantee that the stock price would not fall further after you have bought it. But the margin of safety makes an additional share-price decline less probable and less impactful should it happens.
2.1 If value investing is so good, why doesn’t everyone do it?
Value investing is the concept of buying stocks at a discount to their intrinsic value. Whether you will make money with this approach depends on you.
To be a good value investor, you need to be able to buy when the market is down and everyone is in a panic.
It may take a long time for the market to recognize the value and re-rate the stocks. Do you have the patience to wait for this? Depending on the stocks and market, this may take several years.
Then when the market is bullish and everyone is buying, you should see this as a time to get out - make your money and wait for the downturn.
It is a behavioral challenge as you are going against the crowd. Not everyone can behave in this manner. That is why although value investing is simple, it is not for everyone. No glamour. You look like an idiot most of the time.
Secondly just because you bought at a discount to the intrinsic value, it does not mean that your estimate of the intrinsic value is correct. If you got it wrong, then you are not going to make any money.
2.2 What is the path that usually leads you to decide on what is best to invest in?
I am a value investor and so this sort of narrows the way in which I decide what is best to invest.
The companies I chose to invest in are those that will give me potentially safe returns. So how do I determine “safe”?
Well, it must first be trading at a significant (at least 30%) discount to its intrinsic value. The challenge is then assessing the intrinsic value. To do this well you need to develop 2 skills - how to analyze the business and how to value it.
Secondly, you need a comprehensive risk mitigation process. The 30% discount is only one of them. The other is not to risk all your savings in one asset class. I follow the 3 buckets strategy for this. There are other risk mitigation processes that you build into your investment approach eg
- Have a diversified portfolio.
- Have a conservative valuation method.
- Take a long-term horizon.
OK, I am a very scared person when it comes to investing. I worry more about protecting my downside. But the process has enabled me to outdo the stock market index over the past 15 years.
2.3 Why would you invest in a company if they are neither "new" or "growing a lot" nor planning to pay dividends?
One of the lessons I learned as a value investor is to differentiate between a good company and a good investment.
A good company is one that is very profitable, has lots of growth runway, maybe pays lots of dividends, and has a strong management team.
A good investment is one that makes money for you.
If you buy a good company at a high price and don't have to chance to sell at a higher price, there is no point for you as the investor.
Along this line, if I find an old company with little growth, doesn't pay a dividend but is profitable and sells at a large discount to its intrinsic value as determined by its fundamentals, I would buy.
This is because historically I have found that the market will eventually re-rate such companies. I have waited for 5 to 10 years for this to happen. So you want to buy at a price such that even after 10 years you still get a double-digit average annual return.
2.4 Why are value investors attracted to companies that distribute dividends rather than companies that will reinvest to grow?
I am not sure that your statement about value investor interest in dividend vs reinvestment is correct.
Both dividend and reinvestment are generally from profits. The first relates to profits distributed to the shareholders while the second relates to using the profits for the business.
In theory both serve the shareholders.
I would think that when you look at dividends, it should not be the amount of dividend per se but rather in comparison to the purchase price ie the dividend yield.
Your returns from stock investment come from both capital gains and dividend yield. Ideally, you would want contributions from both. There is no point in buying a company that pays dividends at such a high price that you get a low dividend yield. At the same time, the high price reduces the potential capital gain.
Secondly, when it comes to reinvestment to generate growth, this creates value for shareholders only if the return from the investment exceeds that cost of funds. If the return is less than the cost of funds, growth will not create shareholders' value.
From a valuation perspective, not all reinvestments are equal.
Based on this as a value investor, you would want dividends if the profits reinvested cannot earn more than the company cost of capital.
3. Skill required for value investing
Value investing is about business analysis and valuation.
In learning to be a value investor, focus on these two disciplines. They probably have different concepts and require different skills.
I started by reading books on value investing. The problem with most books is that they are mostly about concepts. I did not come across any “how-to” book that covered the A-Z of value investing.
Investing is a skill that you develop over time. You need an iterative approach of getting a bit of knowledge and then practicing it.
The best way is via practice. Skills don't come from reading books alone. It is about practice as well.
Investing is like driving - there are some basic principles but when you look back there are not that many of these. It is all about practice.
But there is a trick to this. You should actually learn and practice in incremental steps ie learn a bit, do some paper investments, review your mistakes, and then go and learn a bit more.
After all, you have to develop 3 skills:
- How to analyze companies.
- How to value them.
- How to mitigate against risks.
Company analysis is about trying to understand its prospects - track record, business direction, competitive strategy, management capabilities so that you have realistic assumptions for the valuation.
To value companies, you need a valuation methodology and invariably you will need to make assumptions about the business prospects. So you need (1) to ensure that the valuation is not some mindless number-crunching exercise.
And when you are ready to invest, you need a risk mitigation process to protect yourself against bad luck and your behavioral biases.
My advice to those starting on the value investing path is that you need to develop the skills to do all the 3 well.
I would suggest that you refer to the following
3.1. As a value investor, which would be the best sources to learn Accounting?
You actually don't need to learn Accounting. Of course, you need to be able to read and understand the financial statements, but you don't need to be an accountant to do this.
As a value investor, you need to be able to do 3 things - company analysis, valuation, and risk mitigation. These are very different from Accounting.
Having said that, a bit of Accounting knowledge is useful for the following reasons:
- In analyzing and valuing companies, you rely on their financial statements. The quality of the earnings, and whether there are any financial shenanigan affects the reliability of your fundamental analysis.
- There are differences between how accountants treat certain items and how an investor would view them. A good example is the treatment of R&D. Most accountants would expense them off to the P&L. However, in many instances, these should be capitalized and depreciated. The treatment affects the returns.
3.2. What are the best stock analyzers or software programs for value investing?
To invest as a value investor, you need to be able to analyze and value companies.
- The objective of the analysis is to understand the company and its prospects.
- When you value the company, you need to make certain assumptions about its prospects. Your analysis will hopefully ensure that your assumptions are grounded in reality.
So, if by analyzers you mean which is the best way to analyze the company, I am not sure whether there is such a thing. It is like asking which is the best way to forecast the future. If there was a way to forecast the future, the world would know of it by now.
However, it is different when it comes to valuation. This is a “formula-type” of activity and there a several software programs that can compute the value for you. But the “accuracy” depends on your inputs. If you are assumptions are not grounded in reality, you are not going to get any meaningful valuation.
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