Do you really want to master value investing?

Tips C - This post summarizes the value investing insights extracted from my book “Do you really want to master value investing”. They are infographic-based with insights starting from Chapter 1 of the book. I plan to publish 7 infographics every couple of weeks until I complete the whole book. Revision date: 11 Sep 2022
Do you really want to master value investing?

Why Invest?

You invest to prevent the purchasing power of your saving from being eroded by inflation. Of course, to achieve this goal, you have to achieve a rate of return that is greater than the inflation rate. 

Why chose to invest in equities? This is because historically this asset has generated the best returns. The Pros and Cons of investing in the stock market are summarized in the chart in the infographic. 

For the retail investor, there are 4 main ways to invest in the stock market. 
  • Based on Technical.
  • Based on Fundamentals.
  • Factor investing.
  • Indexing.

Why invest?

How much can you make from the stock market?

You have to be realistic about how much you can make by investing in the stock market. The chart in the infographic summarizes the index returns from the world’s top 10 stock exchanges. I have shown the compounded annual return for 2 holding periods – 10 years and 20 years.

You can see that the returns vary both in terms of where you invest and the holding periods. 
  • You can get as high as 14.7 % compounded annual return from investing in the Nasdaq from 2010 to 2019.
  • It drops to 3.9 % per annum when investing from 2000 to 2019.

Similarly, the Nasdaq can deliver a 14.7 % compounded annual return from 2010 to 2109. But if you had invested in the Shanghai Composite Index, you would not have made any money during the same period.

You gain from the stock market comes from both capital gains and dividends. To grow wealth over time, you have to rely on the power of compounding. 

How much can you make from the stock market?

Can you be a millionaire by investing in the stock market?

You get rich from investing through the power of compounding. This requires consistent returns over decades of investing. 

The infographic show the gains from investing in the stock market under various conditions. I looked at the following parameters:
  • Different investment periods.
  • Different compounded annual returns. I looked at 8 %, 10 %, and 12 %.
  • Different investment amount – a one-off $ 1,000 investment and a regular annual sum of $ 1,000.

In the charts, the horizontal axis represents the investment period in years and the vertical axis represents the amount.

You can be a millionaire if you start with a one-off investment of $1,000 and achieve a compounded annual return of 12% over more than 65 years of investing.

However, if you invest $ 1,000 every year, you just need to achieve a 10 % compounded annual return over 50 years to get $ 1 million at the end. Doable?

To be a millionaire by investing in the stock market, you need to start young. Then develop your investing skills so that you can achieve a consistent 10 % return. You should stay invested and ideally invest regularly with more than $ 1,000 each year. 

Can you be a millionaire by investing in the stock market?

How to manage risk 

If you want to be risk-averse when investing, start with a risk mitigation mindset. Look at the risk from a global perspective. There are 3 risk management levels to consider when investing in stocks:
  • Determine the amount of your savings to be set aside for stocks. I used the 3 Buckets strategy for this.
  • Have a stock portfolio.
  • Choose an investment approach that focuses on risk mitigation. I recommend value investing as this focuses on the business rather than treating investing as buying and selling pieces of paper.

How to manage risk?

How long do you hold onto a stock?

The stock holding period is a function of your investment style:
  • If you are a day trader, it is obvious that you get out at the end of the day.
  • If you are a trend follower, you get out at the end of the trend. This could be days or weeks.
  • If you are a value investor, you get out when the price exceeds the intrinsic value.

The holding period is not something that you set upfront. 

Many newbies think that value investing means holding a stock forever. Even Warren Buffett sells stocks. The “forever” is a term used to denote long term and not a situation where you never sell. 

You would sell if the business is no longer viable. If you see what happened to Kodak or Nokia, you know what I mean by not holding stocks forever. 

How long do you hold onto a stock?

Risk mitigation as the central tenet

While there are many value investing books, I have not found any that focuses on avoiding permanent loss of capital as the central tenet. While we all want to make money, I firmly believe that we should adopt a style that focuses on risk.

I define risk as a permanent loss of capital. I have structured my book around how you can avoid permanent loss of capital when looking at the various aspects of value investing.

My key approach is:
  • Allocate only a portion of your net worth to stocks. I use a 3-Buckets approach for this
  • Never invest in only one stock. Have a stock portfolio.
  • Pick your stocks based on fundamentals. While there are several ways to invest from a fundamental perspective, I have chosen value investing. 

Risk mitigation as the central tenet

What is value investing?

I see the following as the key elements of value investing:
  • Buy a bargain. This means determining the intrinsic value and buying at a discount to this value.
  • Have a margin of safety. All valuations are based on assumptions. To protect yourself against errors, misjudgments, and plain bad luck, adopt the concept of a margin of safety in your analysis.
  • Don’t lose money ie take care of the downside and let the upside take care of itself.
  • Valuation is key. Without this, you cannot determine whether the stock is a bargain or whether you have a sufficient margin of safety.

Value investing is just one of the several forms of investing based on fundamentals. The others include growth investing and dividends investing.

While value investing can provide some tailwind to put you on the winning side, there is an element of luck. If you consider the human activity as a combination of luck and skill, you can see a continuum with pure luck on one end and pure skill on the other end.
  • Chess is probably mostly skill.
  • Gambling at the roulette is mostly luck.
  • In between you have value investing. 

You can push investing towards the skill end by developing your investing skills but you cannot fully rule out luck.

What is value investing?

What a typical value investor does

The world's greatest value investors have proven that beating the market is not mere chance. Rather it can be accomplished by trusting the process of careful stock analysis and selection. They have produced gains that, over time, have crushed the S&P 500 index's returns. Examples are:
  • Benjamin Graham’s Graham-Newsome Corporation averaged 17% annual returns from 1934 until 1956.
  • Warren Buffett in his partnership days achieved a 15 % compounded annual return.
  • Joel Greenblatt’s Gotham Capital returned an annualized rate of 40% for 2 decades.
  • Peter Lynch achieved an annual return of 29.2% in his time as the manager of the Magellan Fund at Fidelity Investments.
  • Howard Marks’ Oaktree Capital has generated an annual return of 23% for the past 25 years.

A value investor typically focuses on fundamental analysis and avoiding permanent loss of capital. I defined successful value investing as achieving a better CAGR on a total return basis than that achieved by the index over at least a decade. You need to do the following to be a successful value investor. 
  • Acquire the necessary knowledge and be skillful in applying the concepts.
  • Internalize the value investing mindset.
  • Follow what a typical value investor does.

What a typical value investor does

Value investing skills

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. You need to develop the following skills to be a successful value investor:
  • How to analyze companies.
  • How to value them.
  • How to mitigate against risks.
  • How to construct and maintain a stock portfolio.

Company analysis involves collecting information relating to the company and assessing its performance. It involved both quantitative and qualitative analysis. The majority of the information comes from the company's Annual Reports. I then supplement that with competitors’ Annual Reports, industry reports, and government reports

I assess company performance in a relative sense - whether it is good, average, or poor. This is relative to its peers and trends. I then assess the future relative to the historical performance.

This relative approach will also help in my valuation. It is much easier to value a company based on historical data. I then judge whether the future value would be higher, the same, or worse than the historical value. This should be consistent with the relative assessment of the company’s performance.

Financial Statements analysis is an important element of company analysis. When doing this, focus on those metrics that affect the intrinsic value. You are not assessing a company for its creditworthiness. You are assessing to see whether it is a good company to invest in.

Value investing skills

Company analysis

Company analysis involves collecting and analyzing information related to the company’s business. It covers its business set-up, history, products, and services as well as its financial performance.

It covers both quantitative and qualitative analysis. The quantitative side involves looking at factors that can be measured, such as the company’s assets and profits. Financial Statements analysis is an important aspect of quantitative analysis.

The analysis of the non-numerical items is the other side of company analysis. The qualitative analysis involves studying the descriptive part of the Annual Reports. I also look at market research reports, trade journals, and government reports.

Company analysis

Analysis covered in the book

The main goal of a company analysis in the context of investing is to assess the prospects of the company. You also want to ensure that when you value it, the assumptions you use are grounded in reality.

When investing, you are trying to establish your investment thesis. You want the outlook of the business and its valuation assumptions to be realistic. In analyzing the historical performance, I looked at several areas:
  • The products and services.
  • The company and industry’s economic characteristics. I looked at the business model and its competitive edge.
  • Operations, capital allocation, and financial strengths. 
  • Market potential. 
  • Management. 
  • Business risks.

It is obvious that to do all the above, you need to study not only the company’s Annual Reports and statutory filings but also those of its peers. I also looked at industry market research reports.

Analysis covered in the book

Assessing Management

As a retail investor, your contact with management is only at the annual general meetings. There is hardly enough time to get to know them. You have to take a different approach to assess management. I looked at the following:
  • Background checks including knowledge, experience, and tenure with the company.
  • Operating and capital allocation track record.
  • Shareholders value creation - share buybacks.
  • Honesty, transparency and the alignment of interests.

The goal is to ensure that management does not do things that benefit them rather than the company or shareholders. Secondly, business performance needs a long-term perspective. So, management should not forgo investments that only show results after several years. 

Assessing management

Financial Statement analysis

There are many platforms that not only provide Financial Statements but also standard analysis. 

These typically included liquidity, profitability, activity, leverage, and DuPont ratios. For my Financial Statements analysis, I extract the data from 2 sources:
  • Annual Reports and/or statutory filings. 
  • Platforms or services that provide the company’s financials

I cover 3 things in my Financial Statements analysis – ratios, time series, and peer comparisons. I cover the following in my analysis:
  • Risks.
  • Products and services.
  • Economic characteristics.
  • Management.

Financial Statement analysis

Value traps

If you are a value investor, you would be investing when the price is at a significant discount to intrinsic value. The question is whether your assessment of intrinsic value is correct.
  • If your valuation is wrong, then the stocks are cheap for a reason and you have a value trap.
  • But if your assessment of intrinsic value is correct, then you have a bargain.

From the above perspective, value traps and bargains are two sides of the value investing coin. More importantly, value investing is about confronting the value trap question. Value traps are fundamental to value investing. 

There are 2 main ways to avoid value traps:
  • Have a good company analysis.
  • Have a good valuation approach.

Value traps

To be continued

The e-book is available from Amazon.

Click "Do you really want to master value investing?"

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Disclaimer & Disclosure
I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

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