There are plenty of approaches to investing. Some are more akin to gambling than investing, and some are more of an art than a science. In this article, we are going to discuss value investing, who uses it, and how to analyse stocks like a value investing investor.
We’ve built CityFALCON keeping value investors in mind. Give us a go and let us know what you think.
What is Value Investing?
Value investing is a style of investing. Its main tenet is to look for stocks that are priced under their intrinsic values, possibility with a margin of safety, and buy them. It uses the same ‘buy low, sell high’ idea of any capital-gains focused strategy, but takes it one step further by determining the precise low at which you will enter based on the fundamentals. Note that this is not about timing the market.
Looking at the intrinsic value
First, the value investing investor will determine the intrinsic value from the fundamentals. What exactly the intrinsic value is, or even how it is calculated, differs from investor to investor. Some investors will consider future cash flows, others will only focus on the financial situation (assets and liabilities). We will not discuss which is better here; that decision is based off on your investment style and the period of holding. Whichever you use, you need a price for the intrinsic value, or what the company is worth without any premium.
Value investing is concerned with the long term because you need to wait for the price to change or approach your buy-in point. This could take a long time. And if there is nothing that fits your criteria, you shouldn’t be buying anything. If your criteria are strict, you may have periods of no buying at all. Value investing also tends to see low portfolio turnover since it takes time for stocks to appreciate from the buy-in point.
Contrary at most times
Value investing adheres to a flavour of contrarianism because it does not follow the herd mentality. In fact, it often goes against the herd, as one common expectation among value investing investors is that the market overreacts. Overreactions on the upside are a reason to avoid the stock, while overreactions on the downside are a cause to buy – both of these decisions are directly opposed to the market trend.
Rejects the efficient market hypothesis
Value investing also rejects the efficient market hypothesis. This isn’t a surprise because an efficient market wouldn’t allow any divergence from the true value of the stock. Of course, who believes in the strong efficient market hypothesis anyway? We all know different participants have different levels of information, and the amount of data required is huge. The big difference is that value investing investors don’t believe in the efficient market hypothesis to such an extent that they think prices can be radically divergent rather than just a few points.
A final note, which is important for the contemporary investor: avoid using leverage. Being leveraged risks a margin call, and margin calls force you to close your position when you don’t want to. A value investor must be patient and weather loss periods, not forced to sell due to amplified losses during weak periods.
How does one gauge intrinsic value?
The entire notion of value investing rests on a single indicator: the intrinsic value of the stock. Unfortunately (or perhaps fortunately for those with the skills), this is not easy to calculate. It cannot be easily defined by a neat set of formulae; if it could be, then there would be no one making money with value investing, as markets might actually be efficient.
The intrinsic value is likely to be above the liquidation value (what the company would be worth if it were broken up and sold off) because there are some intangible things like brand awareness and social perception that do not appear on the balance sheet. If you are coming up with a number that falls below liquidation value, check your calculations again. It need not be much higher, though, because a good pick might not have a lot of intangibles.
To find intrinsic value, the value investing investor must look at more than just the stock price. Ideally, start with the company’s product line. Buffett and (Peter) Lynch both say you should invest in an industry which you understand. That is solid advice. If you don’t understand at least why people buy the products and how they generate a profit, you shouldn’t invest in the company. Lynch also stated a good way to make money is to know the industry and know the company before Wall Street.
Once you understand the product, start to look at some of the numbers (value investing investors don’t shun numbers; they’re just not the entirety of the strategy). Look at debt ratios, cash flows, and profitability. If you know the product line, which you should, you can simulate your expectations in the product’s market to get future growth opportunities.
Whether you want to include future revenue in your intrinsic value calculation is up to you, but even if you don’t, you need to know if the outlook for the company’s market is positive or negative.
Since there are so many indicators and ratios available, we have a few tips from The Sage of Omaha, Warren Buffet:
- A high ‘net income to shareholder equity’ ratio à the company is good at generating lots of profit with little investment.
- A low debt profile, preferably reaching far back into the past à the company is not beholden to creditors over your common stock.
- Expect high net profits and the room to grow (this is where you need to know the product line and markets thereof).
- Longer record as a public company à eliminates many pitfalls of new companies, gives a long public record to analyse, and the company is more likely to be in a stable position.
- Do not invest in commodity companies, as they have no way to distinguish themselves from the next.
- Find the intrinsic value and discount it for your final buy-in price (this is called margin of safety).
Investing 101 – Let’s get you started in the stock market.
Margin of safety is a must
The margin of safety is the discount you want to apply to the intrinsic value before you purchase. If you determine a stock’s intrinsic value to be $100, but you have a 20% margin of safety, you will only purchase the stock at $80 or less. The idea for this (and why it is called “margin of safety” and not “discounted margin” or something) is because you never know if your investment will fail. It is always better to buy a solid company on sale rather than full price because if it does happen to be a losing trade, you won’t lose as much.
In our example, you will lose $80 if the stock goes to zero rather than $100 if you had bought it at your calculated intrinsic value. Another advantage to using a margin of safety is to increase the upside. If you buy at your intrinsic value, you can’t expect the market to pay more for it later – but if you buy it at your discounted price, you expect to at least recoup your margin of safety amount.
Benjamin Graham, the mentor to Warren Buffet and himself a very well-known value investing investor, used to use a margin of safety of 33%. High liquidity and exposure via the internet have probably made markets more efficient, but that doesn’t mean opportunity doesn’t exist.
Note on the Balance Sheet
Liquidation value is important as a baseline. These numbers will come from the balance sheet. Make sure your pick is not highly indebted, and make sure, if the company liquidated next week, your investment won’t be erased by the liquidation process.
Note on Cash Flows
Assets, liabilities, and future earnings are not the only part of the puzzle. Value investing investors need to consider current cash flows, too. This is all part of fundamental analysis. Even if the company is sitting on a mountain of cash, if its current cash flows do not line up, it may be a losing trade. If current assets and current liabilities levels are favourable but mismatched in time, the company can run up against financial trouble. So don’t forget about checking the current cash flows in addition to the assets/liabilities situation.
Deep Value Investing
Deep value investing is the same idea as value investing but more extreme. The companies you can look at are nearing bankruptcy, have lawsuits piling up against them, are about to restructure or merge, suffered scandals, or are simply far out of favour. You want companies that have deep discounts (far past your usual margin of safety). These companies may be actively viewed as negative by the market, which means you can get it at a very deep discount.
These stocks may very well be penny stocks, but they need not be. If there are major upheaval in a market (like the 2008 financial crisis, but it doesn’t have to be as dramatic), you can often capitalise on stocks that are “fallen angels” – once well regarded, but now cheap. It can happen easily with biotechs that don’t make it past their second FDA trial or newer companies that get slammed when they miss earnings. You need to do the same research as before, and, for these companies, management is especially important, because the only positive thing in the company may be the management.
Deep value investing is certainly riskier than regular value investing because you actively seek out companies that have been hit hard, not simply companies that happen to be trading cheaply. As it goes in finance, though, the higher the risk, the high the reward. This isn’t gambling, though; just make sure you are solid on your reasons to buy and keep management in mind.
Some Common Events Indicating a Good Purchase
Assuming you don’t have the computing power or time to sift through the tens of thousands of stocks available, you need a way to filter out most of the undesirables. For more information on how to screen stocks, see our article on the screen stocks. Below we will discuss a few scenarios that lead to undervalued stocks so you can spend more time looking at fundamentals than for the stocks themselves.
As mentioned above, the value investing investor has many traits of the contrarian. Equipped with this knowledge, you should easily see that steep run ups in a price are cause for concern. If a stock is on fire, value investing investors stay far away – any time the market is pumping up a stock, it is probably overvalued by the time the general public hears about the hype.
On the other hand, when a stock is in freefall for some minor infraction (like missing analyst estimates), it may be a sign to pick it up for a cheap price. Don’t try catching a falling knife, though. If it blasts through your margin of safety point, make sure you aren’t missing something in your fundamental analysis. By blasting through, I mean heavy momentum still against the stock, even as it approaches your discounted entry point. If you believe your analysis is solid, though, the value investing investor would see the drop as a buying opportunity.
The news is always a good way to see herd behaviour. Whether positive or negative, if you see big movements on news, analyse the financials of the company and do some more research. If you’re tech-savvy, you can integrate the big-movements-on-news criterion with a portfolio of financial ratios and automate the process. It will help eliminate the drudge work of finding the stocks. You still need to do analysis, but you won’t have to sift through news reports, press releases, and financial statements as much.
These guys do not suffer from herd mentality because there is no herd. Unknown stocks are usually the small caps and foreign stocks. This is where your industry knowledge can shine. If you understand some niche market for a new technology and found a company that produces the tech with solid financials, grab the stock. value investing is a long-term game, so be confident if you expect the tech to take off in the near future.
Aside from small cap companies that have so far gone unnoticed, foreign stocks are a good place to look. Obviously, companies like Samsung do not fit the “unnoticed” criteria, but a tiny Korean tech firm (in a market you understand!) is a perfect candidate – even more so because any news of it is likely still in Korean only, so the wider financial world hasn’t heard of it yet.
On that note, if you speak a language with a relatively small number of native speakers, looking at local companies in the language is a good way to find companies that may be undervalued. If you include future revenue and you expect their product to take off, you can probably pick up the stock well below your calculated intrinsic value. Since future cash flows can be comparatively huge for obscure stocks, value investing investors who include it and those who exclude it can diverge significantly from each other in intrinsic value calculations.
Insiders have more information than you. While there are laws against insider trading, insiders are free to buy and sell their stock with good faith. If you are investing in the United States, the SEC requires all insider trades to be reported within two business days. If you see insiders and large shareholders buying more, it is a good sign. Of course, their sale is not necessarily bad, unless it is a fire sale.
If you know a company’s market is cyclical, then the changes may be easier to identify in the stock. Of course, if everyone knows the company moves up and down with cycles, there won’t be any opportunity for you. However, if the market expects a cycle to start or end at time T and it doesn’t, it will likely overreact to the missed cycle and you can take advantage of that.
Some Successful value investing investors
Does value investing work? That is dependent on the individual’s ability to correctly price a stock. In theory, it makes sense. In practice, it makes sense, too, but it may be difficult to implement. So, who has used value investing to make money? Many of the most famous investors have implemented value investing to their advantage. In fact, many of the entries on our Greatest Investors of All Time article are value investing investors.
Probably the most well-known investor today, in any investing style, is Warren Buffett. He is not a household name because he lost money in the market.
His approach is certainly value investing. He is the one who suggests that value investing investors know the industry they intend to enter. It is essential here to understand what you don’t know because what you don’t know can hurt you.
Furthermore, one important rule Buffett follows is for companies to have historical consistency because that makes projecting future cash flows and returns easier. It also implies stability, which means your stock won’t be wildly fluctuating but slowly building to its intrinsic value. Historical consistency also eliminates new offers, which tend to be growth stocks and overpriced.
While not as well-known as Buffett outside the financial world today, he is considered the “father of value investing”. He literally wrote the book (the original one) on value investing and he was the one who came up with the ideas of intrinsic value and margin of safety. His approach stresses the implementation of the margin of safety for the reasons we outlined above. He also liked to diversify, which makes sense, as he looked for low-risk companies, not high-risk ones. Diversification lowers risk.
To put his approach in perspective, here are a few numbers and pick criteria:
- Total debt to current assets ratio of under 1.10 – low debt
- A current ratio of 1.5 or greater – indicates at least 50% more current assets than current liabilities
- No earnings deficits and the latest earnings need to be higher than five years ago
- PE Ratio of 9.0 or less – this is dependent on industry, but look for lower PEs
- Price to Book ratio of 1.2 or less – this shows the underlying value, excluding future earnings; if management closes shop tomorrow, you won’t lose your entire investment
- Companies that are paying dividends – some extra income while you wait and shows excess cash
These can be adjusted, but the principles need to remain. One would be unwise to deviate from these tips, as they are directly from the Father of Value Investing.
Munger worked with Buffett at Berkshire Hathaway, and Buffett said he pushed him to look at the long-term outlook rather than just the current value. Interestingly, he thinks three companies makes a diversified portfolio. He strongly encourages “elementary worldly wisdom”, which in turn encourages one to have more than one model. This allows one to adapt to the situation, not force the situation into a single, perhaps unrelated, model.
The founder of the Baupost Group, Klarman’s approach is long-term. He often holds large amounts of cash, which indicates he does not need to be fully invested all the time. This is consistent with waiting for good bargains. He uses liquidation value as the main indicator in his picks, and he is not beholden to US stocks, even though he is US based.
Schloss is another titan of value investing, and he has many of the same strategies as the others: look for low debt, be patient, don’t sell on bad news or immediately upon hitting your target, and buy near a low of the past few years. One major tip he has that may not apply to everyone is to use assets as the key indicator rather than earnings. He says earnings can change quickly, but assets tend to change slowly.
In his 16 Golden Rules for Investing, one of Walter Schloss’s tips is to “listen to the people you respect”. If you regard someone as intelligent or a good investor, their opinion is useful. You can use it to gauge your own position and even test your own theories and ideas with the person’s thoughts. What is a good way to meet some of those people?
CityFALCON hosts fortnightly events at London Value Investing Club to along investors to mingle amongst each other and to discuss value investing ideas. If you’re based in London, join us for free at one of our events.
Investing is never simple and straightforward. If it were, no one would make any money at it. Value Investing requires patience and a lot of confidence because you are often investing against the trend. If your confidence isn’t unshakeable, you may waver just when you need to stay strong the most. That leads to selling at the wrong point and, of course, losses.
Value investing is not for everyone. Deep value investing is for even fewer people. It is nice because it is cheap, but the contrarian viewpoint is difficult for many to adhere to, especially when all the media coverage, analysis, and trends are stacked against you. Then again, if you did what everyone else does, you would be ordinary. If you want to make money in the market, you need to be extraordinary.
The main tenets of value investing include low debt, solid earnings and profitability, a consistent history, and a little love from the market. An unloved stock trumps a loved stock because the latter is hyped and too well-known; it becomes overvalued easily.
All of the tenets are flexible to an extent, otherwise, they wouldn’t be able to stand the test of time. Using assets as the main key might exclude large parts of some industries, as they are built on services or significant branding. Using future earnings to augment intrinsic value derived from assets is fine, but you should make sure the future earnings do not cloud the financials picture.
We’ve built CityFALCON keeping value investors in mind. Give us a go and let us know what you think.