There is an investing strategy that fits just about everyone. There are plenty of value investing strategies out there, and if you are interested in buying and holding onto good companies, you’re bound to find a value investing strategy that fits your investment style or wishes.
For those who are comfortable taking on more risk, and have the time to monitor price action and charts throughout the day, day trading may be the best fit for them. For those who cannot dedicate the time required to day trading, or who are unwilling to inherit such great risk, value investing may be the more appropriate route to take.
But what is value investing, and how do you start?
How Does the Value Investing Strategy Work?
First and foremost, let’s first consider what is value investing? Simply put, value investing is when an investor uses fundamental analysis to find underpriced companies, or companies positioned for good growth, and purchases shares of that given company.
Unlike day trading, a value investor will typically take a ‘buy and hold’ mindset, and believes in the long term success of the company.
Value investing is famous because of Benjamin Graham and Warren Buffett. If one is questioning, what is Warren Buffett’s investment strategy, the answer is simply long term value investing.
Like any investing strategy, there are numerous variables one must take into consideration before making an investment decision. We’ll cover some of those variables down below.
The term intrinsic value is where value investing predications come from. There are numerous ways an investor can arrive at the intrinsic value of a company.
Simply put, intrinsic value is what an analyst or investor believes the company should be worth, which is not always aligned with what the current share price is. For example, if an investor believes company ABC should be trading at $75/share, and the current share price is $45/share, the investor may elect to take a position in the company.
The investor may expect the price per share to rise to $75 within the next 12 – 24 months. In this example, the intrinsic value is more than the current price per share, so the investor would be taking a long value investment position with this company.
Alternatively, an investor or analyst may review a company and determine its current price per share is above what the intrinsic value should be. In these instances, the investor or analyst would not buy shares of this company as they believe the share price is in a position for correction.
Fundamental analysis is used to arrive at a company’s intrinsic value. There are various fundamental analysis techniques and ratios one could use when analyzing an investment decision. Techniques include:
- A discounted cash flow approach.
- Numerous financial ratios that measure the health of a company. These ratios are often calculated using a companies balance sheet, cash flow statement, or income statement.
- Evaluating and benchmarking a company against its competitors.
Buy and Hold
Buying and holding a stock is typically a more passive, long term, investing strategy which is often also identified as a value investing strategy. When an investor is buying and holding onto a specific stock, they ignore the short term market noise or price of the specific stock.
They are anchored onto the long term value of the company, and realize stocks rarely reach the target price via a straight line.
Margin of Safety
Margin of safety is the difference between your calculated intrinsic value of a company and its current share price. For example, if you calculate company ABC should be trading at $100/share, and it’s currently $40 per share, there is $60 in the margin of safety.
Even if you’re off by $10 or $20 on your intrinsic value estimation, you will still stand to make a healthy profit if you bought at $40/share and sold at $80 or $90/share.
Example of Value Investing
An example of value investing is the classic Warren Buffett example of Coca-Cola (ticker KO). Warren Buffett was attracted to Coca-Cola due to their massive market following, and how they sell millions upon millions of Coca-Cola products per day.
Warren Buffett believed Coca-Cola would be around for the long term, and the market would continue to grow. He initially purchased shares in 1988, and to the present day (July 2021), has never sold a single KO share.
The stock has increased 2,000%+ since he initially purchased it.
In this example of value investing, the investor found a great company with a massive footprint. Warren Buffett realized America, and the world, loved Coca-Cola, and saw the value in brand loyalty.
He understood disrupting Coca-Cola’s business model and product offering would be incredibly difficult, and he chose to invest in a best of breed company.
Factors Involved With Value Investing
There are numerous factors involved with value investing. Such factors include:
Value investors should avoid looking for trends in the stock market and other market noise. Rather they should focus on the fundamental analysis of a business as it is a universally accepted value investing ideology to buy businesses not stocks.
Confidence in Growth and Expectations
Another factor one must consider is their confidence with the growth and future expectations of a company. Value investing strategies are anchored on the belief that a specific company will be performing better in the future, and that future expectation will drive the price of the stock higher.
As a value investor, you need to buy into the long term outlook of a company.
Price to Earnings Ratio
The price to earnings ratio is key in the value investing strategy. To calculate the price to earning ratio, you divide the current share price by the earnings per share.
The higher the ratio, the more overvalued the stock is considered to be in the present day, suggesting a correction may occur. Whereas a lower number may indicate the stock price has room to increase.
5 Steps to Value Investing
Value investing can be done in as few as 5 steps.
Calculate Intrinsic Values
However, you can use those sites to get the necessary information required to calculate the intrinsic value. There are various ways one can arrive at the intrinsic value of a company.
It’s best to use a few different methods to see if they are all closely aligned. Such methods include a discounted cash flow model, an asset-based valuation, or even an analysis based on various financial metrics, such as P/E and EPS.
Identify Undervalued Companies
Once you’ve calculated the intrinsic value of a company, you can determine if the company is currently priced at, below or above your intrinsic valuation. If you’re a value investor, you’ll be looking to take a long position purchasing stock for companies you believe are currently undervalued.
Pay Close Attention to Market Overreactions
Another great opportunity to profit from value investing is to pay close attention to market overreactions. A relevant example would be the rapid market sell off in March of 2020 brought on by the COVID-19 pandemic.
There was a tremendous amount of fear in the market in February and March of 2020, and it caused the market, and stocks, to decline in value in a short period of time. In the months and year that followed, the ETF of the S&P 500 (ticker SPY), rose from a low of $223 to over $430 per share.
Buy and Hold
Once you’ve identified what to buy, it’s time to execute your order. Once your shares are locked in, hold onto them!
Do not worry yourself with the daily financial news. Anchor on your long term belief.
With that said, it’s still wise to have a stop loss in place, or an exit strategy, if things turn really against you.
Discipline is a key competency to value investing. If you’ve done an analysis that a stock should rise $50/share, once/if the price increases by $50, look to sell your position, or re-run your analysis to see if there is more room to grow.
Before taking any position, you should know exactly when you want to sell the stock, at both a lower or higher price.
Advice From the Pros
Despite the various complicated analyses you may find yourself doing, there are some easy to follow rules that can help you make smart value investing decisions.
Buy The Business (Not the Stock)
Buying the business is buying shares of a company with a great product and solid management team. Despite how the stock may be currently performing, a great product and solid management team can get through tough financial times.
For example, Apple is often referred to as a great business. Their management team, innovation, and product is top-notch. This is further backed by their incredible balance sheet, and their cash reserves.
Invest in What You Understand
Investing in businesses that you understand is another way to stay ahead of the game. If you don’t understand how a company makes money, find a company that you do understand.
For example, various pharmaceutical companies may be difficult to follow if you do not have a science background. But if you’re a homeowner, you may know all too well how Home Depot or Lowes generates a profit.
Pick Businesses You Love
If you invest in businesses you love, you’ll find investing more interesting. It will help you connect with the company and customers, on a deeper level.
This connection may help you make better investing decisions. Also you’ll be able to easily ‘keep up with the times’ of a specific company if you’re already a customer.
Ignore the Market (Most of the Time)
For the most part, you can ignore the market media. Warren Buffett has a quote that goes, “Games are won by players who focus on the playing field, not by those whose eyes are glued to the scoreboard.”
In this example, the scoreboard will be the daily price fluctuations. The field will be the underlying business performance, market share, and balance sheet.
Advantages of Value Investing
Value investing has a great deal of advantages. Three of the most common are:
- It’s proven to be successful. The most iconic investor of our time, Warren Buffett, credits value investing for his success and fortune.
- There are tax advantages. If you hold a stock for more than one year, you pay long term capital gains. If you own a stock for under a year, you’ll pay a short term capital gains tax rate, which is higher.
- It’s less time consuming. If you work a full time job, you can’t (and shouldn’t) follow the financial news every minute of the day to make trading decisions. Value investing allows you to ignore the daily news and focus long term.
Disadvantages of Value Investing
Despite the benefits of value investing, there are some disadvantages:
- It’s a slower wealth accumulation game. Your profit comes months, or years, down the road.
- An investor can become so hype focused on their analysis of intrinsic value, they never sell their position. This served Warren Buffett well with Coca-Cola. But, plenty of people purchase a stock at $100 a share, and slowly but surely watch it drop to $90, $80, $70, $60, etc., a share without ever selling.
Value Investing vs Growth Investing
The value investing strategy typically refers to valuing companies based on the intrinsic value. Then, taking an investment position based off of that intrinsic value. Growth investing however, is typically seen as investing in companies that’re expected to grow above and beyond the market average.
The two commonalities between value and growth investing are; both believe the future price per share will be higher than the current price and they both anchor on a longer term position.
Anchor on the Long Term
Investing shouldn’t be a ‘get rich quick’ strategy. To build great wealth, or set yourself for a financially free life, you must have patience.
The value investing strategy is an excellent investing method that will help you accumulate wealth in the long term. There’re quite a few investing strategies out there, and at times, it can seem overwhelming to pick the right one.
Working with a certified financial advisor can help you pick the right investment strategy to supports your goals and financial ambition. Financial advisors do more than tell just you what companies to invest in.
They will protect your money from economic downturn and help you identify overspending in your budget.