Value Investing for the future rather than now

Tired of getting burnt by hot tips, stock market rumours and hype? Looking for something that’s safer? You might want to consider Value Investing.

The profile of a value investor is someone who does not subscribe to the herd mentality that afflicts many traders in the market. A value investor discounts tips and rumours, preferring to dive into the fundamentals of a stock. After a careful study of a particular stock, the value investor moves in to purchase a stock.

Because the value investor is in it for the long run, he/she is someone who understands the nature of the business and therefore is able to see the potential in it.

The bedrock of Value Investing is the concept of “margin of safety.”

This simply means buying a stock that is currently priced lower than its intrinsic value. The discount is the margin of safety.

How does a value investor select an investment?

In layman terms, a value investor is not unlike a shopper who is always looking out for a good buy. Consider a shopper’s diligence in poring over mailers, newspapers for discount vouchers and comparing prices before making a purchase; a value investor exercises the same care and diligence in sniffing out a value stock buy by poring over annual reports and historical information of listed stocks.

While a shopper looks for discount vouchers, the value investor looks at the stock market to search for stocks that are priced lower than the intrinsic value. This discount is the margin of safety.

It goes without saying that a high level of confidence goes hand-in-hand with a value investor; because more often than not, value investors pick stocks that may not be within the radar of stock pundits.

Modus operandi

A value investor buys a stock when it’s down and out, provided the price is right. At any given point in time, there will be companies whose share prices are depressed. The reasons could range from disappointing quarterly results, changes in leadership, unattractive products etc. A value investor will weigh the reasons behind the drop in price. If it appears to the investor that the market overreacted perhaps due to an unattractive product roll-out, the value investor might pick up the shares at a discount and wait it out.

The most well-known value investor right now is none other than Warren Buffett. Over the years, Buffett has refined the theory of value investing encapsulated as such:

  1. Concentrate your ideas within your circle of competence. Know what you’re buying.
  2. Buy only great businesses that have double competitive advantages. Companies that can overcome macro events
  3. Only invest with managers that think like owners. Substantial insider ownership is desirable.
  4. Invest with a margin of safety.

Buffett was guided by the insight that “it is better to buy great businesses at a fair price than a fair business at a great price.”

A key indicator shared by Joshua Kennon (http://www.joshuakennon.com/earnings-yield-as-a-value-investing-strategy/) that value investors look at is the Earning Yield Ratio. This ratio basically tells you, “if this stock were a bond, how much would it earn as a percentage of my investment based on this year’s after-tax profit?” It is the inverse of the P/E ratio.

Earnings yield = 1 ÷ P/E ratio

Example:

Company P/E ratio Earnings yield
A 8 12.5%
B 4 25.0%

In the above example, Company B’s higher earnings yield makes it a more attractive pick for value investing.

According to Kennon, investors fumble when they are affected by the market’s stock price – what other people are willing to pay at any given moment. Benjamin Graham wrote in The Intelligent Investor: “The real money in investing will have to be made – as most of it has been in the past – not out of buying or selling, but out of owning and holding securities, receiving interest and dividends, and benefiting from their long-term increase in value. The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizeable declines nor become excited by sizeable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or ignored.”

In conclusion, Warren Buffett sums up value investing:

“Long ago, Ben Graham taught me that price is what you pay, value is what you get. Whether we are talking about socks or stocks, I like buying quality merchandise when it is marked down.”

 

Sources:
http://www.joshuakennon.com/earnings-yield-as-a-value-investing-strategy/accessed 12 February 2015
http://www.wikinvest.com/concept/Value_Investing accessed 12 February 2015
http://en.wikipedia.org/wiki/Value_investing  accessed 12 February 2015
http://www.investinganswers.com/financial-dictionary/ratio-analysis/earnings-yield-1004 accessed 12 February 2015
Benjamin Graham (1949). The Intelligent Investor New York: Collins ISBN 0-06-055566-1