The Basics of Value Investing

The Basics of Value Investing 03 Jan, 2019

What is Value Investing?

Value Investing is a method of investing where you as an investor choose to invest not according to trend but by evaluating an investment's intrinsic value. Value investing was first popularized by Benjamin Graham. In investing, he puts more importance to the quality and fundamentals of a company compared to its market factors and stock prices.

Value investing is by far different from usual strategies in investing. It focuses on trusting that the stocks you invest in have a high intrinsic value that will potentially increase over time. Value investors look for stocks that they think are undervalued in the market right now, evaluate its intrinsic value, and if it offers great potential buys them.

Usually, when using a value investing strategy, there is a margin of safety that you must follow. The margin of safety helps you ensure that you won't incur losses and gain positive returns. To explain the margin of safety, say for example there's a stock that is currently for sale at $60. Its intrinsic value is $100. Your margin of safety in investing at that time is 30%. This means the stock price should be at close 30% off of the original price. So if the price is $70 or less then you should buy the stock. And when it's price rises to 30%, investors are likely to sell the stock.

But you can also choose not to sell your stocks at all and instead reap your rewards when the stock has finally reached its potential intrinsic value.

Further Reading:

Margin of Safety

Value Investing - Understanding the Principles

Growth Investing vs. Value Investing

Both Growth and Value investing are investing strategies that help to give you the optimal outcome of return that you want. The difference between them is their approach towards investing as a whole. We'll differentiate these two investing strategies

Growth Investing

Growth investment is also similar to value investing in that it doesn't generate an instant return of investment. When you buy growth stocks, you are buying its potential expansion. Companies use their resource to expand their product/services and dominate the competition. In doing so, they create more profit. When buying stocks using growth investing strategy, you are buying its steady growth and in relation its price increases. So you can sell it for a great profit when you feel that the increased growth is at its limit.

The downside of growth investing is that its susceptible to market volatility. One day, you could see a price drop in your stocks or the next day a sudden increase. But its part of the investment strategy. Growth investment is a hit or miss. It all depends on how much the company you invested in can expand and grow and its always a mystery.

Value Investing

As defined, value investing is a strategy of investing using stocks intrinsic value. Investors buy stocks which they think are currently undervalued by the market. They look more into the quality of the company the stocks they are buying. By quality it means a large set of things like the company's management, finances, years of service, and etc… there are a lot of intrinsic values you can use to consider before investing.

Value investing is also not an instant profit. It requires you to wait for a long period. Wait until the stock price goes down due to market downturns and buy. But also choose stocks that you have the knowledge and research on and believe it will give you a profit. Also, waiting doesn't mean to be idle, you also have to update yourself with any news or information about the company. Like for example, they changed their management. This could dramatically affect the direction the value of the stocks you've invested in. So you better keep watch and wait for your investment to grow.

The difference between growth and value investing really is the approach. Growth investment focuses on how much the company is using its resource to expand and dominate the competition. This is a really hit or miss but the profits are rewarding. It's a high risk, high reward.

In value investing, its more of a waiting game. With a low-risk high reward. It's not susceptible to market volatility as you are sure to expect the company will still be operating even in downturn times in the market. You can't expect Mcdonalds to go bankrupt after just one mistake. Value investing is like that.

Further Reading

Comparing the Growth and Value Approaches to Stock Investing

Pros and Cons of Value Investing

Pros

  • Value investing is a low risk-high reward type of investment. You're already buying a stock at a cheap price. There are only but a few factors that can lower it more, provided you've done your research about the stock you're buying.
  • Market volatility is of no concern to you. You are investing in the quality of the company so you expect it to perform. Any external factors that cause the value to go down should not concern you as its only temporary.
  • Lower tax rates - Value investment is a long-term investment which means you get to pay a lower tax rate for your investment income.
  • Low Fees and Commission - Since you won't be transacting as much, you'll pay lesser fees and commission. You'll be waiting for your stocks value to go up to a certain point before you make your next transactions.

Cons

  • Long Term with little changes may bug you. There might come a period of time that your investment isn't growing at all or just growing by a tiny margin. And this might bug you out and make emotional investment decisions.
  • It takes time and effort before making a value investment. Before buying a stock for your value investment strategy, you need to put in the work to acquire all the necessary information you need to make sure that the stock you're buying is of high intrinsic value and you're making the right investment choice.
  • Liquidating can be a problem. Given that the stock may be in a low-value period for a long time, it's really hard to liquidate it.

Warren Buffett on Value Investing

Warren Buffett has followed the Value Investing strategy early on in his life. He was a student of Benjamin Graham, a pioneer of value investing. His net worth amounted to $80.6 billion in 2018. He is known to buy stocks and holding on to it for a long-term play. When he's investing, he's objective is not to net capital gain but to have ownership of companies that have a great quality which would, in turn, be capable of generating profit for him.

If you want to have the know-how on how Warren Buffett does his investments here are some pointers you can read:

  • Check the company's performance consistency. You can do this by checking the company's ROE (Return of Investment). Companies usually disclose this information to the public. You must also compare it to its competitors and historical numbers should also be studied. You can get ROE using the formula

    Net Income / Shareholder's Equity

  • Make sure the company has no debt or has a small debt. This is a no brainer. The more debt the company has the less likely it will net a profitable gain. Also, Higher debt means lower ROE.
  • Check if profit margins are historically increasing. A high-profit margin indicates that the company is performing very well.

Further Reading:

Warren Buffett Strategy: Long Term Value Investing

Warren Buffett's Investing Style Reviewed

Benjamin Graham

Benjamin Graham can be considered the father of value investing. He pioneered the value investing strategy which is widely used up to this day. He focused on a low-risk high reward investment strategy that helped him and his peers make money from the stock market.

Benjamin Graham has many accolades to his name. While being popular as the mentor of the now successful investor Warren Buffett, he also has many other achievements. He is credited as the creator of the security analysis profession, a pioneer of using financial analysis for investing in stocks and help draft the Securities Act of 1933

Benjamin Graham also popularizes using a margin of safety when investing. This ensures that you won't incur heavy losses when you're investing. The margin of safety in common sense is buying stocks well below their evaluated value by you as the investor. This limits the losses you can incur and has a really small downside to your investment.

Without a doubt, Benjamin Graham has contributed so much to value investing and is even the first guy you hear when talking about investing. His contributions helped modern-day investors like us succeed.

Further Reading:

Benjamin Graham: The Intelligent Investor

Benjamin Graham's Seven Criteria for Picking Value Stocks

Examples of Value Investing

A great example of value investing is Warren Buffett's Berkshire Hathaway company. When Buffett made his first investments to Berkshire Hathaway, it was a struggling company. Now it's stocks are one of the expensive ones in the stock market. Warren Buffett had done his researched and found that Berkshire Hathaway was a good quality company. In the present day, it's asset amounts to $508 billion and stock prices of $308,530 from $275 in 1980.

Conclusion

Value Investing has been a popular investing strategy that has been used since the 1930s. It was popularized by Benjamin Graham and Warren Buffett, both of whom are successful investors. If you want to get into investing, then you should try value investing. It's a low-risk high reward strategy which means you won't have to suffer huge losses as a first-time investor.    

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