What Is Value Investing?

May 4, 2018 | By More

Value Investing is a stock investing methodology that is practiced by many successful investors and some of the wealthiest people in the world such as Warren Buffett.

So what exactly is this value investing that led Warren Buffett to be so rich?

In Value Investing, you are essentially buying stocks — which essentially is a part ownership in a business — that is worth $1 for 50 cents (this is just an analogy). There are many reasons why you can buy a stock that is worth $1 for 50 cents.

One of the reason is that many stock investors do not understand what they are buying or selling — they simply buy and sell stocks based on hot tips or based on chart patterns.

That forces them (at times) to sell a good stock at a cheap price.

In which, the practitioners of value investing will take advantage of that by buying the stock they sold.

“Value investing in fundamentally different from stocks trading.While the latter focuses more on price movements and other technical indicators, the former focuses on analysing the business behind the stocks and buying the stocks at a cheap price relative to the business value. This is done by first determining the rough intrinsic value of the business.” – Chris Lee Susanto

Value investing works because simply put, the stock market is not efficient.

That means that the stock market at points in time does not accurately reflect the true value of the business behind the stock.

Someone who practices Value Investing would usually shun away from ridiculously priced stocks, even though the underlying business is good. That is because we should always be reminded that even buying a really good business at an expensive price would still constitute as a bad investment.

Value investing is not without risks.

When buying stocks with the idea that it is selling below its intrinsic value (or also known as the real value of the business that we think should be trading in the stock market at), a lot of personal assumptions and judgments are required to come to that conclusion. There are risks that we may be wrong in our judgement.

Often times, stocks that look cheap via metrics such as price to earnings ratio or other indicators may not be really “cheap”. There are risks that the earnings of the business will continue to drop and as a result, the PE ratio of the business will increase– but the price of the stocks remain the same or drop further. That is a trap that we must look to avoid.

It is a good reminder to myself too, that stocks will not be cheap without any reason.

In Value Investing, we are buying the stocks of businesses that are trading at a price below its intrinsic value.

If the market is efficient as the efficient market hypothesis says, we should not be able to do that.

But the market is not efficient because people are complex creatures and they have emotions — namely greed and fear — which is why value investing can work.

We bank on irrational optimism or pessimism that forces people to sell good businesses at cheap price in the stock market.

In value investing, we should understand the impact of human behavior in the stock market. Hopefully via that understanding, we would be able to invest in good value stock by being patient in focusing on the long term business results instead of short term market fluctuations.

Of course, value investing is not that simple as there a couple of things that we should understand — things like our own investment time horizon, our circle of competence and our understanding of risks and our life goals and needs.

We need to learn the impact of human behavior, more specifically on the fear of people, to use that as a buying opportunity and using the greed of people, use that to sell our stocks at an overvalued price.

The only time frame that matters in investing is the long term– and that no one can predict the future. Therefore, do not be too happy when our stocks go up and do not be too sad when our stocks go down, the truth is we do not know what will happen tomorrow. Focus on our investment process and results will come– over time. That is value investing.

Value investing is essentially buying the stock of a good business with a large enough competitive advantage so that it will not erode easily when going against competitions in the long run.

We have to be very selective about the type of stocks that we buy by analysing their business model as well as the overall industry trends.

When buying stocks, always remember to have a substantial margin of safety in order to minimize our risk by buying it way below their intrinsic value.

“As a value investor, we should have a long-term investing horizon of at least 3–5 years and during bear market, we have to believe in the true worth of the business and be patient — if it is a truly good business, it is only a matter of time before it goes up and while waiting, we are getting dividends (and options premium if you know how to sell options).” – Chris Lee Susanto

I do not believe in buying or selling stocks based on chart indicators but I have no problem with people who do that. Having said that, I’d rather follow the methodology of the world’s most successful investor of all time, Warren Buffett — which is value investing.

“If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.”- Warren Buffett

“The big money is not in the buying and selling…but in the waiting”- Charlie Munger (vice chairman of Berkshire Hathaway, the conglomerate controlled by Warren Buffett)

Here’s 4 questions that we can ponder on about using value investing:

  1. What constitute as a truly good business
  2. If we think the underlying business behind the stock is a good business, what makes us think that we are smarter than the person on the opposite end selling the stock to us
  3. How cheap is cheap for us to buy the stock
  4. Will that stock of a good business remain cheap forever- commonly known as a value trap

Here’s two more key to remember in order to be successful in value investing:

Company’s earnings power and whether the stock is selling at a reasonable price.

  1. Earnings power

A company’s earning power will depend a lot on the market it is operating in. If it is operating in a highly competitive market like selling IT products, it needs to have a competitive advantage.

If not, they will not survive in the long run.

There is a good reason for a company to do business in a competitive industry.

The reason might be because that industry is lucrative and perhaps there is still a huge market for them to earn money from despite the market saturation.

However once the market becomes too saturated, the company that survives will be the one that has a competitive advantage.

In investing, we are looking to assess whether the company has a competitive advantage that will allow them to have a sustainable earnings power and can fend off competition in the long run.

  1. Reasonable selling price

No matter how good the company is, it would not be a good investment if we buy it at an overvalued price.

It never is.

This happens when the market is overly optimistic about a particular stock.

The investors in the stock market will then buy this particular stock and drive up the price super high. This happens simply because they are hopeful about the future of this stock.

However, if the price of the stock has been driven up so high, logically speaking the potential of it going further up is much lower.

In value investing, we always want to buy a stock when it is on sale.

When does a stock go on sale? It goes on sale when there is bad news about a company. There are many types of bad news, it may be because it missed earnings estimate or when there is a scandal.

We look for opportunity like this and we assess whether it causes a temporary or permanent damage to the company. If it is temporary, we go in!

And my friend, that is value investing.

Note: This article was contributed to ValueWalk.com by Chris, Founder at Re-ThinkWealth.com – a value investing and options selling blog. 


Chris Lee Susanto is the founder at Re-ThinkWealth.com – a value investing and options selling blog established in 2015 and based in Singapore (a country with one of the highest GDP per capita in the world).

By the age of 25, he manages a six-figure equity portfolio utilizing value investing and options selling and had achieved an 18.21% annual compounded return since inception. He publishes free weekly investment insights.

 

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The author of this article is a contributor to ValueWalk.com. ValueWalk is your everyday source of breaking and evergreen news on everything hedge funds and value investing.

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