What is value investing?
Value investing is one of the most basic investment strategies. It operates under the assumption that the stock market does not function efficiently, resulting in many assets being overvalued or undervalued. An undervalued stock means it is traded at a price significantly lower than its intrinsic value. This strategy therefore focusses on purchasing the shares at a price lower than their real value, believing that the market will re-evaluate them in the future and the price will rise to reflect its true value.
Value investors do so by looking for companies on cheap valuation metrics, usually with low multiples of their assets or profits, for reasons which are not justified over the longer term. They believe the market tends to overreact to positive and negative news, resulting in stock price movements that do not correspond to a company's long-term fundamentals. This inadequacy allows profiting by purchasing stocks at discounted prices.
Value investor needs to have a great deal of patience, as he has to wait for the market to fully appreciate the stock's value. For that reason, a contrarian mindset and a long-term investment horizon are a necessity for this type of investment approach.
Simply put, value investing meaning the art of buying stocks, which trade at a significant discount to their real value.
Where have you heard of value investing?
If you are a participant in modern financial markets, you will likely have come across the term as it is a popular alternative investment style. You may have heard about value investing from financial advisers and investment managers, who often recommend this strategy to their retail clients.
If you are following financial news, you may have also heard such big names as Benjamin Graham, Warren Buffett, Charlie Munger and Christopher Browne. All of these are the world-renowned value investors.
What you need to know about value investing...
David Dodd and Benjamin Graham are the founders of value investing. In the 1930s, they have created the framework of the strategy.
One of the most significant concepts introduced by Benjamin Graham was the safety margin. The safety margin is the difference between the true value of the stock and its market price. The lower the stock price compared to its intrinsic value, the greater the safety margin. It is commonly used as protection that can reduce the impact of negative factors and mistakes in calculations. When buying a stock with an ample margin of security, there are higher chances that even in the situation of negative events, the given investment won’t be influenced significantly. According to Benjamin Graham, this concept is what differentiates investment from speculation.
Value investing involves a detailed fundamental analysis of the company and the overall industry. The basis for successful value investing lies in a thorough study of the firm's activities. To determine the real value of the stock, an investor has to run a financial analysis, studying a company's fundamental factors, such as its business model, brand, target market and competitive advantages, as well as financial performance, including cash flow, revenue and profit. Some common metrics used to value a company's stock include price-to-book (P/B), price-to-earnings (P/E) and free cash flow.
Value investing is designed for long-term investment. It is especially effective during periods of market recession, as many good companies become undervalued. As the most successful value investing examples suggest, a financial crisis is a fruitful time for a value investor.
However, it is important to always consider the purchase price, even if you have a long-term investment horizon. One should never rely on the belief that long-term growth will cover all the spendings. Buying incorrectly chosen stocks can lead to great losses.
Keep in mind that value investing is not only about cheap stocks. This strategy is aimed at the sound, high-quality companies with great potential.