The Essence of Value Investing

Investors often search for ways that help them beat the market. Just like how each buyer knows that if he waits for the right moment he can get any product at a lower price than the original proposed price, the same could be applied on investments. When you buy an appliance whether it’s in sale or sold at full price, the characteristics of the appliance remains the same. Similarly, the share price of the company can keep changing, even if the true value of the company is maintained. Therefore, share acts as a commodity and as each commodity goes through changes in price due to demand and supply, shares face similar fluctuations.

Buying shares at bargain prices has a rather better chance at gaining income later in their sale, furthermore the loss is also less if their prices did not increase. This is defined by a principle of value investing, called the ‘margin of safety’. It’s like when you buy clothes, you don’t want to pay full price for it simply because of the thought that it could fade or shrink. Let’s say a dress is originally priced at $70, and you buy it at $25. You will end up losing only $25 in case the dress doesn’t turn out to be good but if you had paid the full price, you would have lost a significantly larger share.

Value investors do not believe in the efficient market hypothesis. To keep it simple, they do not follow others. They do not buy the most popular shares of the day, because they usually are expensive. They invest in companies that are not known but their financials are reliable. They believe that sometimes the shares are undervalued or overvalued. Value investing is a long term strategy. Investors don’t invest for instant gratification. They might have to wait for years before the investment pays off.

The definition of a value stock has changed with the advances in investing. Where value once referred to stocks that traded at low prices relative to their earnings with the emphasis on their being cheap, it now broadly encompasses the big U.S. companies whose stocks tend to be cheaper than those of their digital group, despite excellent fundamentals.

 

Principles of Value Investing

  • Value investing is not the same as speculation 

If the investment case for a company involves things that could happen in the future, but not certainly happen, then it’s considered as Speculative. Value investors are not looking for “the next big thing”  or “a company that MIGHT turn out to be good.” They seek to invest in companies at substantial discounts to their true value today, and project based on data that other investors will realise that true value and bid up the price of company’s stock.

  • Value investing requires a contradicting mind

Value investors just don’t go with the flow and bluntly follow what other investors do. They rather seek to invest in those potential companies that others overlooked. One can look for those companies by screening for the indicators that reflect the stock is cheaper than the company’s true value. It is absolutely okay if these companies are lying on the corners of the market and aren’t everyone’s favourite. 

  • The first priority is to avoid losses

Avoiding losses indeed becomes the first priority for value investors. Let’s say your portfolio value is $1000 and it drops 25%, and then it grows 25%. In the end, you’ve lost money. Moreover, you now will need larger returns to meet your goal over time, which in turn means take larger risks than you should, which could impact in huge losses. One should minimize risk of big losses by investing at a discount to a company’s true value in order to be a successful value investor. 

  • Value investing requires extensive research 

Value investors need to be aware of what they own and why they own it. It means that they need to keep track of what’s happening in the market, what’s their company like, competitors, reasons for stock being sold at a discount etc. Staying up to date with all the information helps value investors to project what’s the best time to buy or get rid of the company stocks. 

  • Value investors should think like business owners, because they ideally are 

Great management teams are concerned to generate growth from time to time. Part of knowing what you own and why is getting to know a company’s management team. Look for leaders whose incentives are aligned with shareholders. The managers of the company may not be focusing on the daily fluctuations and changes in the company, but a value investor should in order to raise the chances of success in years to come. 

One doesn’t need to be a legend in value investing strategies to generate market-beating returns, but one needs to understand certain principles to be followed in order to be a successful value investor. 
Written by

Aditya Gupta

Last updated on

October 17th 2019, 11:12 am

Skip the daily news.
Subscribe to our Weekly newsletter for relevant market news and global trends.