Value investing is an approach that looks at assets that appear to be trading at a price that is less than what they are intrinsically worth.
Oct. 1, 2020
Value investors look for stocks that they believe the market is currently underestimating. The idea is that, in the short-term, the market will often be overly reactive to good and bad news, leading to movements in the price of a given asset that does not relate to the long-term fundamentals of the company.
When there is an overreaction and the share price decreases, this could present an opportunity to a value investor to buy shares in a company at a discounted price, giving them more margin for error. Two of the biggest names in value investing over the years are Warren Buffet and his mentor Benjamin Graham.
How does value investing work?
If you know what the true value of an asset is before buying, you will also know when you are purchasing at a discount and when you are paying more than what the asset is actually worth. You can't predict when an asset is going to rise or fall from its deemed intrinsic value, which is why you need to keep an eye on the markets.
There are a number of different ways in which you can try to figure out the intrinsic value of a company. Usually this entails looking at the financials of the company, business model, competitive advantage, target market, brand loyalty and quality of management.
Once you have an idea of what a company may be worth, you can then determine at what price investing in shares of the company is attractive and when it is too expensive. Value investing requires you to be patient, as you may be waiting a significant length of time before the share price discounts to such a level that you are happy to invest.
As you cannot be exactly accurate with your estimates of intrinsic value, a lot of value investors like to build a margin of safety into the process. Benjamin Graham, for example, advised only buying shares of a company if the price was two-thirds or lower of its deemed intrinsic value. This approach reduces your margin of error.
How do stocks become undervalued?
The overall market may be decreasing due to a market crash, which doesn't reflect the fundamentals of a given company a lot of time but reflects the overall bearish sentiment of investors.
Herd mentality has to be considered, as even a small drop in the share price of a company could lead to a mass sell-off as people become worried about further decreases. Some stocks may be undervalued because they don't get much attention, with people often preferring to focus on flashy tech companies.
Cyclicality is another factor in stocks becoming overvalued, as well as bad news. A company could face a setback due to a particular event, such as a scandal involving management or certain legal action.
A lot of investors will overreact to bad news, leading to a sell-off. If a value investor deems that this bad news is just a temporary dip and doesn't affect long-term value, it can provide an ideal buying opportunity at discount prices.
How do I find undervalued companies to invest in?
As mentioned, there are many ways to identify potentially undervalued companies. Being able to read and understand financial statements is a big plus. A lot of investors don't take the time to dig deeper in the figures and find a potential edge. Some popular metrics that value investors like to look at include price-to-book (P/B), price-to-earnings (P/E) and free cash flow.
Companies that have a competitive advantage in a sector where there looks to be sustained demand for many years to come is another big plus when value investing. Looking at the track record of the management team can also give you a good idea of where the company is heading.
Ultimately, value investing is a long-term approach that requires work. You may have to look at dozens of companies before you find a potential value investing opportunity, so patience is key. If you get it right, your returns will often be handsome over the long run.
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