Value investing is a foundational approach to investing in financial markets that emphasises the identification of stocks trading at a substantial discount to their intrinsic value. This strategy revolves around seeking a margin of safety by purchasing undervalued assets. Understanding the intricacies of value investing is crucial for investors looking to make informed decisions in pursuit of long-term financial success. Read on to know more.
Table of Contents
Defining Value Investing
The concept of value investing was introduced by Benjamin Graham and David Dodd, in a book called Security Analysis, in 1934. Since then, the concept of value investing has been practiced by many renowned investors today; the name you are probably most familiar with is Warren Buffett, whom Graham mentored.
Contrary to chasing the hottest trending stocks in the market, value investing focuses on investing in stocks that are underappreciated by the market at large. If we had to get more technical, value investing is the strategy of investing in stocks trading at a price below their intrinsic value. However, to keep it simple, think of value investing as the basic idea of investing in deeply discounted stocks. That said, value investing is much more nuanced than just investing in stocks with a low PE ratio.
How Does Value Investing Work?
When we refer to a stock as deeply discounted, it means it is available at a reduced price, essentially on sale. For instance, if a stock’s actual price is ₹1,000 but is currently trading at ₹500, it is considered to be at a discount. Investors can buy stocks at this discounted rate with the intention of selling them when they reach their actual value, which, in this case, is ₹1,000—a concept known as intrinsic value.
Determining intrinsic value is the responsibility of the investor, involving the prediction of whether a stock is discounted and estimating the extent of the discount. Unlike a universal intrinsic value, which doesn’t exist for any single stock, it is calculated by considering various financial aspects of the underlying company, including revenue, earnings, and cash flows. In essence, intrinsic value represents the present estimated value of a company’s future cash flows. While accurately calculating intrinsic value may be challenging, understanding financial data can help identify discounted stocks. Although the precise discount may not be known, recognising that a stock is trading below its fair value becomes feasible through financial analysis.
Importance of Value Investing
Value investing and the concept of margin of safety are closely linked, as value investors seek a significant difference between a stock’s price and its intrinsic value, providing a cushion for potential errors or unexpected outcomes.
- When a stock is considered to have a margin of safety, its price is notably lower than its intrinsic value, reducing the downside risks for investors who have already purchased it at a discount.
- Unlike products on sale, stocks trading at a discount are often overlooked by the broader market, allowing value investors to operate under the radar. As a result, these value stocks are less affected by subpar or poor financial quarters, minimising the impact on their stock prices.
- Conversely, trendy stocks typically trade above their intrinsic value, as the market has high expectations for them. Any negative surprise, no matter how small, can lead to a significant decline in the stock price. Even the absence of a positive surprise may result in a drastic decrease in the stock price for trendy stocks.
Finding Value Stocks
Value investing doesn’t require precise value calculations; instead, it involves seeking opportunities with a substantial margin of safety, requiring in-depth research on the company’s business and historical trends.
Various investing metrics and ratios, such as free cash flow, P/E ratio (price to earnings), and P/B ratio (price to book), can be used by investors. However, these ratios should not be the sole criteria for decision-making in value investing.
- For instance, consider a deeply cyclical stock with a P/E multiple of 2.5. Analysing its ten-year P/E history reveals a maximum of around 7 during peak periods and a minimum of around 2 during low points, indicating the stock’s position in the business cycle.
- Recognising the stock’s cyclical nature, an investor expects a future P/E multiple of 7 during the next upcycle when profit margins expand. Industry research and signs of an impending upcycle further support the decision to consider the stock for value investing.
While this example provides a simplified blueprint, actual research is more intricate. The process involves evaluating the business’s cyclical nature, identifying its position in the cycle, and assessing signs of emerging demand to determine the potential value opportunity.
Value Investing Vs Value Traps
- In the above example, assume the business was disrupted by a superior product. Due to this, a recovery in demand for that company’s product is now unlikely. In this case, there is no revival in the business cycle and no expansion of profit margins. So, the stock is unlikely to hit peak P/E again.
- Furthermore, the company is expected to lose sales due to the emergence of the disruptive product. In this case, the market may choose to derate the company even further, which will lead to a collapse in the stock price.
As an investor, you should be careful not to invest in such stocks that appear as value investing opportunities but instead are just value traps. Always remember that value investing opportunities arise when you stumble on discounted stocks, not cheap stocks. You may come across discounted stocks as a result of temporary business headwinds or the deep cyclic nature of the business. On the other hand, cheap stocks that the market does not favour due to permanent disruptions.
Conclusion
Value investing is a strategic approach to the stock market that centres on identifying stocks trading at a significant discount to their intrinsic value. It involves seeking a margin of safety by purchasing undervalued stocks. However, while value investing offers the potential for long-term gains, it is not without its risks. Hence, investors must conduct thorough research, analyse financial metrics, and carefully assess the market and industry conditions to navigate the complexities and uncertainties associated with value investing.
