Investment can be done in many ways. There are those who just follow the wind and go where the market goes (or where they think it goes). Then, there are those who implement a systemic strategy and maximize their returns way more than the market. Most people of the second type follow a strategy called value-based investing.
Rather than just following the market and hoping for the best, value investors see the long-term potential in a stock and make their investments accordingly. You could also be a value investor if you put in the work and pick the right stocks. In this blog, let’s explore everything you must know about value-based investing and how you can make the most out of it.
What Is Value Based Investing?
Let’s begin by understanding the basic concept of ‘Value-Based Investing’. It’s an investing strategy that focuses on finding inexpensive companies and profiting from them. It’s based on the concept that each company has an intrinsic value, or what it’s really worth. Investors look for stocks of firms that are trading at a price that is not in line with their fundamental or inherent worth.
Before you start using this approach, you need to gain a solid understanding of the stock market. There are two primary concepts involved – undervaluation and overvaluation. If you are a value investor, you must be looking for undervalued stocks that are trading lower than their intrinsic value. Equal importance should also be given to refraining away from stocks that are trading at a price higher than their intrinsic value.
The value investing approach can also be defined as moving in the opposite direction of the market. To implement that successfully, you need to understand the long-term fundamentals of a company. In many cases, the current prices of shares do not justify their long-term fundamentals. Taking advantage of this is one of the best ways to earn solid returns.
What Are the Components of Value-Based Investing?
In his book The Intelligent Investor, Benjamin Graham introduced four components that define the idea behind value investing. Let us look at them in detail:
- Market: Value investors do not go with the market pricing. However, it is used as a benchmark to justify their investment decisions. The typical strategy in any stock trading involves buying at lower prices and selling when the prices get higher. Value investors, on the other hand, focus on intrinsic value rather than just its market price.
- Intrinsic Value: This reflects the fundamentals of a company rather than its recent ups or downs. It is also the true value of a company. There are several factors that may cause a difference between the market price and the intrinsic value. Value investors believe that the true intrinsic value of a stock will be achieved sooner or later once the market corrects itself.
- Margin of Safety: Intrinsic value calculations often involve some level of subjective assessments. This is why you need a little margin of safety. By adjusting the optimism of the forecast, you get to minimize your risk potential in a deal. For example, your estimate of intrinsic value is $10. Taking into consideration a margin of safety of 20%, you can adjust the value to $8. This will ensure that you do not overpay for any asset.
- Investment Prospect: Value investing works on the principle that prices always return to their intrinsic value. We are not predicting the stock prices two days or two months from now. Rather, we are picking out undervalued businesses that will outperform in the long term. This will eventually reflect in its stock price.
Now that we have learned some of the basic concepts of value-based investing, let’s understand how it works and how you can boost your wealth through value investing.
How Value-Based Investing Works
Here is the core idea of value-based investing – purchase stocks when they are undervalued or on sale and sell them when they reach their true or intrinsic value or rise above it. To understand value investing, you need to know how to calculate the intrinsic value of stock first.
We are not going to go into the details of it too much. We’ve put together an article on how to calculate the intrinsic value of a stock. Please check it out for more information.
Another condition that value investors follow is allowing for a margin of safety when trading in value investing stocks. Stock prices can change owing to several reasons, underlined by a popularized market tendency that causes a share’s price to waver from its intrinsic value.
An example of how not to invest
For instance, let’s assume a company’s stock prices are currently trading at $10 per share in NYSE. A meme frenzy causes the stock prices to rally to $18 per share within a short duration. However, upon careful investigation using the above intrinsic value calculation, you find that the company’s financial and organizational structure is found to be below average and it is worth only $8 per share.
A value investor will never take part in the rallying of this meme stock. This is what differentiates them from other investors who buy these stocks in a bid to get rich quickly. Value investors know this rally is going to end sometime soon, and everything will come down crashing when it does.
Investing with a long-term outlook
The first choice of a value investor would be to find a company with great long-term potential but temporary downtrends. This could be a result of various market biases. The intrinsic value calculation will show which companies are performing below their potential in the market.
For instance, let’s assume Walmart is currently trading at $132 per share, and you determine the intrinsic value of Walmart to be $147 per share. So, the actual potential of the stock is not realized right now in the market. In this case, you can go ahead and buy Walmart. There may be temporary downward movement even further. However, the stock will most certainly bounce back and achieve its true intrinsic value in the long run.
When this happens, you can earn significantly high margins compared to other investors. Holding the stock for a long term till it realizes its true potential is the key here. If you are someone affected by everyday market trends, this may not be a good strategy for you.
What Are the Advantages and Disadvantages of Value Investing?
Continuing the above discussion, let us now have a look at the advantages and disadvantages of value investing for an investor:
Some of the notable advantages of value-based investing are as follows:
- Anyone can invest: This is not a strategy exclusive to the right. Anyone can start their investing journey with value investing. It doesn’t really matter if you had just $100. Also, this is not a get rich quick scheme. So, do not expect to get rich within a couple of months.
- Best way to earn profits: If there’s one thing that is certain, it is the fact that financially strong companies will achieve their true intrinsic value one way or the other. For those who manage to pick the right value stocks, profitability is almost certain.
- Low risk: If you are a value investor, you don’t have to worry about market volatility and related risks. You are not worried about the price of a stock tomorrow. Rather, you focus on the long-term strategy to minimize risks.
- Best way to compound your earnings: Value-based investing offers the best chance to compound your earnings. When you keep investing your returns and dividends, your investment will multiply and fetch great profits.
Despite a great many advantages, value investing is not without its shortcomings. Let’s explore the common ones here:
- Requires patience: Value investing is not suited for individuals who wish to make a quick buck from the stock market. Even after picking the right stocks, you need to be patient till the intrinsic value is realized. This could take a few months or years in many cases. If you are not patient enough to wait that long, you may end up losing money here.
- Requires hard work: Picking the right stocks is not rocket science. However, you still need to put some effort into doing the intrinsic value calculations. You may also have to evaluate multiple stocks before narrowing in on the right one for investing.
- Intrinsic values may vary: This is one of the biggest downsides of value-based investing. There are different methods of calculating the intrinsic value, and the accurate estimate may differ based on the method you’ve chosen. Ultimately, it is your own research skills that count when it comes to intrinsic value estimates.
Warren Buffet once said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” Unless you are planning to retire in the next few years, you have no reason why you couldn’t hold on to the best stocks and watch them realize their true potential.
Value-based investing is still not the most followed strategy when it comes to investing in stocks. However, it should be. By holding on to a variety of stocks from different industries, you can take advantage of market fluctuations and keep your investments in the green almost always.