What is Value Investing & How Does it Work?
Want to invest just like Warren Buffet? Meet value-investing – a low-risk, high-reward strategy that involves researching and buying stocks that are undervalued in the market. Basically, you’re bargain hunting for stocks.
This strategy takes patience and the right mind-set, but Buffett has used the strategy to help him achieve a net worth of over $100 billion dollars! Here’s exactly what value investing is and how you can get started.
- Value investing involves researching and buying stocks based on their company’s value, rather than predicting short-term price movements of stocks.
- It includes fundamental analysis including economic, industry, and company analyses.
- Investment decisions are based on facts and company fundamentals rather than relying on emotions and stock market events.
- Value stocks include JPMorgan Chase, Citicorp, and Berkshire Hathaway.
- Value investing is all about finding stocks that are lower than their intrinsic value (what they’re actually worth vs. what the market says they’re worth).
Value investing doesn’t involve predictions.
“Risk comes from not knowing what you are doing.” – Warren Buffett
When many people picture investing, they see traders predicting stock prices on a trading floor in NYC; gambling whether or not their stock will win big if they buy or sell at the right time.
Value investing isn’t about predicting short-term price movements of stocks. It doesn’t involve any gimmicks or high-stakes trades. It’s actually very simple and based on two principles:
- Find high quality companies
- Buy them at bargain prices
You then sell these investments when their stock price matches the company’s actual value. This process can take years, but you earn dividends in the meantime.
Value investing is based on fundamental analysis rather than technical analysis. Let’s take a look at each analysis and why fundamental is a safer choice for investing.
Benjamin Graham and David Dodd are the fathers of value investing. They said that the value of a stock should be based on the research of a company’s fundamentals, rather than the reactions of the market.
A fundamental analysis can be broken up into three parts:
- Economic analysis. You look at macro and microeconomic factors like the health of the overall economy, which sectors are performing well, supply and demand, etc.
- Industry analysis. You review a company’s competitors, their market share, and the industry overall.
- Company analysis. You analyze both qualitative and quantitative factors including the performance of a company, their management, their financial statements (e.g. balance sheet) and their future profit outlook.
In short, fundamental analysis helps you look at the big picture. As a value investor, you should complete a fundamental analysis before buying a company’s stock. You then have an in-depth understanding of your chosen company’s market and sector before making an investing decision.
Through stock price charts and patterns, a technical analysis looks at the price movement of a stock or other asset. This information is then used to predict the future price movement of a stock.
It’s a favorite analysis of day traders and hedge fund managers and requires a deep understanding of statistics and data mining. A major flaw with technical analysis, though, is that it’s impossible to always accurately predict stock prices.
In short, technical analysis tries to identify where a stock will go next. Fundamental analysis, the crux of value investing, tries to identify the actual worth of a stock.
It takes advantage of irrationality.
“Market prices are set by herds of emotional, greedy, or depressed persons who do not always act rationally.” – Warren Buffett
Value investors use the irrational behavior of people in the stock market to their advantage. They buy pieces of great companies at bargain prices. Then, they wait until the stock goes back up to its true value before selling.
People act emotionally, rather than rationally. This is especially true when it comes to money and investing. Investors often base investing decisions on panic or greed. People also want easy, quick wins. This behavior drives short-term price movements.
When a lot of people buy a stock, the price goes up. When a lot of people sell a stock, the price goes down. The problem is that the decision to buy and sell is based on emotions and a herd mentality.
Here’s how this emotional investing process normally works:
- News – whether positive or negative – comes out about the market, an industry, or company.
- This news can create hype or pessimism, leading to fear or greed.
- Investors make irrational investing decisions as a result.
- They then often lose money or generate low returns.
Value investors ignore the news and hype around particular stocks.
Instead, value investors focus on what they know. They look at the fundamentals of a company. They then buy cheap stocks that others don’t want from companies they trust (assuming that the price of a stock is driven down by fear rather than a fundamental problem with the company).
Great companies with stocks at discount prices normally go up over time, giving you a handsome profit.
You buy great companies at bargain prices.
“Whether we are talking about socks or stocks, I like buying quality merchandise when it is marked down.” – Warren Buffet
As mentioned, value investing involves buying mature, quality companies with strong fundamentals at bargain prices. Value investors sell when prices reverse back to the company’s intrinsic value (or they go up in price).
So what is intrinsic value? Intrinsic value is what a company is actually worth, not what the market says it’s worth. Stock prices can divert significantly from a company’s intrinsic value for a number of reasons.
But value investing assumes that people will eventually realize the value of the company, driving the price up as they buy.
Now, value stocks are typically from boring companies or companies in a temporary crisis (we never said value investing was sexy). But that’s why they’re normally overlooked by investors wanting “shiny” new stocks.
Some value stocks include:
- JPMorgan Chase
- Bank of America Corporation
- Berkshire Hathaway
- Procter & Gamble
- Johnson & Johnson
Here’s how to determine if you should purchase a particular value stock:
Once value investors have calculated intrinsic value, they also have to apply the margin of safety formula:
Margin of safety = 1 – [Current Stock Price] divided by [Intrinsic Stock Price]
The margin of safety is the difference between a company’s stock price and its intrinsic value. You want the stock price to be significantly lower, just in case your intrinsic value calculation is off. This calculation helps investors determine a safe price to buy a stock so they don’t lose more money than necessary.
Warren Buffett explains margin of safety this way: “The more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need.”
Get started with value investing
As Warren Buffett says, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
That’s the core principle behind value investing. It involves a lot of research to select quality companies, but can be worth it over the long run. Here are steps to take to become a value investor:
- Research companies with safe and steady returns.
- Select companies with value stocks that you’re interested in.
- Complete a fundamental analysis.
- Buy stocks if the price is lower than the company’s intrinsic value.
- Ignore the news and hype. Stick to a buy-and-hold strategy.
Did you enjoy this intro to value investing? Learn even more about this strategy when you sign up for the Value Investing Bootcamp: How to Invest Wisely on Udemy. This course helps you learn how to become a successful value investor, step-by-step. Check out the course here.