Everyone’s heard of Warren Buffet, but fewer people are aware of the term ‘value investing’. Well, the two are synonymous in the world of finance, as value investing is the methodology behind Buffett’s rise to the world’s richest moneymaker.
Granted, Buffett had a pretty solid advantage: when he began his journey from investment salesman to billionaire, people were so terrified of the stock market after the disaster of the Great Depression, nobody else was brave enough to buy. He also had a stockbroker father and was mentored by big Wall Street players such as Benjamin Graham from a young age. But his investing ethos essentially gave life to the term ‘buy low, sell high’, and although a lot has changed since value investing made Warren Buffett a billionaire, the principles remain the same today.
What is value investing?
In plain English, value investing is identifying and purchasing stocks that are trading at a lower value to their true ‘worth’. It’s a long term style of investing, where profits come from the correctly predicted growth of those low-value stocks over time.
Why does value investing work?
Although it’s a simple principle, it’s one that requires a significant amount of background work, strategic thinking, and solid understanding of valuation metrics. In order to identify a profitable stock, we need to understand why a stock might be underperforming, and how likely it is for its fortunes to reverse.
Why might a stock trade lower than its worth?
There can be many reasons a company stock might have a lower-than-expected buy-in price. The most common is recent disappointments in earnings or profit. As we know, the market is largely driven by sentiment (namely greed and fear), and an unexpected loss report can send a stock price tumbling.
A value investor will look at a stock that’s taken a hit, analyse why this might have happened, and make a decision as to whether it’s a short term setback, or long term bad news. If it’s the former, a value investor might decide to invest in that stock.
One of the underlying theories behind this style of investing is that companies and their stock prices generally recover. Anyone who’s spent at least a few months on a trading app will likely be aware of this. When your portfolio takes a hit, and you’ve missed the ideal getting-out point, the most sensible thing to do is often to wait. This perspective is based on confidence and security in the mind of the value investor, who calmly waits and eventually profits, while more reactive and emotional traders panic and sell at a loss.
What is Warren Buffett's investment strategy?
To this day, Buffett’s investment strategy is inherently derived from his mentor, Benjamin Graham. It focuses on finding securities whose intrinsic worth is greater than their price suggests. Buffett has established several core tenets in selecting undervalued company stocks to invest in:
A clear business philosophy and identifiable practices are essential for drawing Buffett’s investment. He is known for avoiding tech stocks, including unproven dot-com bubble stocks, saving him significant losses when the bubble burst in the early 2000s.
Buffett favours companies that pay dividends over those that don’t. His philosophy is that those who pay dividends are more confident and more conscientious, as opposed to companies who pocket the profits for themselves. He also takes into account a company’s transparency, and innovation in their approach.
Buffett uses the EVA (economic value added) calculation in order to estimate a company’s profits outside of the shareholders’ stakes. Many traditional value investors also use the ‘fundamental rule of thumb’ screen which combines the P/E ratio (the stock price divided by the earnings per share), dividend yield, and adjusted return on equity.
How to identify value stocks
There are a few things that value stocks with good potential often have in common. These include a high dividend yield, a low P/B (price to book) ratio, and a low P/E (price to earnings) ratio. The latter is a good place to start, as it tells you how much over its actual value it’s trading.
These core evaluative measures are a little too broad to cover here, and understanding them will take time, but tutorials can easily be found online and via YouTube. Many trading platforms will also show you a company’s P/E to save you doing the calculation yourself.
This fundamental knowledge will set you on course to trade strategically, as opposed to on a tip-off or a hunch.
Think of value stocks as the opposite of growth stocks. The ultimate way to pursue a course of value investing is to focus on the good old-fashioned company fundamentals, learn your ratios, and harness the power of compound interest for long term investments rather than quicker, riskier turnarounds.