6 02 2011
By definition, value investing is the process of selecting stocks that trade for less than their intrinsic value. A value investor typically selects stocks with lower than average price-to-book or price-to-earning ratios. Of course, it is not nearly this simple. Value investing is the corner stone of long-term growth. Those who practice it survive the ups and downs of the market and are more likely to emerge wealthy than those who ride the market, in principle, due to the higher quality of the companies falling under the prerequisites of the value investor. Value investing is essentially concerned with getting the most profit at the lowest cost. The basis of value is profit. Value investing is an investment style which favors good stocks at great prices over great stocks at good prices. Value investor extraordinaire Warren Buffett has used this style to become a billionaire.
It’s important to keep in mind that value investing is not concerned with how much the price of a stock has risen or fallen necessarily, but rather what is the “intrinsic” or inherent value of the stock, and is it currently trading below that price, i.e. at a discount to it’s intrinsic value. The important point here is that when looking at stocks that are trading at or above their intrinsic value, the only hope for gaining value is based on future events, since the stock price already represents what the company is worth. However, when dealing with stocks that are undervalued, or available at a discount, unforeseen events are unimportant in that without any new earnings or additional profits, the shares are already “poised” to return to that inherent value which they have.
The question now, of course, is “why would stock prices not always reflect the true value of the company and the intrinsic value of its shares?” In short, value investors believe that share prices are frequently wrong as indicators of the underlying value of the company and its shares. The efficient market theory suggests that share prices always reflect all available information about a company, and value investors refute this with the idea that investment opportunities are created by disagreements between the actual stock prices, and the calculated intrinsic value of those stocks.
Finding Value Stocks
Value investing is based on the answers to two simple questions:
1. What is the actual value of this company?
2. Can its shares be purchased for less than the actual (intrinsic) value?
Clearly, the important point here is, “how is the intrinsic value accurately determined?” An important point is that companies may be undervalued and overvalued regardless of what the overall markets are doing. Every investor should be aware of and prepared for the inherent market volatility, and the simple fact that stock prices will fluctuate, sometimes quite significantly. Benjamin Graham has often said that if investors cannot be prepared to accept a 50% decline in value without becoming riddled with panic, then investing may not be for them…or rather, successful investing, as it often takes significant losses in a particular security before gains are made, due to the idea that value investors do not try to time the market, and are focused on the underlying fundamentals of the companies. Furthermore, the quality of the companies targeted by the value investors’ screening methods should be, over the long term, less volatile and susceptible to market “panic” than the average stock.
This is also a two way road of sorts. On one hand, there is no sense in worrying about depressions, upturns, and recoveries due to the underlying quality of the value investments. On the other hand, investments should only be made in companies which can flourish and do well in any market environment. Doing solid investment research and making equally solid investment decisions will take investors much further than trying to forecast the markets.
How Many Different Stocks?
In terms of diversification, there are many discrepancies over exactly how many different stocks a solid portfolio should be made up of. My personal view is that there should not be as many stock as normally make up a mutual fund. Many will disagree with this, but what it’s worth, I think that owning a portfolio of 100, 200, or even more companies not only serves to limit risk, but it really limits the possibility for reward as well. Also, as Warren Buffett has said many times, the more companies you own, the less you know about each one.
As I write this, there are 42 stocks in our recommended portfolio. This number may very well grow in the coming months, as it may decrease in number, but one thing to keep in mind is, out of the thousands of companies available for purchase, only a very small percentage meet the stringent requirements of the diligent value investor. This is both a blessing and a curse. Very often, there is simply nothing to buy, and this is fine. The trap to avoid falling into is to lower your requirements for a stock when there simply isn’t anything meeting the normal requirements. This is how many an investor has fallen into making poor investment decisions, putting money into companies not really adequate for their respective portfolio, and it will certainly have a long term effect on gains.